Earlier this week, the two-year and five-year U.S. treasury auctions drew weak interest from investors concerned that the Fed may need to unwind its stimuli and raise short-term borrowing rates to combat inflation. With the results of shot-term auctions fresh in their minds, market participants eagerly awaited the results of today's seven-year treasury note auction. However, unlike the two-year and five-year note auctions, the seven-year not auction was quite well received. Why was this so?
To understand why investors, such as foreign central banks, were more willing to buy longer-dated treasuries one must first understand the yield curve. The yield curve must first be divided into the long and the short end. Short-term yields are directly influenced by Fed interest rate policy. Two-year and five year auctions were thus weak. However, recent ten-year and thirty-year auctions garnered much interest (along with today's seven-year auction). This is because long-term yields are reflection of inflation expectations and the market is not expecting much.
How can that be you say? The U.S. government is issue debt and printing dollars in record amounts, how can inflation be moderate? Weak job growth and subdued economic activity will keep inflation from spiraling out of control. The lack of decoupling between the U.S. and its trading partners will also help to keep prices down as exporting countries work to keep currency exchange rates favorable. The Fed will also work to keep inflation moderate by removing stimulus and raising rates. Still, inflation will creep higher and long-term rates will rise accordingly.
If inflation and long-term rates will rise, why do not foreign investors simply purchase short-term treasuries and reinvest at ever-higher yields? Because the are not retail investors (sorry for the shot, but the truth hurts). Foreign buyers of U.S. treasuries know that when the Fed becomes less accommodative it moves at a glacial pace, typically 50 basis points at a time. This means that, even if the Fed raised the Fed funds rate at all eight FOMC meetings in a given year, the Fed Funds rate would only rise by 400 basis points. Even that gradual scenario is probably too aggressive considering the head winds facing the economy from deleveraging, higher taxes and other anti-growth policies brewing on capital hill.
This leaves one with a dilemma on the short end of the curve. Buy the two-year or the five-year and one could go through an entire rate cycle without being able to roll at a higher yield. But T-bills and one spends so much time at ultra-low yields similar to what we have today and it is difficult to equal the yield once could lock in by purchasing the 10-year treasury note.
Retail investors often make the mistake of assuming that when short-term yields rise, long-term yields must respond in kind. First, short-term yields almost always rise faster than long-term yields during times of Fed tightening. This is because short-term yields respond directly to higher Fed Funds rates, but longer-term yields are influenced by inflation expectations, which usually abate as tighter Fed policy crimps growth. Secondly, long-term rates may not rise at all when the Fed tightens as a combination of modest inflation expectations and foreign currency management results in large scale long-term treasury buying (as seen with Greenspan's so-called conundrum).
The bottom line is the market is forecasting a flatter yield curve and although it may be 18 to 24 months away, it is coming.
Thursday, July 30, 2009
Wednesday, July 29, 2009
Being There
I had an interesting conversation with a financial adviser today. He was bemoaning the fact that trading desks are for profit enterprise. What my Chauncey Gardner did not understand is that for profit trading desks make the markets work. Many financial advisers believe that trading desks should serve only to provide bids and offers for their clients. Although many trading desks endeavor to provide the best trading levels with the context of the markets, profit must be generated to pay salaries, technology expenses, research analysts, strategists and to finance positions. Besides, why should a firm leave money on the table?
Finance positions? That's right, traders must pay their own firms to finance their inventory. Without generating a profit from trading activities trading desks would not earn enough revenue from sales credit rebates to function. What about not maintaining an inventory and simply sourcing bonds from the Street? Source bonds from whom? Someone has to make markets, take positions and maintain inventory. Typically, the firm with the largest inventory provides an advantage for its brokers and clients.
Financial advisers often point out the disadvantages of clients who invest with discount brokerage firms to save on commissions. It is pointed out that one gets what one pays for. Financial advisers should remember that the next time they complain about for profit trading desks for doing so is the pot calling the kettle black
Finance positions? That's right, traders must pay their own firms to finance their inventory. Without generating a profit from trading activities trading desks would not earn enough revenue from sales credit rebates to function. What about not maintaining an inventory and simply sourcing bonds from the Street? Source bonds from whom? Someone has to make markets, take positions and maintain inventory. Typically, the firm with the largest inventory provides an advantage for its brokers and clients.
Financial advisers often point out the disadvantages of clients who invest with discount brokerage firms to save on commissions. It is pointed out that one gets what one pays for. Financial advisers should remember that the next time they complain about for profit trading desks for doing so is the pot calling the kettle black
Tuesday, July 28, 2009
Casy Jones You Better Watch Your Speed
Today, San Francisco Fed president, Janet Yellen stated in a speech in Coeur D'Alene, Idaho that she sees the "first solid signs of recovery. However, she also said: "That recovery is likely to be painfully slow." "A gradual recovery means that things won't feel very good for some time to come." So are we recovering or not? Yes, but it will not feel or look like the recoveries of the past 25 or so years.
The U.S. economy can be compared with a person that has taken a stimulant to reinvigorate himself or herself. The 1970s were a time of economic malaise. Former Fed Chairman, Paul Volcker's raising of interest rates to defeat inflation was a slap in the face for the U.S. economy. Lower taxes under President Reagan and a policy of lowering rates to make borrowing more affordable and to promote home ownership and business expansion was an economic amphetamine.
The problem wit taking amphetamines is that when it wears off one usually feels worse than before. There is no free energy. At sometime one must rest. One can keep taking amphetamines, but that just makes it worse in the end. The same is true of the U.S. economy. The Fed's speed induced economic recovery which began in the 80s would sputter from time to time. However, instead of permitting the economy to correct, the Fed would ease monetary policy to the point that recessions were mild and short-lived. This was known as "The Great Moderation". It became accepted that the Fed had found away to limit economic discomfort by prudent and creative interest rate policies. In actuality all the Fed did was give the patient more "speed" every time he was about to crash. As we have recently witnessed, when the patient is cut off from his supply he crashes hard. The U.S. economy was on a two and one half decade high. The financial crisis was the crash.
It is the prospect of an economic recovery without economic amphetamines which is leading level-headed financial experts to manage their expectations. The cheerleaders don't get it or don't want to get it. Investors have become accustomed to repeat performances of rapid and sharp recoveries without really understanding why. Many market participants have become lazy. They look at charts of previous economic cycles and assume that it all has to happen the same way once again. The problem is that the recovery has to happen with reduced leverage.
If the economic recovery will be gradual, why the strength in the stock market. The fact is that the market is not as efficient as seminar lecturers and mutual fund wholesalers would have us believe. Markets reflect more than fundamentals. They reflect fear and greed. When the equity markets plummeted to their lows last March, that reflected fear more than fundamentals. The rally since then reflects greed more than fundamentals. Sure, we will see improved earnings and possibly, positive GDP for the second or third quarter of 2009, but that will be more because business reduced unnecessary activities during 2008. Manufacturers stopped producing, choosing instead to let inventories decline. Businesses stopped placing orders for equipment choosing to make do with what they had. Now, businesses are spending, as are consumers, to a point. What we are seeing is, mostly, replacement spending with some opportunistic discretionary spending.
Who is spending? Those who can borrow. This means very-well-qualified consumers and businesses, especially businesses. Due to low interest rates and fairly tight credit spreads within the industrial sector, corporate borrowing can be attractive for some companies, but as with consumers, it is high-quality businesses which are able to borrow. Lower-rated corporations have not been able to borrow. Instead, corporate defaults are rising and are currently approaching 11%. This makes the high-yield bond arena a very dangerous place, in spite of the its rise due to greed-induced speculation.
It is who is able to obtain credit and who isn't which will shape the coming economic recovery. Unlike during the past decade, both individuals and corporations will have to prove their abilities to repay debt. Weak companies will no longer be able to tap the corporate bond market at low rates or obtain sweetheart covenant-light loans from banks. The same is true for individuals. One will now actually have to prove their abilities to pay.
Why is it so different now? In the past, banks and investment banks could slice and dice pools of glow-in-the dark loans and create AAA-rated securities. Investors (even alleged professionals such as municipalities and pensions) looked no further than the credit rating. No one knew or wanted to know what kind of radioactive collateral was residing within these structures.
The banks were all to happy to write these loans, so long as they could securitize them and get the toxic waste off of their balance sheets. The prospects of not being able to securitize and sell lead as gold is putting a damper on Wall Street alchemy. It is the prospect of investors and (saints preserve us) credit ratings agencies actually basing their decisions on the quality of the underlying assets is causing some pundits, such as economist Brian Wesbury to renew calls to suspend mark-to-market accounting.
The argument is that if banks have to value assets at prevailing market prices, it may cause banks to appear under capitalized when compared to the so-called hold-to-maturity value. Problems abound with this thinking.
1) Do you know what the hold to maturity value is of a pool of loans? Of course not, neither do the banks. Yes, they have sophisticated models which give banks estimates, but all models are backward looking. They cannot account for unknown unknowns.
2) Would you trust banks to properly and fairly value asset-backed securities without the market to voice its opinions? I wouldn't
3) This may be the most important,. Loans held on bank balance sheets ARE NOT SUBJECT TO MARK TO MARKET! This is why the PPIP is stalled. Banks have not marked their toxic loans much and do not wish to sell them at markets prices. Heck, they don't want to sell them at models derived prices as that would lead billions of dollars of realized losses. Levering up is not going to happen.
Where does this leave us? We could see fairly string growth later in 2009 and in early 2010 as businesses replenish inventories and replace equipment, but then it is back to slow progress as Americans live within their means, almost. This will be a very jobless recovery, but a recovery nonetheless.
The U.S. economy can be compared with a person that has taken a stimulant to reinvigorate himself or herself. The 1970s were a time of economic malaise. Former Fed Chairman, Paul Volcker's raising of interest rates to defeat inflation was a slap in the face for the U.S. economy. Lower taxes under President Reagan and a policy of lowering rates to make borrowing more affordable and to promote home ownership and business expansion was an economic amphetamine.
The problem wit taking amphetamines is that when it wears off one usually feels worse than before. There is no free energy. At sometime one must rest. One can keep taking amphetamines, but that just makes it worse in the end. The same is true of the U.S. economy. The Fed's speed induced economic recovery which began in the 80s would sputter from time to time. However, instead of permitting the economy to correct, the Fed would ease monetary policy to the point that recessions were mild and short-lived. This was known as "The Great Moderation". It became accepted that the Fed had found away to limit economic discomfort by prudent and creative interest rate policies. In actuality all the Fed did was give the patient more "speed" every time he was about to crash. As we have recently witnessed, when the patient is cut off from his supply he crashes hard. The U.S. economy was on a two and one half decade high. The financial crisis was the crash.
It is the prospect of an economic recovery without economic amphetamines which is leading level-headed financial experts to manage their expectations. The cheerleaders don't get it or don't want to get it. Investors have become accustomed to repeat performances of rapid and sharp recoveries without really understanding why. Many market participants have become lazy. They look at charts of previous economic cycles and assume that it all has to happen the same way once again. The problem is that the recovery has to happen with reduced leverage.
If the economic recovery will be gradual, why the strength in the stock market. The fact is that the market is not as efficient as seminar lecturers and mutual fund wholesalers would have us believe. Markets reflect more than fundamentals. They reflect fear and greed. When the equity markets plummeted to their lows last March, that reflected fear more than fundamentals. The rally since then reflects greed more than fundamentals. Sure, we will see improved earnings and possibly, positive GDP for the second or third quarter of 2009, but that will be more because business reduced unnecessary activities during 2008. Manufacturers stopped producing, choosing instead to let inventories decline. Businesses stopped placing orders for equipment choosing to make do with what they had. Now, businesses are spending, as are consumers, to a point. What we are seeing is, mostly, replacement spending with some opportunistic discretionary spending.
Who is spending? Those who can borrow. This means very-well-qualified consumers and businesses, especially businesses. Due to low interest rates and fairly tight credit spreads within the industrial sector, corporate borrowing can be attractive for some companies, but as with consumers, it is high-quality businesses which are able to borrow. Lower-rated corporations have not been able to borrow. Instead, corporate defaults are rising and are currently approaching 11%. This makes the high-yield bond arena a very dangerous place, in spite of the its rise due to greed-induced speculation.
It is who is able to obtain credit and who isn't which will shape the coming economic recovery. Unlike during the past decade, both individuals and corporations will have to prove their abilities to repay debt. Weak companies will no longer be able to tap the corporate bond market at low rates or obtain sweetheart covenant-light loans from banks. The same is true for individuals. One will now actually have to prove their abilities to pay.
Why is it so different now? In the past, banks and investment banks could slice and dice pools of glow-in-the dark loans and create AAA-rated securities. Investors (even alleged professionals such as municipalities and pensions) looked no further than the credit rating. No one knew or wanted to know what kind of radioactive collateral was residing within these structures.
The banks were all to happy to write these loans, so long as they could securitize them and get the toxic waste off of their balance sheets. The prospects of not being able to securitize and sell lead as gold is putting a damper on Wall Street alchemy. It is the prospect of investors and (saints preserve us) credit ratings agencies actually basing their decisions on the quality of the underlying assets is causing some pundits, such as economist Brian Wesbury to renew calls to suspend mark-to-market accounting.
The argument is that if banks have to value assets at prevailing market prices, it may cause banks to appear under capitalized when compared to the so-called hold-to-maturity value. Problems abound with this thinking.
1) Do you know what the hold to maturity value is of a pool of loans? Of course not, neither do the banks. Yes, they have sophisticated models which give banks estimates, but all models are backward looking. They cannot account for unknown unknowns.
2) Would you trust banks to properly and fairly value asset-backed securities without the market to voice its opinions? I wouldn't
3) This may be the most important,. Loans held on bank balance sheets ARE NOT SUBJECT TO MARK TO MARKET! This is why the PPIP is stalled. Banks have not marked their toxic loans much and do not wish to sell them at markets prices. Heck, they don't want to sell them at models derived prices as that would lead billions of dollars of realized losses. Levering up is not going to happen.
Where does this leave us? We could see fairly string growth later in 2009 and in early 2010 as businesses replenish inventories and replace equipment, but then it is back to slow progress as Americans live within their means, almost. This will be a very jobless recovery, but a recovery nonetheless.
Monday, July 27, 2009
The Time of the Season
Certain financial institutions have been termed "zombie banks" These are banks that exist, but are not alive in the truest sense. Now we have a zombie bank which may have zombie preferreds.
The Citi exchange has finally closed. Surprisingly, the prices of CprP and CprM have not declines appreciably. In fact, their prices have climbed. It appears as though the shareholder vote to permanently wipe out the dividends in Citi non-cumulative preferred shares has failed (mostly due to poor equity holder participation). It could be that some are speculating that C will now pay dividends on its preferred equity shares. Don't hold your breath. Others may be betting on an exchange with sweeter terms. Don't bet the farm. Chances are that C will simply suspend non-cumulative preferred dividends and equity dividends until it gets enough participation.
The bottom line is that paying the dividends is very unlikely. Tune in tomorrow for the true state of leverage in the U.S.
The Citi exchange has finally closed. Surprisingly, the prices of CprP and CprM have not declines appreciably. In fact, their prices have climbed. It appears as though the shareholder vote to permanently wipe out the dividends in Citi non-cumulative preferred shares has failed (mostly due to poor equity holder participation). It could be that some are speculating that C will now pay dividends on its preferred equity shares. Don't hold your breath. Others may be betting on an exchange with sweeter terms. Don't bet the farm. Chances are that C will simply suspend non-cumulative preferred dividends and equity dividends until it gets enough participation.
The bottom line is that paying the dividends is very unlikely. Tune in tomorrow for the true state of leverage in the U.S.
Tuesday, July 21, 2009
All About The Benjamin
Fed Chairman Ben Bernanke made a strong showing before the House Financial Services Committee. Mr.Bernanke gave a well-thought-out and carefully-worded testimony on Capital Hill. Although he acknowledged that the worst of the financial crisis may have passed, the U.S. economy still faces significant headwinds. Because of this the Fed continue to maintain an accommodative interest rate policy. The U.S. treasury market reacted sharply to Mr. Bernanke's testimony as prices of the ten-year treasury note and the 30-year government bond rose sharply on the Fed Chairman's tame inflation outlook. The equity market rallied (again) as accommodative Fed policy is traditionally good for business. However, are the markets reacting in a rational manner or are market participants looking to the future through rose colored glasses?
Prices of long-dated treasuries rallied on Mr. Bernanke's testimony that inflation will be held down by labor market dislocations. However, when the labor market does improve, long-term rates could rise. It is quite possible that the bond market is being overly optimistic that inflation pressures will be muted. Of course it could be managing its expectations that the economy is in for a modest and protracted recovery.
The equity markets are expressing a different view. The equity market is view a moderation of economic decline as a sign that a sharp economic recovery is around the corner. However, history shows us that the equity markets are both overly optimistic and overly pessimistic. This is why we have bubbles and corrections. In my opinion it is the equity market which is wearing the rose colored spectacles. The economy is stabilizing and will eventually experience sustained growth, but it will have to do so without the turbocharging effects of cheap, easy-to-obtain leverage. This is your grandfather's economy. at least for now.
It turns out that CIT's bailout was no such thing. The $3 billion emergency financing, besides being insufficient in the long term, comes with significant strings attached. The deal hinges on bondholders agreeing to accepting less than 100 cents on the dollar in the form of common equity in exchange for their bonds.
The proposed exchange offers 82.5 cents on the dollar, in common stock, to holders of the floating-rate CIT bonds due 8/15/09. Holders of, as yet unnamed, longer-dated bonds would receive 80 cents on the dollar in the form of CIT common. How far out are these other maturities? Probably out through 2010 as that is CIT immediate concern.
To execute the exchange, CIT needs 90& of affected bondholders to agree to the exchange. If 90& of these bondholders agree, all holders of the affected bonds will be awarded common stock at the aforementioned ratios whether or not the want common. Unless one wishes to be an equity investors in CIT, one should sell their CIT bonds and reinvest the cash. What happens if the deal is not approved by bondholders? A bankruptcy filing would be the most likely outcome.
I have had many questions regarding GE Capital. GECC does have issues with poorly-performing loans and a challenged business environment, but it has issued TLGP bonds which are backed by the FDIC and have an implied backing by its parent, GE. I believe that GE will continue to support GECC as to not do so would incur the wrath of the government which would be on the hook for $48 billion of GECC TLGP bonds should GE Capital default. I cannot see the government doling out $48 billion when deep-pocket GE sits idly by. I am sure Sheila Bair and Tim Geithner would be on the phone to GE CEO Jeff Immelt "suggesting" he write a check.
I believe GECC senior notes to by a buy for accounts who can tolerate continued volatility.
Prices of long-dated treasuries rallied on Mr. Bernanke's testimony that inflation will be held down by labor market dislocations. However, when the labor market does improve, long-term rates could rise. It is quite possible that the bond market is being overly optimistic that inflation pressures will be muted. Of course it could be managing its expectations that the economy is in for a modest and protracted recovery.
The equity markets are expressing a different view. The equity market is view a moderation of economic decline as a sign that a sharp economic recovery is around the corner. However, history shows us that the equity markets are both overly optimistic and overly pessimistic. This is why we have bubbles and corrections. In my opinion it is the equity market which is wearing the rose colored spectacles. The economy is stabilizing and will eventually experience sustained growth, but it will have to do so without the turbocharging effects of cheap, easy-to-obtain leverage. This is your grandfather's economy. at least for now.
It turns out that CIT's bailout was no such thing. The $3 billion emergency financing, besides being insufficient in the long term, comes with significant strings attached. The deal hinges on bondholders agreeing to accepting less than 100 cents on the dollar in the form of common equity in exchange for their bonds.
The proposed exchange offers 82.5 cents on the dollar, in common stock, to holders of the floating-rate CIT bonds due 8/15/09. Holders of, as yet unnamed, longer-dated bonds would receive 80 cents on the dollar in the form of CIT common. How far out are these other maturities? Probably out through 2010 as that is CIT immediate concern.
To execute the exchange, CIT needs 90& of affected bondholders to agree to the exchange. If 90& of these bondholders agree, all holders of the affected bonds will be awarded common stock at the aforementioned ratios whether or not the want common. Unless one wishes to be an equity investors in CIT, one should sell their CIT bonds and reinvest the cash. What happens if the deal is not approved by bondholders? A bankruptcy filing would be the most likely outcome.
I have had many questions regarding GE Capital. GECC does have issues with poorly-performing loans and a challenged business environment, but it has issued TLGP bonds which are backed by the FDIC and have an implied backing by its parent, GE. I believe that GE will continue to support GECC as to not do so would incur the wrath of the government which would be on the hook for $48 billion of GECC TLGP bonds should GE Capital default. I cannot see the government doling out $48 billion when deep-pocket GE sits idly by. I am sure Sheila Bair and Tim Geithner would be on the phone to GE CEO Jeff Immelt "suggesting" he write a check.
I believe GECC senior notes to by a buy for accounts who can tolerate continued volatility.
Monday, July 20, 2009
I Don't Want To Spoil The Party
I feel like a spoil-sport lately. I have been finding cracks in nascent economic optimism. I continue to warn about certain troubled banks and now I must rain on the parades of those celebrating the "rescue" of CIT Group.
Sadly, there is now rescue, merely a stay of execution. CIT's creditors have bought the company some time to do an debt for equity swap. What this means is that it is unlikely for ANY CIT bonds to mature at par. Instead, bondholders will be asked to accept CIT equity and a yet-to-be-determined ratio. A cramdown could be in the making. This occurs when an exchange is put to a vote among bondholders. If a majority of bondholders (usually two thirds or more) agree to an exchange, ALL bondholders are subject to the exchange. This is what the government tried to accomplish with GM, but bondholders said no and sent the company into bankruptcy.
For most investors the answer is simple. CIT bonds were purchased by most investors for reliable income with moderate risk. CIT bonds are now highly speculative and their income streams are very unreliable. I say to take the cash and move on.
Note: Citi W.I. common shares began trading in the OTC market today. The closing price was $2.57. This is roughly at parity with C preferreds likely to be exchanged. With the short squeeze abating, regular C common prices fell today. I have previously stated that due to the arbitrage and short squeeze present on C common that it was unlikely that it would trade at parity with the preferreds. I also said that if the spread between C common and preferreds narrowed, it could happen with the common price falling into line with the preferreds. The W.I. shares, immune from a short squeeze, are trading at parity to the preferreds. In essence, the common has move lower into parity with the preferreds. C W.I. shares (OTC symbol CTGGV) are a good indicator of where C common will trade post exchange
Sadly, there is now rescue, merely a stay of execution. CIT's creditors have bought the company some time to do an debt for equity swap. What this means is that it is unlikely for ANY CIT bonds to mature at par. Instead, bondholders will be asked to accept CIT equity and a yet-to-be-determined ratio. A cramdown could be in the making. This occurs when an exchange is put to a vote among bondholders. If a majority of bondholders (usually two thirds or more) agree to an exchange, ALL bondholders are subject to the exchange. This is what the government tried to accomplish with GM, but bondholders said no and sent the company into bankruptcy.
For most investors the answer is simple. CIT bonds were purchased by most investors for reliable income with moderate risk. CIT bonds are now highly speculative and their income streams are very unreliable. I say to take the cash and move on.
Note: Citi W.I. common shares began trading in the OTC market today. The closing price was $2.57. This is roughly at parity with C preferreds likely to be exchanged. With the short squeeze abating, regular C common prices fell today. I have previously stated that due to the arbitrage and short squeeze present on C common that it was unlikely that it would trade at parity with the preferreds. I also said that if the spread between C common and preferreds narrowed, it could happen with the common price falling into line with the preferreds. The W.I. shares, immune from a short squeeze, are trading at parity to the preferreds. In essence, the common has move lower into parity with the preferreds. C W.I. shares (OTC symbol CTGGV) are a good indicator of where C common will trade post exchange
Tuesday, July 14, 2009
Run Away! Run Away!
There is some measured optimism among bondholders of CIT. The firm is in talks with the government to arrange an aid package. While this may be good for CIT in the near term, it is not a long-term fix. Also, government aid could be painful to bondholders.
The FDIC is reluctant to give CIT the go ahead to issue FDIC-backed TLGP bonds. This is with good reason. CIT needs to refinance approximatelty $10 billion of debt by year end. FDIC chief Sheila Bair does not want to be on the hook for billions of dollars of CIT bonds believing that CIT's business model is broken. She is not incorrect.
CIT lends to small and often, less creditworthy businesses. When CIT was able to access cheap capital, the high rates it charged many of its small and mid-sized corporate borrowers earned it a handsome profit. However, rising delinquencies and higher borrowing costs have broken CIT's business model. With investors shunning the securitization markets and few investors interested in investing in loans given to risky companies, there is a good chance that CIT is not long-term viable.
Because CIT may have difficulty surviving, to reduce it's exposure and to not let investors off the hook, the government could coerce bondholders, especially of short-term bonds, exchange their bonds for equity or longer-term debt to alleviate CIT's need to refinance during the next several months. What to do? I do not think that CIT is viable as an independent lender and now bank is able to (or is crazy enough to) buy the firm. A independent lender to risky borrowers is not a good place for one's fixed income assets. Just get out.
The FDIC is reluctant to give CIT the go ahead to issue FDIC-backed TLGP bonds. This is with good reason. CIT needs to refinance approximatelty $10 billion of debt by year end. FDIC chief Sheila Bair does not want to be on the hook for billions of dollars of CIT bonds believing that CIT's business model is broken. She is not incorrect.
CIT lends to small and often, less creditworthy businesses. When CIT was able to access cheap capital, the high rates it charged many of its small and mid-sized corporate borrowers earned it a handsome profit. However, rising delinquencies and higher borrowing costs have broken CIT's business model. With investors shunning the securitization markets and few investors interested in investing in loans given to risky companies, there is a good chance that CIT is not long-term viable.
Because CIT may have difficulty surviving, to reduce it's exposure and to not let investors off the hook, the government could coerce bondholders, especially of short-term bonds, exchange their bonds for equity or longer-term debt to alleviate CIT's need to refinance during the next several months. What to do? I do not think that CIT is viable as an independent lender and now bank is able to (or is crazy enough to) buy the firm. A independent lender to risky borrowers is not a good place for one's fixed income assets. Just get out.
Monday, July 13, 2009
And I Lever
Bright are the stars that shine. Dark is the sky. I know this economy of mine will never die and I lever.
My apologies to Sir Paul McCartney. The U.S. had been carrying on a two decade love affair with ever-cheaper leverage and with easier access to potential borrowers (even those who should not have has access).
Once Paul Volcker broke the back of inflation Fed policy became relatively simple, when the economy stalled simply lower rates. Making monetary policy more accommodative enabled consumers to borrow more. It also enabled home owners to refinance homes at lower and lower rates and affordably tap home equity. Lowering rates put home ownership within the reach of an ever increasing number of people. This drove home prices higher (more pennies in the piggy) and encouraged home builders to construct McMansions on every available plot of land they could find. Not since the post-war days of William Levitt.
This all worked well as long as borrowing costs could be made cheaper when the economy stalled. However, lowering rates is a finite proposition. One cannot lower rates below zero and that is currently where the Fed Funds rate is, effectively. The second factor which led to two decades of economic growth was so-called financial innovation. Seeing mega dollar signs, banks and investment makes wanted to keep the gravy train rolling. To do this they had to find away to offer credit (leverage) to a wider ranger of potential borrowers. But how? Enter the Quants.
Wall Street began hiring quantitative mathematicians. They were literally rocket scientists. Financial institutions were led to believe quantitative formulas could account for any and every eventuality. However, formulas are only as good as the data which is inputted. Since prior data was from a time with more stringent lending standards there was no way the models could have been 100% reliable. They could not account for human nature, such as the reluctance to continue paying a mortgage on a home purchased with down payment. However, few bank executives questioned the models as the money was rolling in.
Although this all came to a head late in 2006, it had been building for two decades. Because this trend went on for so long, many market participants strategists, money managers and economists began to believe that short, shallow recessions and V-shaped recoveries were going to me the norm going forward. Many have been calling for a V-shaped recovery this time around only to be disappointed. For twenty years they have mistaken leverage-induced economic activity for real growth, in spite of falling real wages.
Where do we go from here? We will almost certainly live in a world with much reduced levels of leverage. Growth will be based on productivity. There is no re-levering this time around. Home prices will rise, but more gradually. Wages will rise, but not sharply. The stock market, following a small correction, will experience a small rally and will probably trade sideways for years, much like the 1970s as long-term borrowing costs gradually rise until they reach levels which inspire the next era of easing.
FYI: Don't be surprised if we see 12% unemployment
My apologies to Sir Paul McCartney. The U.S. had been carrying on a two decade love affair with ever-cheaper leverage and with easier access to potential borrowers (even those who should not have has access).
Once Paul Volcker broke the back of inflation Fed policy became relatively simple, when the economy stalled simply lower rates. Making monetary policy more accommodative enabled consumers to borrow more. It also enabled home owners to refinance homes at lower and lower rates and affordably tap home equity. Lowering rates put home ownership within the reach of an ever increasing number of people. This drove home prices higher (more pennies in the piggy) and encouraged home builders to construct McMansions on every available plot of land they could find. Not since the post-war days of William Levitt.
This all worked well as long as borrowing costs could be made cheaper when the economy stalled. However, lowering rates is a finite proposition. One cannot lower rates below zero and that is currently where the Fed Funds rate is, effectively. The second factor which led to two decades of economic growth was so-called financial innovation. Seeing mega dollar signs, banks and investment makes wanted to keep the gravy train rolling. To do this they had to find away to offer credit (leverage) to a wider ranger of potential borrowers. But how? Enter the Quants.
Wall Street began hiring quantitative mathematicians. They were literally rocket scientists. Financial institutions were led to believe quantitative formulas could account for any and every eventuality. However, formulas are only as good as the data which is inputted. Since prior data was from a time with more stringent lending standards there was no way the models could have been 100% reliable. They could not account for human nature, such as the reluctance to continue paying a mortgage on a home purchased with down payment. However, few bank executives questioned the models as the money was rolling in.
Although this all came to a head late in 2006, it had been building for two decades. Because this trend went on for so long, many market participants strategists, money managers and economists began to believe that short, shallow recessions and V-shaped recoveries were going to me the norm going forward. Many have been calling for a V-shaped recovery this time around only to be disappointed. For twenty years they have mistaken leverage-induced economic activity for real growth, in spite of falling real wages.
Where do we go from here? We will almost certainly live in a world with much reduced levels of leverage. Growth will be based on productivity. There is no re-levering this time around. Home prices will rise, but more gradually. Wages will rise, but not sharply. The stock market, following a small correction, will experience a small rally and will probably trade sideways for years, much like the 1970s as long-term borrowing costs gradually rise until they reach levels which inspire the next era of easing.
FYI: Don't be surprised if we see 12% unemployment
Thursday, July 9, 2009
On and On
This morning, many market participants are practically giddy over the Initial Jobless Claims report which indicated that the number of new applicants for unemployment insurance dipped below 600,000 to 565,000. The airwaves have been filled with optimistic chatter this morning declaring that the recession and the job market may finally be turning a corner. What about replacement do they not understand?
A dead give away as to the impairment of the job market can be found in the continuing claims data. Continuing claims increased by 159,000 to 6.88 million. Why the disconnect? It is really quite simple. The economy is approaching (or is at) replacement levels of activity. In other words, employers are running out of workers to lay off. If Continuing Claims were to start dropping I would be cautiously optimistic, but only if the economy began adding jobs soon after. However, we are not there yet. Face it, the economy is mired in an economic tar pit.
What does this mean for the second half of 2009? The impaired economy will go on and on. Remember, unlike Non-Farm Payrolls and the Unemployment Rate, which are lagging indicators, Jobless Claims are coincidental indicators. Also, keep in mind that last week was a shortened work week due to the Independence Day holiday. Government offices were closed on Friday July 3rd. This may have prevented some displaced workers from filing claims.
Further evidence that fixed income investors believe that the global economy will be impaired for a protracted period of time was yesterday's very strong 10-year U.S. treasury auction. Among the buyers were foreign central banks. The bond market has historically been a better predictor of future economic condition than the stock market. The bond market is telling us to manage our expectations and to be prepared to a long march out of this deep economic valley.
There are reports this morning that some owners of pools of mortgages are selling homes at far lower prices than where banks are willing so sell foreclosed homes. The media pundits are bemoaning that this will depress the housing market. Au contraire mes amis.
Selling homes at fire sale prices will further depress home prices, but it could speed a recovery in the housing sector as it moves the huge excess supply of homes more quickly. What it does hurt are the banks. Remember, banks have been reluctant to mark mortgages held on their balance sheets to market, preferring to value them on a hold to maturity basis. If homes are being sold at huge discounts, the drive the values of the impaired loans being held by banks lower. This is true whether one uses a current market or hold to maturity valuation. Why does it affect the hold to maturity value. Many banks are trying to sell the properties securing the impaired loans on their balance sheets. When an impaired property is sold, the outstanding mortgage is settled for however many dollars the property was sold. If home prices are driven lower because of aggressive selling and lower prices, hold to maturity values will decline. Maybe the government should hurry up and configure a plan to handle the dissolution of a large financial institution?
A dead give away as to the impairment of the job market can be found in the continuing claims data. Continuing claims increased by 159,000 to 6.88 million. Why the disconnect? It is really quite simple. The economy is approaching (or is at) replacement levels of activity. In other words, employers are running out of workers to lay off. If Continuing Claims were to start dropping I would be cautiously optimistic, but only if the economy began adding jobs soon after. However, we are not there yet. Face it, the economy is mired in an economic tar pit.
What does this mean for the second half of 2009? The impaired economy will go on and on. Remember, unlike Non-Farm Payrolls and the Unemployment Rate, which are lagging indicators, Jobless Claims are coincidental indicators. Also, keep in mind that last week was a shortened work week due to the Independence Day holiday. Government offices were closed on Friday July 3rd. This may have prevented some displaced workers from filing claims.
Further evidence that fixed income investors believe that the global economy will be impaired for a protracted period of time was yesterday's very strong 10-year U.S. treasury auction. Among the buyers were foreign central banks. The bond market has historically been a better predictor of future economic condition than the stock market. The bond market is telling us to manage our expectations and to be prepared to a long march out of this deep economic valley.
There are reports this morning that some owners of pools of mortgages are selling homes at far lower prices than where banks are willing so sell foreclosed homes. The media pundits are bemoaning that this will depress the housing market. Au contraire mes amis.
Selling homes at fire sale prices will further depress home prices, but it could speed a recovery in the housing sector as it moves the huge excess supply of homes more quickly. What it does hurt are the banks. Remember, banks have been reluctant to mark mortgages held on their balance sheets to market, preferring to value them on a hold to maturity basis. If homes are being sold at huge discounts, the drive the values of the impaired loans being held by banks lower. This is true whether one uses a current market or hold to maturity valuation. Why does it affect the hold to maturity value. Many banks are trying to sell the properties securing the impaired loans on their balance sheets. When an impaired property is sold, the outstanding mortgage is settled for however many dollars the property was sold. If home prices are driven lower because of aggressive selling and lower prices, hold to maturity values will decline. Maybe the government should hurry up and configure a plan to handle the dissolution of a large financial institution?
Tuesday, July 7, 2009
Who'll Stop The Rain
I feel like a harbinger of doom these days, but it nearly impossible to be optimistic when economic data and government policy could drive a clown to suicide. Let's recap the latest dispiriting news.
The Kommisar's In Town: Senator Bernie Sanders of Vermont and Representative Bart Stupak of Michigan are pressuring the CFTC to limit the size of commodity bets for commodities with "finite supply" (specifically oil, gasoline and natural gas) for certain market participants (this includes index funds and ETFs. The dynamic duo blame speculators for the recent rise in energy prices.
No kidding guys? Last year, I wrote that speculators were responsible for the dramatic spike of oil prices. I suggested that oil was being used as a dollar hedge. Oil is denominated in dollars. I one believes that the dollar will weaken, a possible strategy is going long oil futures (directly or indirectly via funds or derivatives). In spite of the criticism from market "experts", I and like-minded people were proven correct that speculation was responsible for rising oil prices. It all unraveled when the markets realized that decoupling was a foolish pipe-dream and that the dollar remains the world's reserve currency. However, even though I agree with Mr. Sanders and Mr. Stupak that speculators are largely responsible for the recent spike in oil prices, I do not think that it is the government's responsibility to manage the investment or speculation positions of private investors. That is socalistic government overreach. Fears of this kind of overreach in the financial sector is hampering the recovery by keeping investors on the sidelines or has them seeking other opportunities. I say: invest far from the government (sorry C, AIG GM and Chrysler).
Speaking of our aforementioned wards of the state. The price of AIG common stock continues to drop as the acknowledgement of exposure to European banks, government involvement and a recent reverse stock split (often considered the final act of a dying firm) has investors rattled. The market is not being kind to C as the threat of more off balance sheet toxic assets, mega share dilution (5.5B shares becoming approximately 23B shares) and poor earnings continue to push C stock lower. Investors may want to reconsider exchanging C preferreds for common and just get out of Dodge.
I have been of the opinion that investors should sell their C preferreds and move on to better opportunities. When CprP and CprM were trading in the $21 to $22 area investors were given a gift. However, amateur investors and misguided financial advisers foolishly believed that the preferreds had to trade at exchange parity with C common and that the price of C common was fundamentally correct. Neither assumption was true.
If one owns CprP, CprM or CprI, one needs to sell or convert as C will permanently wipe out their dividends and delist them This wil render them worthless. CprG, CprF and other preferreds near the top of the waterfall schedule, although not being wiped out, should continue to lose value as the arbitrage fades. This has already happened with CprG and CprF, but hasn't caught up with CprU, CprW and CprE. When the exchange is over, these preferreds should trade at yield levels similar to those found with preferreds farther down the waterfall schedule. That means the 9.00% yields found with U,W, and E will become 11.00% (or higher) yields resulting in sharp drops in prices. Get out now!
Home Sweet Home: Mortgage and home-equity delinquencies continue to rise. Bloomberg News reported:
Late payments on home-equity loans rose to a record in the first quarter as 18 straight months of job losses and a slumping economy left more borrowers unable to pay their debts, the American Bankers Association reported. Delinquencies on home-equity loans climbed to 3.52 percent of all accounts in the quarter from 3.03 percent in the fourth and late payments on home-equity lines of credit climbed to a record 1.89 percent, the group said. An index of eight types of loans rose for a fourth straight quarter, to 3.23 percent from3.22 percent in October through December, the group said.
Housing is not poised to recover. Even when it does recover it is not returning to bubble levels for years. This will impair homeowners, banks and homebuilders for some time. The consumer could be on the sidelines for quite awhile longer. As consumers are responsible for about 70% of U.S. economic activity, recovery will move at a glacial pace. One pundit on CNBC suggested that the way to housing recovery may be to permit home prices to fall to levels at which consumers could afford them and obtain financing. What a novel idea, one which was suggested by yours truly in March 2008. However, the current administration is determined to plan the economy and its recovery. As Americans are all victims of capitalism, the system must change. Never mind that Americans largely did this to themselves. I don't recall roving bands of brigands forcing people to purchase homes the could not afford using mortgage vehicles which they could never pay.
I still say that fixed income investors should ladder or barbell with emphasis on the two to five year area on the curve. CDs and callable agencies should be used on the short end of the curve and non-TARP banks, telecom and utility companies should make up the seven to ten year area of one's portfolio. There is not much point in extending far out on the curve. This includes preferred securities.
The Kommisar's In Town: Senator Bernie Sanders of Vermont and Representative Bart Stupak of Michigan are pressuring the CFTC to limit the size of commodity bets for commodities with "finite supply" (specifically oil, gasoline and natural gas) for certain market participants (this includes index funds and ETFs. The dynamic duo blame speculators for the recent rise in energy prices.
No kidding guys? Last year, I wrote that speculators were responsible for the dramatic spike of oil prices. I suggested that oil was being used as a dollar hedge. Oil is denominated in dollars. I one believes that the dollar will weaken, a possible strategy is going long oil futures (directly or indirectly via funds or derivatives). In spite of the criticism from market "experts", I and like-minded people were proven correct that speculation was responsible for rising oil prices. It all unraveled when the markets realized that decoupling was a foolish pipe-dream and that the dollar remains the world's reserve currency. However, even though I agree with Mr. Sanders and Mr. Stupak that speculators are largely responsible for the recent spike in oil prices, I do not think that it is the government's responsibility to manage the investment or speculation positions of private investors. That is socalistic government overreach. Fears of this kind of overreach in the financial sector is hampering the recovery by keeping investors on the sidelines or has them seeking other opportunities. I say: invest far from the government (sorry C, AIG GM and Chrysler).
Speaking of our aforementioned wards of the state. The price of AIG common stock continues to drop as the acknowledgement of exposure to European banks, government involvement and a recent reverse stock split (often considered the final act of a dying firm) has investors rattled. The market is not being kind to C as the threat of more off balance sheet toxic assets, mega share dilution (5.5B shares becoming approximately 23B shares) and poor earnings continue to push C stock lower. Investors may want to reconsider exchanging C preferreds for common and just get out of Dodge.
I have been of the opinion that investors should sell their C preferreds and move on to better opportunities. When CprP and CprM were trading in the $21 to $22 area investors were given a gift. However, amateur investors and misguided financial advisers foolishly believed that the preferreds had to trade at exchange parity with C common and that the price of C common was fundamentally correct. Neither assumption was true.
If one owns CprP, CprM or CprI, one needs to sell or convert as C will permanently wipe out their dividends and delist them This wil render them worthless. CprG, CprF and other preferreds near the top of the waterfall schedule, although not being wiped out, should continue to lose value as the arbitrage fades. This has already happened with CprG and CprF, but hasn't caught up with CprU, CprW and CprE. When the exchange is over, these preferreds should trade at yield levels similar to those found with preferreds farther down the waterfall schedule. That means the 9.00% yields found with U,W, and E will become 11.00% (or higher) yields resulting in sharp drops in prices. Get out now!
Home Sweet Home: Mortgage and home-equity delinquencies continue to rise. Bloomberg News reported:
Late payments on home-equity loans rose to a record in the first quarter as 18 straight months of job losses and a slumping economy left more borrowers unable to pay their debts, the American Bankers Association reported. Delinquencies on home-equity loans climbed to 3.52 percent of all accounts in the quarter from 3.03 percent in the fourth and late payments on home-equity lines of credit climbed to a record 1.89 percent, the group said. An index of eight types of loans rose for a fourth straight quarter, to 3.23 percent from3.22 percent in October through December, the group said.
Housing is not poised to recover. Even when it does recover it is not returning to bubble levels for years. This will impair homeowners, banks and homebuilders for some time. The consumer could be on the sidelines for quite awhile longer. As consumers are responsible for about 70% of U.S. economic activity, recovery will move at a glacial pace. One pundit on CNBC suggested that the way to housing recovery may be to permit home prices to fall to levels at which consumers could afford them and obtain financing. What a novel idea, one which was suggested by yours truly in March 2008. However, the current administration is determined to plan the economy and its recovery. As Americans are all victims of capitalism, the system must change. Never mind that Americans largely did this to themselves. I don't recall roving bands of brigands forcing people to purchase homes the could not afford using mortgage vehicles which they could never pay.
I still say that fixed income investors should ladder or barbell with emphasis on the two to five year area on the curve. CDs and callable agencies should be used on the short end of the curve and non-TARP banks, telecom and utility companies should make up the seven to ten year area of one's portfolio. There is not much point in extending far out on the curve. This includes preferred securities.
Monday, July 6, 2009
The major concern among investors and business counterparties, with regards to investing along side or doing business with the U.S. government, is whether economics or politics direct policy. We have already seen government efforts to control pay, strong-arm creditors and dictate which facilities of government-rescued companies will stay open and which will be forced to close. It is this last point which is the subject of this post.
We have already seen Massachusetts Representative Barney Frank force GM to keep open an inefficient and unnecessary distribution facility located in his district. Now GM (60% owned by the U.S. Government) has decided to build its new small car (originally slated to be built in China) in Orion, Michigan. This in spite of the fact that a facility in Spring Hill Tennessee is more up-to-date. Originally, the government assured businesses, investors and municipalities that economics, not politics, would drive the decision making process. However, GM stated that carbon foot print and community would be major considerations in deciding where to build its new small car. Apparently an obsolete factory located in the middle of UAW country offers the right mix of community and carbon foot print. A healthy dose of Michigan incentives sealed the deal.
Building small cars in the U.S. is difficult (even foreign manufacturers with U.S. assembly plants build their smallest cars overseas), but building them in Michigan in a UAW plant is downright stupid, unless the government will step in. Count on it!
In previous posts I have made comparisons between the U.S. Government's involvement in the auto industry with that of the UK and the British government. There is another troubling comparison to be made. That is between Chrysler / FIAT and AMC / Renault.
In the 1980s Renault was looking for a foothold in the U.S. AMC was out of R&D money and had no small car following the second gasoline crisis of 1979. AMC and Renault decided to merge. AMC began building Renault cars in the U.S. (much like FIAT wants Chrysler to do). However, fuel prices fell and finicky French cars were out. By 1987 the jig was up and Chrysler, which had been on the ropes several years earlier, acquired AMC and its very profitable Jeep division.
Now we have a Renault redux at hand. Will American consumers buy Chrysler-built FIAT commuter cars, vehicles with performance and possibly with reliability below that of Chrysler small cars of the recent past? Maybe at first, but this does not appear to be a good fit or long-term fix. Give Chrysler an R&D budget and some Tennessee factories and it would probably fair better. However, the government does not wish to upset the UAW.
One last note outside the auto sector. I warned readers regarding the preferred to equity exchange being conducted by a certain large bank that it is unlikely that the preferreds would trade at parity with the common and that when and if the spread narrow it could be the common which takes a bath as the short squeeze diminishes. This is apparently happening. The equity markets are often not fundamentally correct.
We have already seen Massachusetts Representative Barney Frank force GM to keep open an inefficient and unnecessary distribution facility located in his district. Now GM (60% owned by the U.S. Government) has decided to build its new small car (originally slated to be built in China) in Orion, Michigan. This in spite of the fact that a facility in Spring Hill Tennessee is more up-to-date. Originally, the government assured businesses, investors and municipalities that economics, not politics, would drive the decision making process. However, GM stated that carbon foot print and community would be major considerations in deciding where to build its new small car. Apparently an obsolete factory located in the middle of UAW country offers the right mix of community and carbon foot print. A healthy dose of Michigan incentives sealed the deal.
Building small cars in the U.S. is difficult (even foreign manufacturers with U.S. assembly plants build their smallest cars overseas), but building them in Michigan in a UAW plant is downright stupid, unless the government will step in. Count on it!
In previous posts I have made comparisons between the U.S. Government's involvement in the auto industry with that of the UK and the British government. There is another troubling comparison to be made. That is between Chrysler / FIAT and AMC / Renault.
In the 1980s Renault was looking for a foothold in the U.S. AMC was out of R&D money and had no small car following the second gasoline crisis of 1979. AMC and Renault decided to merge. AMC began building Renault cars in the U.S. (much like FIAT wants Chrysler to do). However, fuel prices fell and finicky French cars were out. By 1987 the jig was up and Chrysler, which had been on the ropes several years earlier, acquired AMC and its very profitable Jeep division.
Now we have a Renault redux at hand. Will American consumers buy Chrysler-built FIAT commuter cars, vehicles with performance and possibly with reliability below that of Chrysler small cars of the recent past? Maybe at first, but this does not appear to be a good fit or long-term fix. Give Chrysler an R&D budget and some Tennessee factories and it would probably fair better. However, the government does not wish to upset the UAW.
One last note outside the auto sector. I warned readers regarding the preferred to equity exchange being conducted by a certain large bank that it is unlikely that the preferreds would trade at parity with the common and that when and if the spread narrow it could be the common which takes a bath as the short squeeze diminishes. This is apparently happening. The equity markets are often not fundamentally correct.
Friday, July 3, 2009
Ride My See Saw
Yesterday's employment data is the latest story in the up and down emotional ride on Wall Street. Optimists (blind optimists I say) become practically giddy when data indicates that the pace of economic contraction is slowing. Yet when data, such as yesterday's Non-farm Payrolls report indicates that the employment situation has worsened, those with rose colored glasses point out that NFP is a lagging indicator. Fair enough, but we have had this "lagging indicator" at troubling levels for a year. When do the Pollyannas concede that the economy is still in decline?
Other data gives us a clue as to the true state of employment. One is average weekly hours. Yesterday's report indicated that average hours worked in the U.S. fell to 33 hours, the worst in four decades. This indicates that not only are many Americans unemployed, but many are underemployed. Many workers who desire full-time employment are working part-time jobs to survive. Labor underutilization (combined unemployment and underemployment) stands at approximately 16.5%. There can be no economic recovery if there is not an employment recovery. Jobless recoveries are not true recoveries.
Many economists are calling for economic recovery to began in the second half of 2009, but is that what they are really saying? In reports I have read by economists at most major firms, the pace of recovery is expected to be under 2.00%. That is not all that strong. Also, signs of recovery in the second half 0f 2009 may only be a dead-cat bounce of the bottom. In other words, it may only be a correction of an downside overshoot as the economy worsened. Even a dead cat will bounce if it is dropped from a high enough place. The more dramatic the fall, the more significant the bounce, but as with a dead cat, the economy will settle back down to reflect the economic conditions being experienced by consumers.
Why then do many strategists and financial media types keep forecasting a robust recovery, at some point? For one, they have agendas, but it is mostly due to their being creatures of habit. During the past 25 years whenever the economy would stall, the Fed would simply lower rates making leverage less expensive. Wall Street would use "innovation" to make leverage available to an ever-wider group of people. This created an accelerant-driven economy. The problem is that such stimulus is finite. One cannot cut rates forever. It all ends at 0.00%, where the Fed Funds rate is now.
It is the lack of leverage which will curb economic growth. The key here is not to figure out how to increase leverage again (this is how we it into this mess), but prices and salaries will have to moderate. That's right, we need modest inflation or (dare I say it) deflation. Put away your smelling salts, I am not suggesting that the U.S. engage in a purposeful deflationary policy, but let's be realistic.
Let's consider home prices. The price of homes in many areas of the country far out-paced inflation is most other sectors. Home prices need to be permitted to continue to fall to prices at which prospective home buyers can afford and obtain mortgages. This is capitalism. Will some consumers feel less wealthy and pare spending? Yes. Will they be unable to go on home equity fueled spending binges as they have during he past two decades? Absolutely, but any time you stimulate the economy by using leverage, you are moving future sales forward. Just like a person taking stimulants to avoid sleep. Staying active longer only means a longer, deeper sleep later on. U.S. consumers will have to learn to live within their means.
I think consumers can do this, but businesses such as home some builders and some auto manufacturers cannot survive in a productivity drive economy. Home builders who can profitably sell $250,000 homes will survive. Those who need to sell large quantities of $500,000 McMansions will not. Auto manufacturers who can sell $25,000 vehicles profitably will survive. Those which need to sell $45,000 SUVs for profit will fail. This also means that overhead (wages and benefits) in these industries must also fall. Good luck with the current administration.
Also beware of Keynesian policies. Money spent on government job projects (roads, etc.) are almost never efficient and will only have minimal benefits for the economy. Making energy more expensive will not spur the creation of green energy. It will just send more manufacturing offshore where it can be done more cheaply.
What is my prediction for the economy? I think that when the economy expands, it will settle in at growth rates between 1.00% and 2.00%. Wages will rise slowly. Home prices will fall further before settling in and rising with an inflation rate similar to that of growth. Chrysler, GM and Ford will either fail or shed the UAW. Success and the UAW are incompatible.
Other data gives us a clue as to the true state of employment. One is average weekly hours. Yesterday's report indicated that average hours worked in the U.S. fell to 33 hours, the worst in four decades. This indicates that not only are many Americans unemployed, but many are underemployed. Many workers who desire full-time employment are working part-time jobs to survive. Labor underutilization (combined unemployment and underemployment) stands at approximately 16.5%. There can be no economic recovery if there is not an employment recovery. Jobless recoveries are not true recoveries.
Many economists are calling for economic recovery to began in the second half of 2009, but is that what they are really saying? In reports I have read by economists at most major firms, the pace of recovery is expected to be under 2.00%. That is not all that strong. Also, signs of recovery in the second half 0f 2009 may only be a dead-cat bounce of the bottom. In other words, it may only be a correction of an downside overshoot as the economy worsened. Even a dead cat will bounce if it is dropped from a high enough place. The more dramatic the fall, the more significant the bounce, but as with a dead cat, the economy will settle back down to reflect the economic conditions being experienced by consumers.
Why then do many strategists and financial media types keep forecasting a robust recovery, at some point? For one, they have agendas, but it is mostly due to their being creatures of habit. During the past 25 years whenever the economy would stall, the Fed would simply lower rates making leverage less expensive. Wall Street would use "innovation" to make leverage available to an ever-wider group of people. This created an accelerant-driven economy. The problem is that such stimulus is finite. One cannot cut rates forever. It all ends at 0.00%, where the Fed Funds rate is now.
It is the lack of leverage which will curb economic growth. The key here is not to figure out how to increase leverage again (this is how we it into this mess), but prices and salaries will have to moderate. That's right, we need modest inflation or (dare I say it) deflation. Put away your smelling salts, I am not suggesting that the U.S. engage in a purposeful deflationary policy, but let's be realistic.
Let's consider home prices. The price of homes in many areas of the country far out-paced inflation is most other sectors. Home prices need to be permitted to continue to fall to prices at which prospective home buyers can afford and obtain mortgages. This is capitalism. Will some consumers feel less wealthy and pare spending? Yes. Will they be unable to go on home equity fueled spending binges as they have during he past two decades? Absolutely, but any time you stimulate the economy by using leverage, you are moving future sales forward. Just like a person taking stimulants to avoid sleep. Staying active longer only means a longer, deeper sleep later on. U.S. consumers will have to learn to live within their means.
I think consumers can do this, but businesses such as home some builders and some auto manufacturers cannot survive in a productivity drive economy. Home builders who can profitably sell $250,000 homes will survive. Those who need to sell large quantities of $500,000 McMansions will not. Auto manufacturers who can sell $25,000 vehicles profitably will survive. Those which need to sell $45,000 SUVs for profit will fail. This also means that overhead (wages and benefits) in these industries must also fall. Good luck with the current administration.
Also beware of Keynesian policies. Money spent on government job projects (roads, etc.) are almost never efficient and will only have minimal benefits for the economy. Making energy more expensive will not spur the creation of green energy. It will just send more manufacturing offshore where it can be done more cheaply.
What is my prediction for the economy? I think that when the economy expands, it will settle in at growth rates between 1.00% and 2.00%. Wages will rise slowly. Home prices will fall further before settling in and rising with an inflation rate similar to that of growth. Chrysler, GM and Ford will either fail or shed the UAW. Success and the UAW are incompatible.
Wednesday, July 1, 2009
Were Have All The Green Shoots Gone?
The debate rages as to whether the economy is improving or is it merely settling at its cyclical bottom. I believe the answer is "yes". By this I mean that the economy is worsening at a slower pace and that is a good thing, but it should not be surprising. After all, the economy can not drop forever. There is such a thing called replacement.
Replacement is the level of economic activity generated by consumers subsisting. Industrial production cannot go to zero as consumers need to replace broken appliances, fix leaky roofs and replace worn-out vehicles. What they are not doing is spending on discretionary items. Consumers are not upgrading appliances for the sake of convenience or enjoyment. They are not remodeling their homes nor and are waiting to make repairs until they cannot wait any longer. Car buyers are taking advantage of incentives and being most frugal when replacing vehicles which have seen better days. Few are opting for a loaded Tahoe. Watching the equity markets could lead one to believe that a V-shaped recovery was just around the corner. However, equity markets (and equity-like markets) are not necessarily the best indicator of forthcoming economic conditions, in spite of their inclusion in the list of leading indicators. Permit me to explain.
Of all the markets, the equity markets are most influenced by emotions such as fear and greed. When an economic downturn is at hand, equity investors tend to abandon the markets irrationally out of panic. When the worst appears to be over, they rush back into the market assuming that the economy must recover as rapidly as it declined. This strategy has sometimes worked, especially during the past 25 years of Fed induced recoveries. However, that did not necessarily apply before the days of Paul Volcker and probably will not apply this time around.
The fixed income markets are generally less prone to irrational fears or blind optimism. Of all the markets, the fixed income markets tend to reflect well-thought-out decision making. This is mainly due to whom are the market participants. Among these participants are foreign central banks, pension funds, insurance companies, etc. Smaller, less sophisticated investors have only a minimal impact on the fixed income markets. Notable exceptions have occurred in the T-Bill markets last winter when panicked retail investors, many of them equity oriented (or fixed income yield hogs) purchased treasuries at negative yields. Small investors acting en masse generated enough demand for treasury bills that yields for retail-sized T-Bill purchases when negative. That was a rare occurrence, a stampede if you will. Bond dealers were all too happy to sell bonds to the on-rushing herd as they drove themselves over a financial cliff.
False or premature hope can also occasionally appear in the high yield bond market. Many speculators or income-oriented yield hogs will rush in and buy high yield bonds hoping to score big on a recovery. What they don't realize is that high grade bonds and companies usually recover first and more quickly. Also lost on these investors is that corporate defaults often lag economic data. Companies often default after experience an extended period of time with poor earnings and either run out of cash and can no longer pay their debt or are sufficiently weak that they cannot refinance their debt. Think of high yield companies as salmon. During a recession they swim against the current trying to survive. When they finally get through these companies are so impaired that they fail. When one considers that we have just finished our sixth quarter of recession it is unlikely that many high yield companies will be able to refinance their debt at the sweetheart rates and with the easy covenants typical of several years ago if at all. That debt starts coming due on 2010. Hold on to your hats boys and girls, the defaults are coming.
Note: High yield bonds should be purchased for a total return, equity-like strategy. Relying on junk bonds for income is just plain foolish.
I have been of the opinion for quite some time that the recovery will be long and gradual. San Francisco Fed president Janet Yellen agrees. Yesterday, she stated that the Fed Funds Rate could stay at 0.00% for years and that, if the Fed could, it may take the Fed Funds Rate negative. That is not indicative of a V-shaped recover. Ms. Yellen also noted that China really doesn't have an alternative to the U.S. dollar as a reserve currency. This means that China and other exporters will probably keep supporting the dollar and help to keep long-term rates reasonably low for the near future. A few years from now, the amount of debt issued and dollars printed should push rates higher, but don't expect rates seen in the early 80s or even early 9os.
Welcome to your grandfather's economy. One which cannot be rekindled simply by making leverage cheaper and more available. The 25 year trend of lower rated ended when the Fed eased to 0.00%.
There are opportunities in fixed income. 5-10-year corporate bonds, especially non-TARP banks and, to a lesser extent, telecom and utilities offer attractive values, not only on an absolute yield basis, but also on a spread basis. As we know, credit spreads are the real keys to corporate bond investing
Replacement is the level of economic activity generated by consumers subsisting. Industrial production cannot go to zero as consumers need to replace broken appliances, fix leaky roofs and replace worn-out vehicles. What they are not doing is spending on discretionary items. Consumers are not upgrading appliances for the sake of convenience or enjoyment. They are not remodeling their homes nor and are waiting to make repairs until they cannot wait any longer. Car buyers are taking advantage of incentives and being most frugal when replacing vehicles which have seen better days. Few are opting for a loaded Tahoe. Watching the equity markets could lead one to believe that a V-shaped recovery was just around the corner. However, equity markets (and equity-like markets) are not necessarily the best indicator of forthcoming economic conditions, in spite of their inclusion in the list of leading indicators. Permit me to explain.
Of all the markets, the equity markets are most influenced by emotions such as fear and greed. When an economic downturn is at hand, equity investors tend to abandon the markets irrationally out of panic. When the worst appears to be over, they rush back into the market assuming that the economy must recover as rapidly as it declined. This strategy has sometimes worked, especially during the past 25 years of Fed induced recoveries. However, that did not necessarily apply before the days of Paul Volcker and probably will not apply this time around.
The fixed income markets are generally less prone to irrational fears or blind optimism. Of all the markets, the fixed income markets tend to reflect well-thought-out decision making. This is mainly due to whom are the market participants. Among these participants are foreign central banks, pension funds, insurance companies, etc. Smaller, less sophisticated investors have only a minimal impact on the fixed income markets. Notable exceptions have occurred in the T-Bill markets last winter when panicked retail investors, many of them equity oriented (or fixed income yield hogs) purchased treasuries at negative yields. Small investors acting en masse generated enough demand for treasury bills that yields for retail-sized T-Bill purchases when negative. That was a rare occurrence, a stampede if you will. Bond dealers were all too happy to sell bonds to the on-rushing herd as they drove themselves over a financial cliff.
False or premature hope can also occasionally appear in the high yield bond market. Many speculators or income-oriented yield hogs will rush in and buy high yield bonds hoping to score big on a recovery. What they don't realize is that high grade bonds and companies usually recover first and more quickly. Also lost on these investors is that corporate defaults often lag economic data. Companies often default after experience an extended period of time with poor earnings and either run out of cash and can no longer pay their debt or are sufficiently weak that they cannot refinance their debt. Think of high yield companies as salmon. During a recession they swim against the current trying to survive. When they finally get through these companies are so impaired that they fail. When one considers that we have just finished our sixth quarter of recession it is unlikely that many high yield companies will be able to refinance their debt at the sweetheart rates and with the easy covenants typical of several years ago if at all. That debt starts coming due on 2010. Hold on to your hats boys and girls, the defaults are coming.
Note: High yield bonds should be purchased for a total return, equity-like strategy. Relying on junk bonds for income is just plain foolish.
I have been of the opinion for quite some time that the recovery will be long and gradual. San Francisco Fed president Janet Yellen agrees. Yesterday, she stated that the Fed Funds Rate could stay at 0.00% for years and that, if the Fed could, it may take the Fed Funds Rate negative. That is not indicative of a V-shaped recover. Ms. Yellen also noted that China really doesn't have an alternative to the U.S. dollar as a reserve currency. This means that China and other exporters will probably keep supporting the dollar and help to keep long-term rates reasonably low for the near future. A few years from now, the amount of debt issued and dollars printed should push rates higher, but don't expect rates seen in the early 80s or even early 9os.
Welcome to your grandfather's economy. One which cannot be rekindled simply by making leverage cheaper and more available. The 25 year trend of lower rated ended when the Fed eased to 0.00%.
There are opportunities in fixed income. 5-10-year corporate bonds, especially non-TARP banks and, to a lesser extent, telecom and utilities offer attractive values, not only on an absolute yield basis, but also on a spread basis. As we know, credit spreads are the real keys to corporate bond investing
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