Never Assume

I had the pleasure to touch base with a financial adviser who was a reader of a former publication I published. We reminisced about days gone buy and he informed me that he respected my work in spite of my blowing the call with the GSE preferreds. I took a little exception to that.

It is true that I stated that I thought that a government seizure of the GSEs and a cessation of their preferred dividends was not the most likely scenario, I did warn that the government (for political reasons) could suspend GSE preferred dividends. It made no sense to do so from an economic standpoint as it only saves about $2 billion annually for each FRE and FNM. It also wiped out the non-cumulative preferred market which in turn helped to sow capitalization concerns among U.S. financial institutions. This helped to cause the runs which brought about the demise of Lehman Bros., forced Merrill Lynch into the arms of BAC and forced Goldman and Morgan Stanley to become bank holding companies (to be able to borrow from the Fed and acquire Tier-one capital via deposits). In fact, the government's plan to buy preferred stock interest in banks via TARP was the direct result of the banks in ability to issue Tier-one-qualifying preferred stock because of the treatment of the FRE and FNM preferreds. My opinion is based on logic. If asked, I will always tell what I believe makes sense, but will also warn that markets and government officials will often behave illogically.


What illogical phenomena do I see?

1) Dow 10,000: There is no fundamental reason for the rapid and significant recovery of the equity markets. Unemployment will continue to rise and once inventory replacement subsided, economic data will moderate. Lending will not become as easy as it had been because too many investors have the consequences of lax lending standards fresh in their minds. To be fair, the deep decline of the stock market was equally unjustifiable. The equity markets are the least efficient at predicting or even reflecting economic conditions, followed closely by the high yield bond market, due to the amount of fear and greed prevalent in those markets.

2) The shunning of 10-year corporate bonds. Investors do not understand the difference between credit products and interest rate products. Corporate bonds ARE NOT interest rate products

3) The love affair investors have with floating rate bonds. Floaters are designed to NOT BENEFIT investors merely because rates rise. Most floaters have coupons which reset versus LIBOR, but trade off of long-term treasury benchmarks. This means that even if rates across the yield curve moved higher by 500 basis points in unison such bonds will trade at deep discounts because the coupon will be significantly lower than the trading benchmarks. A flat curve is needed for price appreciation. CPI floaters measure the change of the rate of inflation, not merely positive inflation. Hence the low or zero coupons we now see on such bonds.

4) The recovery has to be as robust as "always": What is always? The last two cycles is not "always", but that is what many investors and pundits use as their historical examples. With lending standards becoming more responsible, look for PIMCO's forecast of 3% - 4% peak growth to come to fruition.



I'll leave you with the reminder of the warning given back in 2004 that GM could file for bankruptcy and was not too important for the economy to not be permitted to file.