The debate rages over whether or not the U.S. economy is in or heading into a recession. As I have said in a previous post, as long as growth is slowing it will feel like a recession. However, the recession may be felt more on Wall Street than on Main Street.
Think about who is being most negatively affected. Not much has changed on Main Street. Job Growth has slowed, but has not begun to shrink (we are below the replacement rate). Most of the pain is being felt by Wall Street firms which believed formulas could be trusted to manage risk with out intensive oversight and risk management. Fire and forget may work with guided missiles, but not with misguided strategies.
Some pundits insist that Main Street is feeling the pain in the form of falling home prices. Though this may be true when viewed from the peak of the market. Most markets exhibit higher prices than at the beginning of the housing bubble. Those who are hoping that the Fed eases sufficiently to reinflate the bubble are either irresponsible or stupid.
My confidence in the economy is such that I thin that the 2/1 Nonfarm Payrolls report will indicate that the economy has added 90k+ jobs.
My opinion that the Fed is fostering some inflation pressures (may be necessarily) that I believe that we will see a 10-year treasury yield of over 4.50% and a 30-year gov't bond yield of at least 5,00% by year end.
Tis bind market screams for a barbell using CDs or agenices on the short end and corporate bonds and preferreds on the long end.
Thursday, January 31, 2008
Wednesday, January 30, 2008
Cry Baby Cry, Make The Fed Sigh
Like a bad parent of a spoiled child the Fed eased another 50 basis points. I want to be clear, we are not insinuating that the Fed is wrong to ease. The Fed has better access to data than I and the FOMC members are much brighter than I. However, I have two concerns.
1) The Fed's prior 175 basis points of easing have yet to work their way through the economy. Conventional wisdom states that it takes at least six months for Fed easing (or tightening) to work through the economy.
2) Like a spoiled child, the market may now believe that all it needs to do is "panic" and the Fed will ease.
Of the two concerns, it is the second that worries me the most. If the Fed eased too much, it can always tighten. However, weaning the markets off of the Fed's tit could be very difficult and make spark an almost violent response from the markets when the Fed eventually pauses.
The problem may not be that the Fed eased, but why it eased or at least the perception of why it eased. The Fed could have its work cut out for itself. It may be creating a moral hazard for nothing. Yes, GDP was a paltry 0.6%, but other data suggests that we may be at or near the bottom of the current economic crisis. Durable Goods was strong. Jobless Claims have been low. The ADP Employment report was very strong, pointing to a stronger Nonfarm Payrolls report on Friday. Core inflation perists.
This harkens back to the 1970s when the Fed would risk inflation in the attempt to not hamper growth. What it got was much inflation and not much growth. It took Paul Volcker's aggressive tightening to finally subdue inflation and sent us on a two decade journey to manageable inetrest rates (rate which were common before the disasterous "Great Society" era. Hopefully we are not seeing the pilot of "That 70s Fed".
1) The Fed's prior 175 basis points of easing have yet to work their way through the economy. Conventional wisdom states that it takes at least six months for Fed easing (or tightening) to work through the economy.
2) Like a spoiled child, the market may now believe that all it needs to do is "panic" and the Fed will ease.
Of the two concerns, it is the second that worries me the most. If the Fed eased too much, it can always tighten. However, weaning the markets off of the Fed's tit could be very difficult and make spark an almost violent response from the markets when the Fed eventually pauses.
The problem may not be that the Fed eased, but why it eased or at least the perception of why it eased. The Fed could have its work cut out for itself. It may be creating a moral hazard for nothing. Yes, GDP was a paltry 0.6%, but other data suggests that we may be at or near the bottom of the current economic crisis. Durable Goods was strong. Jobless Claims have been low. The ADP Employment report was very strong, pointing to a stronger Nonfarm Payrolls report on Friday. Core inflation perists.
This harkens back to the 1970s when the Fed would risk inflation in the attempt to not hamper growth. What it got was much inflation and not much growth. It took Paul Volcker's aggressive tightening to finally subdue inflation and sent us on a two decade journey to manageable inetrest rates (rate which were common before the disasterous "Great Society" era. Hopefully we are not seeing the pilot of "That 70s Fed".
Monday, January 28, 2008
I'm Bad. I'm Countrywide
The Wall Street Journal published an article today discussing invstors' concerns that Bank of America may not back Countrywide bonds as they do there own when and if the deal closes in the third quarter of 2008. To those concerns I say, duh!!!
Investors should never assume that an acquiring company will guarantee the debt of what is now a new subsidiary or business unit. It is not uncommon for different units of a conglomerate to be responsible for their own debt without cross default protection with the parent or other divisions. This is how most utilties are arranged. The local operating subsidiary issues bonds and is only responsible for its own bonds. It does not back the parent's or other subs' bonds. Also, the parent is only responsible for its own bonds.
Here is a shocker for some of you. Bonds issued by local operating subs are, in most cases, more secure than those issued by the parents. Local operating subs of utioities actually generate cashflow and own the equipment. Utility parents are merely shells which earn money from internal dividends paid to the parent by the operating subs. The subs pay their own exenses before giving a dime to the parent.
Similar situations exist on financials. Ford does not guarantee Ford Motor Credit bonds and vice versa. GM and GMAC had a similar arrangement before the 51% sale to Cerberus. The situation between GMAC and Rescap does not involve any cross default protections. If Rescap's situation worsens, GMAC is not responsible for Rescap bonds.
I say all of this not to frighten CFC bondholders, but to manage their expectations. CFC will be in much better shape when the deal with BAC closes. CFC bonds will be more secure. However, though more secure, they may not be obligations of BAC. Investors should decide for themselves if they need BAC to guarantee CFC bonds and preferreds or is an improved CFC provides enough comfort for their needs.
Investors should never assume that an acquiring company will guarantee the debt of what is now a new subsidiary or business unit. It is not uncommon for different units of a conglomerate to be responsible for their own debt without cross default protection with the parent or other divisions. This is how most utilties are arranged. The local operating subsidiary issues bonds and is only responsible for its own bonds. It does not back the parent's or other subs' bonds. Also, the parent is only responsible for its own bonds.
Here is a shocker for some of you. Bonds issued by local operating subs are, in most cases, more secure than those issued by the parents. Local operating subs of utioities actually generate cashflow and own the equipment. Utility parents are merely shells which earn money from internal dividends paid to the parent by the operating subs. The subs pay their own exenses before giving a dime to the parent.
Similar situations exist on financials. Ford does not guarantee Ford Motor Credit bonds and vice versa. GM and GMAC had a similar arrangement before the 51% sale to Cerberus. The situation between GMAC and Rescap does not involve any cross default protections. If Rescap's situation worsens, GMAC is not responsible for Rescap bonds.
I say all of this not to frighten CFC bondholders, but to manage their expectations. CFC will be in much better shape when the deal with BAC closes. CFC bonds will be more secure. However, though more secure, they may not be obligations of BAC. Investors should decide for themselves if they need BAC to guarantee CFC bonds and preferreds or is an improved CFC provides enough comfort for their needs.
Friday, January 25, 2008
Floaters Sink Rising Hopes
In the course of my business, I speak with many financial advisers. By and large they are responsible people who try to to what is best for their clients. However, when it comes to product knowledged and knowledge of the capital markets, some are not much more knowledgeable than the clients they advise.
One of the most misunderstood products is the floating rate bond. Simply stated, a floating rate bond has a coupn which adjusts, or floats, off a a benchmark. Benchmarks can include LIBOR the Constant Maturity Treasury or a measure of inflation. Investors and financial advisers like these bonds because they believe (assume) that a floating coupon will result in a bond trading at or nea par regardless of market condtions. Nothing could be further from the truth.
In theory, if a bond's coupon would be linked to a benchmark which had a similar maturity as the bond itself, the bond could trade in a fairly narrow range. This would be more true of an interest rate product such as a government bond. All other bonds are credit products and are influenced by changes to the issuers perceived creditworthiness. This is expressed by the credit spread (the number of basis points above a similar U.S. treaury investors will receive in terms of yield for taking on the credit risk of a corporate bond or agency. Widening credit spreads could cause prices to fall (or at least not rise when treasury prices are rising) or vice versa.
Another factor comes into play. This is optionality. All adjustable and optional features are there to benefit the issuer, not the investor. It is common to see a long-term floating rate security adjust is coupon versus a short-term benchmark. When yield curves are steep, credit spreads aside, prices of floaters could be at significant discounts. Why? If a bond spreads ist coupon 100 basis points over 3-month LIBOR and thre month LIBOR is at 4.50%. The bond will have a coupon of 5.50%. However, let's say the bond matures in 30 years and thirty year bonds from that issuer are trading at 7.00%. The floating rate bond would have to trade at a similar yield.
Many of you may be saying: "When the yield curve is flat, floaters can trade at par or even a premium. This is true, but the upside is usually limited by a call feature. The possibility of an issue being called limits its upside. Since the downside potential is greater than the upside potential, callable bonds are said to be negatively convexed.
How are these features more beneficial to the issuer than to the investors? An issuer issues a floater because it believes that it will pay a lower average coupon than if it comes with a fixed rate for that maturity. What if it is wrong? Here is where the call feature comes into play.
At the time a bond becomes callable, if the issuer can refinance the bond at a lower rate, it will call the bond. If it can't, the bond will remain outstanding. The lesson here is that bond option features are there to benefit the issuer.
Investors looking for income and less volatility should consider high-coupon / short-duration high-quality bonds. Duration should not be confused with maturity. Simply stated, duration is the weighted average life of a bonds cashflows (higher the coupon, lower duration). This is a simple explanation of duration. There are several other measures of duration, but that is a discussion for another day.
One of the most misunderstood products is the floating rate bond. Simply stated, a floating rate bond has a coupn which adjusts, or floats, off a a benchmark. Benchmarks can include LIBOR the Constant Maturity Treasury or a measure of inflation. Investors and financial advisers like these bonds because they believe (assume) that a floating coupon will result in a bond trading at or nea par regardless of market condtions. Nothing could be further from the truth.
In theory, if a bond's coupon would be linked to a benchmark which had a similar maturity as the bond itself, the bond could trade in a fairly narrow range. This would be more true of an interest rate product such as a government bond. All other bonds are credit products and are influenced by changes to the issuers perceived creditworthiness. This is expressed by the credit spread (the number of basis points above a similar U.S. treaury investors will receive in terms of yield for taking on the credit risk of a corporate bond or agency. Widening credit spreads could cause prices to fall (or at least not rise when treasury prices are rising) or vice versa.
Another factor comes into play. This is optionality. All adjustable and optional features are there to benefit the issuer, not the investor. It is common to see a long-term floating rate security adjust is coupon versus a short-term benchmark. When yield curves are steep, credit spreads aside, prices of floaters could be at significant discounts. Why? If a bond spreads ist coupon 100 basis points over 3-month LIBOR and thre month LIBOR is at 4.50%. The bond will have a coupon of 5.50%. However, let's say the bond matures in 30 years and thirty year bonds from that issuer are trading at 7.00%. The floating rate bond would have to trade at a similar yield.
Many of you may be saying: "When the yield curve is flat, floaters can trade at par or even a premium. This is true, but the upside is usually limited by a call feature. The possibility of an issue being called limits its upside. Since the downside potential is greater than the upside potential, callable bonds are said to be negatively convexed.
How are these features more beneficial to the issuer than to the investors? An issuer issues a floater because it believes that it will pay a lower average coupon than if it comes with a fixed rate for that maturity. What if it is wrong? Here is where the call feature comes into play.
At the time a bond becomes callable, if the issuer can refinance the bond at a lower rate, it will call the bond. If it can't, the bond will remain outstanding. The lesson here is that bond option features are there to benefit the issuer.
Investors looking for income and less volatility should consider high-coupon / short-duration high-quality bonds. Duration should not be confused with maturity. Simply stated, duration is the weighted average life of a bonds cashflows (higher the coupon, lower duration). This is a simple explanation of duration. There are several other measures of duration, but that is a discussion for another day.
Wednesday, January 23, 2008
Power of the Press
In a classic episode of great minds think alike, the Wall Street Journal's editorial pages contained several op/ed pieces (including one form the Journal itself) warning of the dangers which could arise from overly accommodative Fed policy and the potential for the creation of a moral hazard.
Sadly, other than the Journal, this space and an excellent blog published by Bondguy1824, few pundits have expressed concern abount the Fed's 75 basis point ease and its apparent commitent to keep cutting rates.
Here are some facts of life biys and girls. Everything in life entails some degree of risk. Buy a stock or a bond, you take on risk. Lend money, you take on risk. Drive a car, you take on risk.
Though one cannot eliminate risk, one can take steps to manage and minimize it. However, if the Fed, the government or your Aunt Tilly bails you out every time you make poor decisions, what is your incentive to behave in a more prudent fashion?
While the Fed is bailing out foolish or irresponsible investors and banks, it risks of further depressing the U.S. dollar and causing increased inflation pressures. I for one have been spoiled by Paul Volcker and Alan Greenspan. Their monetary policies have, for the most part, been so successful, I never thought we would see a return to the thrilling days of yesteryear.
Your assignment is to read up on the economy of the 1970s and how the Fed and the government responded to higher energy prices and episodes of slower growth. Then, think carefully the next time you want a Fed or government bailout.
Sadly, other than the Journal, this space and an excellent blog published by Bondguy1824, few pundits have expressed concern abount the Fed's 75 basis point ease and its apparent commitent to keep cutting rates.
Here are some facts of life biys and girls. Everything in life entails some degree of risk. Buy a stock or a bond, you take on risk. Lend money, you take on risk. Drive a car, you take on risk.
Though one cannot eliminate risk, one can take steps to manage and minimize it. However, if the Fed, the government or your Aunt Tilly bails you out every time you make poor decisions, what is your incentive to behave in a more prudent fashion?
While the Fed is bailing out foolish or irresponsible investors and banks, it risks of further depressing the U.S. dollar and causing increased inflation pressures. I for one have been spoiled by Paul Volcker and Alan Greenspan. Their monetary policies have, for the most part, been so successful, I never thought we would see a return to the thrilling days of yesteryear.
Your assignment is to read up on the economy of the 1970s and how the Fed and the government responded to higher energy prices and episodes of slower growth. Then, think carefully the next time you want a Fed or government bailout.
Tuesday, January 22, 2008
The Duke of Hazard
Ben Bernanke, hearing the cries of powerful investors during an election year, cut both the Fed Funds rate and the Discount rate 75 basis points. Apparently, if investors want the Fed to bail them out, they only need throw a tantrum. It is bad for parents to give into spoiled children. It is equally bad for the Fed to give into spoiled investors.
Here are the plain facts. 1) The Fed created an asset bubble by lowering rates too far, keeping them too low for too long and raising them too slowly.
2) Markets which are permitted to function properly subscribe to Einstein's Theory. For every action there is an equal and opposite reaction. If we have a period of easy money driving home prices and growth to outrageous levels, there must be a corresponding correction.
Investors don't want that to happen. They want a one way street of ever higher asset prices with no correction and they expect the Fed to give it to them. If the Fed continues to act accordingly, we will have the much feared stagflation.
Remember how we had stagflation in the 1970s. The Fed would not take steps to combat inflation because it did not want to hamper growth. What happened was that inflation kept trending higher and growth slowed anyway because no one could afford anything. Paul Volcker came in and, counterintuitively, raised rates during a period of slow growth. Once he broke the back of inflation, interest rates came down and economic growth began a trend of a robust, but sustainable pace.
Traders an investors should not only be rewarded when they take risk and bet right, the also need to be allowed to take their lumps when they bet wrong or get in over their heads. This helps to maintain orderly markets over the long run. Bailing out investors and traders when they get into trouble only encourages bad behavior and makes future similar market disruptions more likely and, possibly, more severe. This is the infamous moral hazard.
Here are the plain facts. 1) The Fed created an asset bubble by lowering rates too far, keeping them too low for too long and raising them too slowly.
2) Markets which are permitted to function properly subscribe to Einstein's Theory. For every action there is an equal and opposite reaction. If we have a period of easy money driving home prices and growth to outrageous levels, there must be a corresponding correction.
Investors don't want that to happen. They want a one way street of ever higher asset prices with no correction and they expect the Fed to give it to them. If the Fed continues to act accordingly, we will have the much feared stagflation.
Remember how we had stagflation in the 1970s. The Fed would not take steps to combat inflation because it did not want to hamper growth. What happened was that inflation kept trending higher and growth slowed anyway because no one could afford anything. Paul Volcker came in and, counterintuitively, raised rates during a period of slow growth. Once he broke the back of inflation, interest rates came down and economic growth began a trend of a robust, but sustainable pace.
Traders an investors should not only be rewarded when they take risk and bet right, the also need to be allowed to take their lumps when they bet wrong or get in over their heads. This helps to maintain orderly markets over the long run. Bailing out investors and traders when they get into trouble only encourages bad behavior and makes future similar market disruptions more likely and, possibly, more severe. This is the infamous moral hazard.
Monday, January 21, 2008
Dazed and Confused
Listening to the talking heads and the gibberish coming from Capital Hill has me concerned about the future of the U.S. The talking heads preach doom and gloom and the boys and girls in DC believe that a one time (small) tax rebate will fix what three years of poor monetary policy has done to the economy.
Noticeably absent from media criticsm have been borrowers. No one blames the borrowers. Granted, some borrowers were duped by unscrupulous or incompetent mortage brokers, but come on people. A home is the biggest purchase a person is likely to make. It is usually one's primary means of shelter. Doesnt it make sense that one would be certain they can afford the hoem they are purchasing.
Fair criticsim can be heaped upon the Fed and the banks and Wall Street and the Bush administration, but what about borrowers?
The call is for a Fed bailout. Well, unfortunately, borrowers, lenders and investors who made poor decisions will receive Fed assistance. The Fed will risk creating a moral hazard with borrowers in order to avoid turmoil in the banking system (it does not want a repeat of the 1930s).
With LIBOR back at normal spreads versus T-bills and Fed Funds, why is the Fed concerned about liquidity? Because the big banks and brokers are whispering dire warnings in its ear. It would be irresponsible for the big financial institutions to exaggerate their problems.
We do not think the large banks and brokers are exaggerating. This means that their exposure to subprime is larger than most could have imagined this time last year. In the future we will have an explanation of CDOs and why "AAA" vehicles are now nuclear waste.
Noticeably absent from media criticsm have been borrowers. No one blames the borrowers. Granted, some borrowers were duped by unscrupulous or incompetent mortage brokers, but come on people. A home is the biggest purchase a person is likely to make. It is usually one's primary means of shelter. Doesnt it make sense that one would be certain they can afford the hoem they are purchasing.
Fair criticsim can be heaped upon the Fed and the banks and Wall Street and the Bush administration, but what about borrowers?
The call is for a Fed bailout. Well, unfortunately, borrowers, lenders and investors who made poor decisions will receive Fed assistance. The Fed will risk creating a moral hazard with borrowers in order to avoid turmoil in the banking system (it does not want a repeat of the 1930s).
With LIBOR back at normal spreads versus T-bills and Fed Funds, why is the Fed concerned about liquidity? Because the big banks and brokers are whispering dire warnings in its ear. It would be irresponsible for the big financial institutions to exaggerate their problems.
We do not think the large banks and brokers are exaggerating. This means that their exposure to subprime is larger than most could have imagined this time last year. In the future we will have an explanation of CDOs and why "AAA" vehicles are now nuclear waste.
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