Got To Keep The Loonies On The Path

Recent news stories are enlightening me to a painful fact. Most people no nothing about finance. I am not talking about high finance engineered in boardrooms around the globe, but personal finance. Recently, we saw how investors (and some advisers) confused the word auction with maturity. Ignorance also exists on the financing side of personal finance. It turns out, many people do not understand how their financing vehicle of choice works. Many people have no idea how lending rates are set. While the detailed story is beyond the scope of a daily blog, we will attempt to she some light on the subject.

An article on the front page of today's Wall Street Journal discusses declining home prices. One person interviewed by the Journal was disappointed because he could not refinance his adjustable-rate mortgage into a fixed-rate mortgage and thought that the lower Fed Fund rates would cause fixed rate mortgage rates to drop.

What this and many other borrowers do not understand is that the Fed does not directly influence long-term interest rates. Long-term interest rates are mostly influenced by inflation data and expectations. This is evidenced by the steep U.S. treasury yield curve. Higher inflation is preventing long-term financing rates from falling further.

Another factor preventing the refinancing of adjustable-rate mortgages is that banks have more stringent lending standards. It is more difficult to qualify for a mortgage and those who can qualify are paying a higher spread over treasuries than in the past. This is not unexpected as banks are attempting to better quantify credit risk.

One has to ask the question: Didn't borrowers realize that adjustable-rate mortgages adjust? Most did, but believed (or were duped into believing) that if rates went up, they could refinance in to a low-rate fixed-rate mortgage. Few were concerned with home prices as they always go up, no? Why someone would gamble with their home is beyond me. Never risk the roof over your head. Buy a home you can afford with a fixed-rate mortgage and be happy.

Some politicians are voicing opinions about how to bail out homeowners and preventing home prices from trending even lower. Unfortunately, failure to let prices adjust to the forces of supply and demand (there is much more supply than demand) will only deepen and prolong the pain. This is making people loony.

Deep Black and Blue

Today, the financial press was rife with stories about more subprime related writedowns. Now Variable Interest Entities (VIEs) threaten to add to the pain. Look for more writedowns and possible bank and broker restructuring.

In my posting entitled "Ain't That A Shame. You're The One To Blame " I pasted financial advisers for not understanding auction-rate securities. Now PIMCO's Bill Gross is jumping on the personal responsibility bandwagon. He calls ARS "Old-maid cards foisted upon investors"

Brokers I have spoken with defend their decisions to use ARS as short-term investors because, as some claim, firms have stated they would support auctions or, they were led to believe successful auctions were guaranteed.

I have the opportunity to become a broker. My concern is that I am not a good asset-gatherer as investors like the slick sales type, not the knowledgeable analytic type who will tell it like it is.

Here is a message to investors. If you are disappointed with your broker, look in the mirror to see the one to blame.

Lies, Lies, I Can't Believe A Word You Say

An article in today's Wall Street Journal reports that, in an attempt to win voters in Ohio, is spouting future policy which would include preventing or delaying foreclosures and freezing the interest rates of adjustable-rate mortgages. This played well with Mrs. Clinton's working class audience, but is it legal to alter the terms of mortgages by presidential or even congressional fiat?

The average person must be thinking: Banks are regulated by the Fed and are influenced by the Treasury, force policy upon the banks. The problem is that, in moist cases, the banks are not the lender of record, they are merely the servicers. The lenders are investors who own mortgage-backed securities. In order to change the terms of mortgages, investors need to approve. Binds are legally-binding agreements. Wouldn't it be to investors advantage to permit changes which would avert defaults? Maybe, but it is their decisions to make.

Think that most of the investors are independently wealthy? Guess again. Many MBS investors are surprisingly middle class. In fact, many funds found in 401Ks own MBS. How would you like the government changing the terms of your investments?

The bottom line is that all the talk of changing mortgage terms for borrowers who made poor decisions is a load of election year crap. The only mortgages which may be changed are ones where fraud can be proved and then the loans in question will probably be refinanced at the expense of the original lender or mortgage broker with investors receiving their principal.

Little GTO

The investor community is up in arms that Wall Street firms are not supporting auctions (never mind that regulators are poised to investigate firms for bid rigging and supporting auctions which would have failed if not for firm support, unbeknownst to many investors).

It appears as though ARS was marketed with a kind of guaranteed takeout or GTO. ARS marketers allegedly reassures brokers and investors that if auctions did not receive sufficient interest to be successful, the firm running conducting the auction would step in with its own capital to ensure a successful auction. Up until now, this was true in the vast majority of potentially troubled auctions. However, just because it is true, doesn't make it right.

Much of my background comes from the trading side of the business. One of the first things one is taught is, as a seller, to never offer a guaranteed takeout to a buyer. In other words, don't sell a bond to someone with the promise that you will buy it back at a predetermined price. For one thing, do to so is an NASD violation and market conditions may change to where this promise is impossible to keep. , what is taboo (and illegal) in the cash bond market was de rigeur in the ARS market.

The questions now become: What happens first? Do investors launch lawsuits against Wall Street firms or do regulators (and attorneys general) begin fining Wall Street firms. Both could be on the horizon.

Also, think the ARS markets are coming back soon? Guess again. Muni issuers are just as upset about failed auctions (double digit interest rates will do that). They will more likely tap the conventional bond market. Another "enhanced" product bites the dust.

Ain't That A Shame. You're The One To Blame

The recent debacle in the auction-rate securities market has resulted in much finger pointing. Investors are pointing their fingers at brokers. Brokers are pointing finegrs at marketers. Marketers are pointing their fingers at traders. They all should be pointing fingers at themselves.

Why? Let's discuss. Investors ae upset because they were, (allegedly) told by brokers that auction rate securities can be liquidated on the auction date. Brokers are upset becasue marketers told them the same thing, plus, that auctions at our firm (insert name here) never fail. Marketers are upset claiming that they were only doing their jobs marketing the product and were merely stating past performance. Blame can be spread around here.

1) If you are an investor, didn't you wonder what the actual maturity of your security was? Were you told that auctions always go off? If so, you were either lied to or were given information by someone who was lied to. Your liquidity was dependent on other investors willing to buy your ARS. This is just like any other security.

2) If you are a financial advisor, shame on you (unless you were lied to). Did you ask about the final maturity, failed auctions etc.? The prospectus definitely discussed this.

3) If you are a marketer of ARS and did not disclose the possibility of auction failures with brokers, you were negligent and irresponsible. I don't care what you were told to say or what you thought you should say. Brokers and clients should have been warned that acutions can and do fail, albeit rarely. You could have mentioned penalty rates to which investors are entitled, but the possibility of failed auctions should have been discussed.

Although I wil not cut brokers too much slack (the have a responsibility to their clients)., I will come down the hardest on sales and marketing people. Too many do not know what they are selling. They read a script and push whatever they are told to push. Sorry, I was only following orders did not cut it at Nuremburg and it doesn't cut it here.

I have been told by brokers that when some brokers and managers called prior to auction failures asking if ARS were really long-term securities in disguise, many were actually yelled at for merely askimg the question.

The truth is that ARS are in fact perpetual securities which can, in most cases, be used as a money market substitute. Investors are paid higher yields for incurring the risk of failed auctions. Investors are also rewarded for failed auctions by receiving a higher "penalty rate". Some penalty rates are sufficently high that the issuer is motivated to retire this paper. Othes do not have a terribly high penalty rate. This means that these securities could be around for a while. At least until a successful auction.

If you need a money market, inevest in a money market. There is no such thing as a free lunch or free yield.

Think For Yourself

Part of my duties is to write an Internal Use Only market commentary. Today I decided to discuss the Auction Rate Secuirties debacle. Some were not thrilled with what I had to say.

Today I had the audacity to tell brokers that if they believed that perpetual securities which rely on successful auctions to provide liquidity were true money markets, they were mistaken. I had one broker tell me that the ARS department marketed ARS to brokers as money markets and they appear on clienst statements and firm planning software as money markets. As far as they and their clients were concerned, ARS were money markets. The fact that these instruments had no maturity, they had auctions. One only needed to liquidate at the auctions (frequency depends on the issue) and one received his or her cash. But, what would happen when auctions fail. As Bondguy 1824 mentioned in his blog, auctions have failed in the past (albeit not on such a large scale). Nothing is certain except a stated maturity date. This is where the problems lie.

Investors who hold ARS with failed auctions usually receive interest payments which are much higher than the advertised rate. In the case of ARS issued by the Port Authority of NY and NJ, the coupon jumped from 4.20% to 20%. Who wouldn't like that? Someone who needed to cash out.

Apparently brokers and clients all over Wall Street, instead of using ARS as money market alternatives (exchanging potentially less liquidity for enhanced yield), they used them as they woud use a CD or Treasury Bill.

Claims by brokers that ARSwere market as a riskless liquid way to enhance return rings hollow with me. If one is receiving higher return, one is probably incurring some kind of increases risk. There are no free lunches. I have no way of verifying how ARS was marketed to brokers and clients. I do not work in that capacity, but it appears to be the most recent case of the ignorant leading the ignorant leading the ignorant. Watch the lawsuits fly.


Let this be a lesson to all brokers, investment advisers etc. You (yes you) must know your clients and your products.

I Can't Believe It's Not Butter

Short-term investors are finding out that you can't always get what you want. In recent days, the auction rate securities auction has seen many failed auctions. Though it is not our market, we have received enough questions regarding auction-rate preferreds that we will touch on the subject. Besides, this is a problem which could portend another credit crunch which would affect our markets as well.

During the past few days, there have been many failed autcions. There were 100 failed auctions just yesterday, according to the Wall Street Journal. Many of the failed auctions were for funds exposed to student loans. Investors do not wish to be exposed to securities backed by risky assets. This does not mean that these auction rates securities will default, but getting out of them could be challenging. This goes back to point that a money market aletrnative is not a money market. Is margerine, butter? Is aspartame, sugar? Of course not. Though the can often be viable subsitutes, they are still substitutes. We are not saying that investirs should stay away from auction securities. Only that, as with all investments (including funds and managed vehicles) both FAs and clients should know what they are getting themselves into.

What does renewed credit crunch mean for short-term rates and Fed policy? Another round of liquidity difficulties increase the likelihood of further Fed easing. There could also be another disconnect between short-term borrowing rates (Fed Funds effective rate and U.S. dollare LIBOR) and the actual Fd Funds rate and T-Bills. Further Fed easing also increase the possibility of inflation, or at least decrease the possibility of deflation. Therefore, long-term treasury yields could trend higher this year, even as short-term rates are forced lower by Fed policy.

What about credit spreads? Renewed liquidty concernds could spark another round spread widening, especially among the financials. However, if the Fed is successful, the financial sector could experience the greates amount of spread tigtening during a recovery. With credit spreads in the financial sector at or near record wides, we believe they offer value for investors who can tolerate headline risk. We do not see much value in buying long-term treasuries at this time. Actually, we do not see much value in buying very short-term treasuries either. Agencies, corporates, preferreds and certian bank products offer the best values in taxable fixed income.

Investors may also consider insured munis which have strong underlying credit ratings. There have been occassions in which insured munis were trading with higher yields than their uninsured brethren as some investors pre-emptively sold their insured positions.

Knock, Knock Loan Shark

The price of the 30-year government bond tumbled yesterday after billionaire investor Warren Buffet offered to reinsure municipal bonds insured by MBIA, Ambac and FGIC for a princely sum of 1.5 times the premium the insurers receive from issuers to insure already highly-rated municpal bonds. I would like that deal too if I were Mr. Buffett. One and a half times the normal premium to insure bonds that have as much chance of defaulting as I do of becoming the King of England. Mr. Buffet specifically stated that he (Berkshire Hathaway) will not reinsure CDOs. This probably means more writedowns for banks and brokers. This should not be surprising to my readers.

The monoline bond insurers have rebuffed Mr.Buffets offer. Interim Ambac CEO Michael Callen stated:

"Ambac feels that acceptance of the Buffett offer would show a sign of absolute desperation for a financial-guaranty company"

The Wall Street Journal reports that MBIA and FGIC offered no response to calls seeking comment.

Fitch Managing Director Thomas Abruzzo comented:

"As far as we see it, it doesn't address their problems."It's going to cost them a significant penny, money out the door, and net-net, the benefit of the offsetting reduction in risk may not help the companies at all."

Clients concerned about their municipal bonds there is a lesson to be learned here. Warren Buffett is willing to take on the risk of reinsuring municpal bonds because he knows there is very little risk in doing so. Why is he asking such an exorbatent price to guarantee municipla bonds? First, there are the costs associated with engineering such a scheme (legal fees etc.). Secondly, this is a free market. Suply and demand rules. Mr. Buffett is asking the what he thinks is worthwhile compensation for undertaking such a plan (he is also asking what he thinks he can get). This is all fine and dandy, but it is a bit odd coming from someone who preaches a modified form of socialism. Could this be a case of a double standard?


The Wall Street Journal's Ahead Of the Tape column discusses how it may be the auditors which force firms to accurately price their opaque securities (when possible). The Journal reports that it was AIG's auditor, Pricewaterhouse Coopers, which forced the insurer to "properly" value its exposure to subprime mortgages.

If auditors take a hard stance on accurately reporting subprime exposure, more writedowns could follow. We believe that no auditor wants a repeat of Arthur Andersen / Enron. This could be compounded if financial institutions are forced to place more SIVs and CDOs on their books.

Credit Problems Come Creeping Like A Nun

Today we are hearing that other shoes may drop on the large banks and finance companies. This time the culprits are leveraged loans and the CLOs created from them. Simply put, levraged loans are loans given to private equity firms by banks to finance leveraged buyouts. Most equity investors shriek with delight when their shares are the beneficiaries of a leveragd buyout. Typically, private equity firms take a relatively weak company private and pay up for outstanding shares. Bondholders typically loathe LBOs because outstanding bonds are subordinate to bank l0ans (some day we will discuss capital structure) and, with more debt heaped upon balance sheets, LBO companies are that much less secure. How much less secure? No one truly knows for sure because, as private companies, they are no longer to report earnings an usually do not pay ratings agencies too assign credit ratings.

During the salad days of easy money and record low defaults, investors scooped up new debt issuance or CLOs created from LBO loans. A CLO is similar do a CDO except that they are secured by leveraged loans. As with CDOs, CLOs are broken up into tranches from super senior to equity tranches. As with CDOs, CLO tranches which are AAA are rated as such, notbecuase the collateral is of high qulaity, but rather because there is much collateral and the AAA-rated tranches have a senior claim on assets and cashflows.

Which banks are exposed to CLOs? The same ones exposed to CDOs. Expect billions more in writedowns, though not as much as with subprime CDOs. The pain is not over for financial institutions. There is still likely to be fallout from a weakening cmomemrcial mortgage sector. If the economy slows, it is unlikely that the commercial mortgage sector will escape unscathed.


One has to wonder what money markets, pension funds, municipal investment pools and professional money managers are still loaded with this garbage and are unwilling or unable to unload it due to poor bid prices or lack of buyers.

That is the bad news. The good news is that it is unlikely that any of the big banks will default (though one namless big bank is doing its best to cause angst among investors and employees). Oversight and controls were very lax. It is likely that they will become much more careful managing risk.

Todays announcment by insurance firm AIG that its accounting accurate has many on Wall Street fearing more skeletons in closets of Wall Street. We would be willing to bet that more pain, mergers and restructuring is coming to banks, brokers and insurers. In spite of all this, credit spreads make bonds issued by larger firms compelling, if one is willing to ride out the volatility. I would choose large troubled banks over homebuilders for a speculative play. Homebuilders will continue to tred lower. I would expect more homebuilders, including another large builder, to join Technical Olympic and a myriad of smaller builders into bankruptcy.

Decouple My A$$

Much has been made by the supposed decopuling of the U.S. economy from those of our traditional trading partners. This (as Yul Brynner said in "The King and I") is a puzzlement. Our trading partners are, by and large, export driven. To where do they export? To the U.S.! If our economy slows and we aren't buying, they aren't selling.

The whining has already started ahead of this weekends G7 meeting. The Europeans and Canadians are already whining about the weak U.S. dollar's impact on their economies. That is right, they ae upset that their currencies are too strong versus the dollar.



Some blame the Chinese for keeping the dollar weak. Although it is true that China is a big reason why long-term interestrates are not higher in the U.S. (China buys long-dated treasuries). Who can blame China? The Chinese do not want the yuan to appreciate too much versus the dollar to keep their exports competitive. China will do what is right for China.



This is driving other countries (or blocs) insane. Relatively-low U.S. rates makes investing in dollars unattractive. No foreign exchange into dollars keeps the dollar weak. A weak dollar makes most foreign imports to the U.S. more expensive and it amkes U.S. exports more competitive.



Please understand that I do not advocate a weak dollar. A weak dollar is negative in other ways (energy inflation etc.) but has been inetresting to see central bankers from economies which thought they had a "better" model squirm when the market they rely on for their very existence begans to be closed off from them.

Not What It Seems

Ride My See-Saw

Most investors (and the general public) mistakenly believe that interest rates are interest rates. When the Fed raises the Fed Funds rate, all interest rates rise. When the Fed lowers interest rates, all interest rates fall. This is definitely not the case.

Short-term rates are directly influenced by Fed policy. The Fed controls (or at least greatly influences) short-term liquidity (think back to August and September 2007). But what about the long end of the curve? What determines long-term rates? This can be answered in one word inflation.

Long-term rates reflect the market's inflation expectations. Long-term rates are only influenced by Fed policy in as much as Fed policy influences inflation. Here is what typically happens during a Fed easing cycle.

Woolly Bully

The economy begins to falter for one reason or another. Long-term rates begin to fall in anticipation of reduced inflation pressures. This causes the curve to flatten or, in extreme cases, invert. This is where the idea that an inverted curve foretells a recession was born. In reality, it isn't foretelling anything. It is reacting to economic conditions which are already materializing.

In response to the slowing economy (which is usually accompanied by waning inflation pressures), the Fed begins to ease. At this time, an inverted curve will begin to flatten and a flat curve will begin to steepen. When a yield curve steepens because of falling short-term rates, it is called a "bull steepener" It is called "bull because it because prices of short-term treasuries are rising. Usually, at least since Paul Volcker, the Fed is successful. What comes next is "the bear"

Grizzly Bear

If the Fed is successful, it's more accommodative policies should promote growth. Along with growth should come some measure of inflation. What is almost certain to follow are inflation fears. As investors become concerned with mounting inflation pressures, they are reluctant to lock in on the long end of the curve. Why lock in at lower rates when higher inflation will erode real returns? Investors demand higher rates of return on the long end of the curve to account for higher inflation. This causes long-term rates to rise. This is a bear steepener. It is a bear steepener because prices of long-term treasuries are falling. For this reason, some capital invested in long-dated treasuries is moved into growth investments. So this is a trend toward higher inflation, a steeper yield curve and higher long-term rates, right? Wrong. Since Paul Volcker, the Fed has displayed great vigilance when it comes to containing inflation.

Note: The fundamental definition of a bear steepener is when long-term rates rise more than short-term rates. A bull steepener is when short-term rates fall more than long-term rates.

Here Comes The Fed

The Fed, in an attempt to corral inflation pressures, begins to tighten (raise Fed Funds rates). As the Fed does this, the curve begins to flatten. This is a bull flattener. This will continue until the Fed is satisfied that inflation has been quelled. However, since the Fed typically overshoots to varying degrees, the economy eventually slows and the cycle continues.

Where are we now in the cycle? Well, by many accounts we are still in the Fed easing cycle. However, we are possibly approaching the point at which the market becomes concerned that inflation pressures will build and we could see higher long-term rates (the transition from a bear to a bull steepener). Look What You're Doing

Many investors reaction to this is to abandon the long end and buy treasury bills (thereby creating the bear steepener they fear). Though we agree that investors may not want to invest in long-dated treasuries, we believe that purchasing treasury bills at current levels is less than optimal. Unless Mr. Bernanke permits inflation to roar out of control for the sake of growth (not very likely), long-term rates will probably not rise enough to make investing at treasury bill rates below 2.00% a prudent decision. What are investors to do?

Conservative investors can ladder or barbell. One need not barbell the extreme ends of the curve. Barbells from 6-months to five years or two-years to 10-years may prove to be advantageous. One need not equally weight the ends of a barbell.

Ladders may be better options for more conservative investors as they are more resistant to changing yield curves and can be weighted in a variety of ways. Conservative investors should consider agency bonds as well. As we have said before, agency bonds are not in any kind of trouble. Moderate investors can not only play the changing shape of the yield curve, but also the changes of credit spreads. The Gate Is Straight, Deep and Wide. Break On Through To The Other Side

Credit spreads also change with the cycles of the economy. As economic conditions worsen, credit spreads tend to widen. This is why yields of corporate bonds and preferreds do not follow treasury yields basis point for basis point. In fact, they can often move in the opposite direction. This is what has happened in recent months. The more cyclical the business sector, or if the news from a sector is especially troubling (like the financial and housing sectors), the greater the spread widening.

When the economy turns around, credit spreads should tighten. Bonds whose yields moved higher when treasury yields fell (spread widening) could experience stabilizing or falling yields as business prospects improve. This is spread narrowing. Many investors get greedy and purchase bonds with the widest credit spreads, often without knowing the complete story on the issuer, in an attempt to capture the most gain on the recovery. We take a different approach to playing a spread narrowing.

We prefer to look for the widest spreads among high-quality bonds. Our reasoning is that, though there could be more upside potential with a junk bond during an economic recovery, there also could be a greater chance of default before a recovery gains traction. This is the reason we are proponents of purchasing preferreds and bonds issued by Merrill, Wachovia and Lehman rather those issued by Hovnanian, KB Homes and Standard Pacific. We have already seen Technical Olympic file for Chapter XI protection, along with a host of smaller builders. Though the potential reward looks attractive in the high yield sector, the risks are significant. During the past several years, corporate defaults sank to below 1.0%. The slowing economy could help that number rise to its historical levels of over 4.0% (or beyond).

We believe that fixed income investors with moderate risk tolerances would do well to invest using a laddered or barbelled strategy. Using agencies (or certain bank vehicles) on the short end, transitioning to corporates and preferreds as one goes out on the curve, could give the best bang for the buck and leave investors properly position for the next change of the economic cycle.

Can't You See The Real Me

The world or high finance is a-buzz regarding the expoits of "rogue" trader Jerome Kerviel. Many followers of this story are inetrested in how Mr. Kerviel kept his big bets hidden for so long. I would like to discuss why he did it and why it took so long for him to be caught.

Jerome Kerviel has stated that he wanted to prove that someone from modest beginnings and a non-descript educational background could trade with the big boys. Coming from a similar background, I can understand his feelings (though I cannot excuse his actions).

I too went to a non-prestigious university (CUNY) and come from a very middleclass background. I worked my way through school while holding down an operations job on a Wall Street trading desk. Eventually I landed a job trading corporate bonds. The traders who were from similar backgrounds as myself were cordial. Some were even supportive. The traders who attended prep schools and prestigious private colleges (some of them Ivy's) looked down there long noses at me. I was once told by a superior that they would never consider me a "real" trader, no matter what I did.

This was partially true. Eventually, I was given the responsibility of running my small firm's retail corporate bond / preferred security trading book. However, when bonus time came around, my bonus was a fraction of what some "better educated" traders in lesser positions. My base was also lower. Having a young family and a mortgage (and realized I was still being paid better than the general population) I kept doing my job producing the best years my firm's retail trading department ever had before or since. There was no monkey business, just smart trading within the firm's limitations. Eventually I traded government bonds, high yield and even helped out the municpal desk, gaining a deep knowledge of the fixed income markets. Still, I was a second class trader. My revenge came when my firm was purchased by a larger firm. All those traders were laid off and I was hired by the new owners. Some of these traders went on to be successful, others are out of the business.

How in the world did Jerome Kerviel's superieors. The 2/2/08 edition of the Wall Street Journal discusses how the controls in place at Societe Generale almost caught Mr. Kerviel and how he cleverly remained one step ahead of them until recently. Bull!

If Mr. Kerviel's superieors were doing there job, he would not have been able to have run his scheme for more than a month. Three factors came into play

1) Mr. Kerviel's superiors were blinded by dollar (euro) signs. Not just those generated my Mr. Kerviel, but those being generated in large numbers during the asset bubble known as the housing boom.

2) Societe Generale had too much faith in their own controls and never imagined that a middleclass boy from Britanny who attened a regional college could ever be intelligent enough to create such a scheme.

3) SG believed that it's highly-educated, elite management team and traders were infallible. If they couldn't conceive it, it couldn't be done. SG management still hasn't explained earlier writedowns unrelated to Mr, Kerviel's scheme.


Similar culture's of elitism exist at U.S. banks and brokerages. Some have pushed out talented old school traders and have repalced them with quants. The biggest offenders are some of the firms with he biggest writedowns. Who knows, maybe there will be a U.S. version of Soc Gen, unless it can be covered up before it leaks to the press.