Thursday, October 30, 2008

Down the Drain

The Fed continues to flush its balance sheet down the toilette to support our ailing financial institutions. The chart above shows Treasuries as a % of total assets at the Fed. The Fed started as a "reserve" for gold, then held only Treasury debt. Now, its main assets are loans to the country's banks.

I am not sure what will happen if some of these loans go bad for the Fed. Would it do any harm for them to just print more money and say it never happened? I am not sure.

What I am sure of is that the Paulson/Bernanke team have turned our financial market into a scrabble-like crisscross of mixed incentives. Banks have made major mistakes and inflicted a disaster of leverage on this country, and now our first priority is to help them? Hank Paulson forces them to take large amounts of easy money, Ben Bernanke coddles them with commercial-paper facilities and Sheila Bair comforts them with debt guarrantees.

These are the same banks like Citigroup that ran huge SIVs, which rammed hundreds of billions of dollars of extra debt into our economy just so they could make money. These companies stood at the central of the financial whirlwind that has shaken our land and pushed us towards something you might call socialism. Why do they deserve any support right now?
We've given them public money with no strings attached, and even now cannot force them to extend credit. Taking a page from the Bush tax cuts, we're insuring their debt for the next 8 months, and then it just stops?

The next problem is that they have failed to understand what hurt the interbank market. Everyone just assumes there is something deeply wrong when Libor stays significantly above the "official" rate like Fed funds or t-bills. But they forget that Libor is linked to a credit, and very real market prices exist for that credit.

Amid the meltdown on September 17th, yields of all financial sector corporate bonds spiked about 100bp. At the same time, panicked buyers pushed 3-month Treasury yields near 0%. Financials had major credit risk, so there's no surprise their yields were higher. At the same time, riskless yields plunged. Unlike in previous downturns, the fate of banks and the Treasury diverged.

Instead of recognizing this obvious reality of the market, the authorities have taken several actions to force interest rate unnaturally lower. They are spending billions to help the commercial paper market and insuring bank liabilities.

The interesting thing is that financial sector CP rates didn't move considerably during this period. In fact, the overnight, 15 and 90 day rates FELL... That means more people were buying those notes than selling that day.

What did move? Long-term corporate bonds and Libor -- the products that trade in the capital market.

What didn't move? Commercial paper.

Between Sept. 10 and Oct. 1, non-Treasury money market funds lost $440bln of their funds, or about 19%, according to AMG Data Services. That's why Sept. 17 was such a key date.. It was right at the start of a big liquidation that dumped billions of dollars in short-dated financial paper to be dumped on the market.

Bank of America's 1.5-year notes (BAC 7.800 02/15/2010) fell 3 points on Sept. 16.

The next day, its 10yr notes (BAC 5.650 05/01/2018) fell about the same amount. (Stocks also sold off.)

Many short-term financial sector bonds are linked to Libor -- "floating rate notes." These FRNs would have fallen when the market was flooded with other short-term debt.

When they fell, their yields rose. Because their yields are linked to Libor, Libor also was forced higher.

That's why Libor (and the TED spread) rose the following 1-2 days. Lots of floating-rate debt was trading cheap, with higher yields. With the market setting a price, Libor had to rise:
Eurodollar deposits (London)" ,Maturity,"3-month" (source)
09/12/2008, 3.00
09/15/2008, 3.00
09/16/2008, 3.20
09/17/2008, 3.75
09/18/2008, 5.00
09/19/2008, 5.00
09/22/2008, 5.00

Once again, we find the problem in the capital markets, not within the banks. This is not a banking crisis.

While we're talking about things in the capital markets, it appears there will be many headwinds in the credit market. It is clear that any improvements will be met with huge amounts of corporate bond sales.

Once the rallying in spreads ends, it might be hard for the stock market to keep moving higher. Looking purely at the chart, I would doubt the S&P500 could break through 1000. But, the election will probably have a positive impact. If Obama wins decisively and makes good actions right away, people might get excited about the end of the Bush reign -- which represented 8 years of lousy stock markets.

Even if things go perfectly for Obama and stocks go on a rally, I think the S&P 500 won't be able to make it through 1,200.

Getting back to banks: Once again, the problem began in the bond market, and then spread to the banks. After all, banks have grown more dependent on the capital markets during the last 20 years, using structured vehicles and corporate debt sales to fund operations.
Foriegners have also gotten much more involved in the credit market:
Here, the blue line shows the percent of U.S. corporate bonds owned by overseas investors vs those owned by life insurance companies. It's important because overseas investors will make decisions based on their own interests. They all had a single reason to buy U.S. corporates, so they all did the same thing. It's likely that if something bad happens, they will ALL become sellers as well. Their decisions are all based on trade and inflation.

Once again, a potential danger is lurking in the in the credit market -- the capital market. This is where problems START.

This is why I support a system that would bypass the banks by having the government buy corporate bonds and asset-backed securities. This would allow credit to flow to the economy and take pressure off the banks to lend.

Policy needs to focus on the capital market rather than the banks.

And, it needs to think about the health of the economy, not the health of the banks. But then again, who owns the Fed, but the banks?

Interest rates cannot be low forever. It seems that stocks do best when interest rates decline. At some point they have to rise. We might as well increase them as soon as possible, unless we want to suffer Japan's fate.

Tuesday, October 28, 2008

leverage rules, the Libor disconnect

in june 2008, a total of 45bln of credit securities were issued in the USA

in sept, 18bln, a multiyear low, of debt was issued. this month it's to be even lower.

in the world of credit, debt needs to get refunded. if companies don't sell new debt, they cannot roll over bonds coming due. many large companies like ATT, Comcast, GE, etc, issue bonds to pay for long-term assets.

normally any quality company can simply issue new debt and no one in the stock market even knows it happened. when it's not available, the shareholders are first in line to pay for it. dividends will be at risk, etc. it's a completely new kind of risk that's going to face non-financial companies (so far, we've only worried about banks, etc... GM could be next to go...)

I have observed that if a bond falls 10%, the same company's stock will fall 20-30%.

I am sure some official economist/credit expert somewhere knows the exact level... what that means is, when a company's debt comes due, management HAS to find a way to pay that money back. if they don't, it's chapter 11.

what I fear is that many industrial companies and others operate with small amounts of cash and require bank lines for working capital, etc. this environment will be brutal, and companies will be forced to raise capital and accept much lower earnings multiples.

this economy benefitted from 25-30 years of falling interest rates. that allowed a continuous process of multiple expansion... that era is over. deleveraging is how it will end.


by becoming more reliant on the capital markets, the banks have added a new element of risk. they decided to become reliant on capital markets and to sell bonds. now that these bonds are blowing up, how can anyone expect the banks to deal with each other?

if a company's long-term debt is trading like junk, how can anyone expect it to operate as a steady, reliable bank? why would other banks ever want to deal with it?

then the Fed goes and drives short-term rates lower. using the period of "normal" spreads, a bank like BAC would issue 3yr floating rate debt at about 5-10bp more than Libor. at the time, libor was about 5.25-5.50.. that means the cost of their credit risk is about 5.5% ... more or less all of their bonds yielded this.

suddenly, the Fed cuts rates. now, Libor "should" go lower. with fed funds of 3%, libor "should" be about 3.20%. why?

the interbank market is being affected by credit risk in the capital market.

if you now see Bank of America's 5-10 year bonds yielding 7-10%, you might be willing to accept 5% for the overnight risk on the name. but why should you accept something like 3.2?

but that's what the Fed is asking you to do. "ben and ted's unexcellent adventure"

because Libor is set by the market, it is the instrument that reprices. it's like ben bernanke came along and said "you WILL agree to lend to washington mutual for 2.5%, because the FOMC says so."
and the market answers back "no you won't. I will just refuse to bid on loans until Libor reaches the correct level." and then ben bernanke says "oh yeah, I forgot about Libor."
Libor is now around 3.40, and that's after some declines. the Fed needs to accept that Libor is a rate set by the market. somehow people have used this market to express an opinion. this is why they markets exist, after all.

in 2002, fed funds was 1%. something like 10yr bonds by jpm or citi back then would have yielded something like 4.2-4.5% -- at the most. and libor then would have been about 1.30%.

so, the normal spread between 10yr yields and 3 month yiedls was about 300bp.

now the yield on those long-term bank bonds is 8-9%.... using the old logic from 2002, libor should be somewhere closer to 5-6%. and, in 2002, there wasn't a debt crisis, so if anything it should be higher now....

this is why I am starting to fear the government's solution of insuring bank debt. it won't end well. this is why the only answer is for the govt to buy long-term debt.. ABS and corporates.

Wednesday, October 22, 2008

how strong are U.S. institutions?

this is from a recent AFP article:

"I'm hoping it's not close," said Richard L. Hasen, a professor who specializes in election law at Loyola Law School in Los Angeles.
"I am certain there will be problems on election day."

I generally would avoid sensational things like this, especially when it's from a newswire trying address an edgy topic... but I have heard enough worries about this issue now in the media that it's worth worrying about...

essentially, I think many of the country's voting facilities remain in pre-2000 (bush v gore) conditions. what happens if we have a contested election that drags on for months amid this economic crisis?

I have been arguing that the U.S. judicial-political-economic system has come to a major crossroads. we have abused our own system for decades, twisting our own constitution to mean anything we want it to mean, ignoring problems like healthcare and social security. our political class has no ability to do necessary things -- they are like spoiled children and don't recognize necessary things. they do what they think will get them re-elected, and nothing else.

the things that moved our system along previously have all petered out. we are now drifting without rudder or appreciation of what's going to happen politically. our naive and childish tendencies to "trust in america" and "trust in democracy" can't help us now that we've wandered so far from our constitutional basis.

Tuesday, October 21, 2008

judging the government's solutions

my plan of buying corporate and asset-backed bonds would do a better job of fixing the financial market than our current approach. in the last 10 years, banks have become less important as lenders in our economy, and the "capital markets" have become a larger source of money. over that time, all kinds of loans -- home mortgages, credit card balances, mortgages on office buildings, car dealer inventories -- have been funded by selling bonds. they are packaged into trusts, which then issue debt in the capital market. this is the new way our economy funds itself, and there are many benefits despite some real problems. fortunately, my plan would call for an overhaul of the credit-rating agencies -- major enablers of the binge.

my plan would embrace the new capital-market dominated reality. instead of trying to fix the banks, which long embraced these trusts, I think policymakers should look to the structuring technology as the solution. that means restoring the market for asset-backed securities -- especially those tied to credit cards and home mortgages. bank balance sheets and deposit bases are now much less important the economy. and, banks are private companies with their own shareholders to answer to. giving them free money and free guarantees, and then expecting them to effectively deploy the capital into the economy is naive. what's the incentive, other than the scorn of hank paulson, who'll be out of office in a few months? why should any bank put that money to work now?

paulson's "TARP" (troubled asset relief program) wanted to simply buy up distressed assets. some of his logic made sense because right now, some securities are TRULY MISPRICED and have very low risks of default under even the worst situations... the problem is that the market is frozen and no one wants to be the first one to buy.

that's why we need the government as a buyer... if the Treasury were to decree that AAA asset-backed paper should have a spread of 50 basis points over Treasuries, it would trigger a massive rally in securities that are now trading at areas around +500bp-600bp. because their default risks are so low, these are real instances of the market "going too far." many of these bonds were purchased by entities such as structured investment vehicles (SIVs), which got the money by borrowing short term in the "commercial paper" market. but now the commerical-paper market is crashing the SIVs have to pay back their debts, forcing them to sell longer-term asset-backed securities ...

a liquidity drain this size will inevitably reverberate throughout the economy. between aug 8 2007 and feb. 6 2008, the asset-backed CP market shrank by $378bln, or some 2.7% of GDP.

the market then more or less stabilized, as asset-backed CP levels remained close to $800bln from december through late july. it then fell 9% over the next five weeks.... then lehman brothers magicallly collapsed. (while it's hard to draw actual lines of connection, when you're dealing with large leveraged bets like this, it doesn't really matter how things work because everything winds up interconnected anyway.)

with less liquidity from ABCP, there was less money available to buy longer-term asset-backed (structured) securities, so issuance plunged:with less demand for these kinds of asset-backed securities, it's harder for credit card companies to securitize account balances. that means tighter standards, smaller credit lines and higher interest rates ... even businesses that have no exposure to housing will encounter tighter conditions as vendors demand earlier payments, etc. it will mean less money for ordinary people and small businesses... in other words, the exact thing the government wants to prevent.

this is a classic financial contagion scenario, where weakness in one area harms other areas. but this time, the problem is occurring in the capital market much more than the interbank market. we mustn't forget that the first indications of the credit crisis were visible in the asset-backed commercial paper chart above... it started falling in August 2007... while stocks went on to make new highs, the die was cast. by the end of the year, the sp-500 began a sharp bear market... by march, bear stearns was gone...


this housing boom and bust cycle was created in that capital market. that's where we have to solve it.

I believe the efforts so far will largely fail because they inject money into the wrong place. instead of rewarding banks with cheap subsidized capital, we should use that money to revive the market for long-term bonds. in this new modern system, the CAPITAL MARKETS, NOT THE BANKS, ARE THE SOURCE OF LENDING. investors are already on the sidelines with plenty of cash. they are afraid to buy now and recognize losses, but if the government were to establish official prices, they would rush back to the market.

such a solution would get money more quickly to the parts of the economy that need it. instead, we're trying to cobble together some kind of solution based on precedents established in other countries. we're giving the money to banks, which are bleeding out of every limb, and ASKING THEM to pass it along. this seems like plain wishful thinking to me. maybe hank paulson is just too close to wall street to know any better.

pursuing a capital-markets solution such as mine will also guarantee taxpayer upside. after all, bonds are priced relative to Treasuries. if they just took the average spreads over the last 10-15 years, it would allow to buy AAA at about +50bp, AA at +80bp, etc.


this would put a lot of onus on the credit-rating agencies. after all, the government would use their ratings to determine borrowing costs across the entire economy. that would require a major overhaul of the industry. for years, moody's and S&P have existed in a nebulous, murky realm. they take a cut of all issuance, which makes them resemble the investment banks that manage debt offerings. but unlike the banks, they cannot easily be sued. that's because they have the legal standing of journalists... this places them in a very priviledged place... they profit from surging debt issuance, but can't get in trouble when something goes wrong. heads they win, tails you lose.

we need to fix this situation. the rating agencies were at the very center of the credit collapse. (they're already ensconced in regulatory regimes around world involving pensions, insurance, banking, etc.) we cannot allow them to just slip into the woodwork. that's another benefit of my capital-markets solution... it would necessarily cast moody's and S&P into the political spotlight, where they belong.

as for-profit organizations, they inevitably seek growth first and foremost. in their case, they found that growth in structured products:

it appears Moody's and S&P made much more money rating complex debt securities than old-fashioned stuff like plain vanilla corporates and soveriegns. furthermore, those same issuers had less debt to sell. so the rating agencies turned to the most obvious growth opportunity: structured debt, most of which was tied to consumers rather than companies or countries.

on Feb. 4, 2004, Moody's acknowledged that the traditional corporate business would slow, but then assured investors with these words:

We also expect good growth in consumer spending in 2004. As a result, we expect that revenue from rating asset-backed securitizations, together with moderate growth in the commercial mortgage securitization and credit derivatives segments of the business, will substantially offset an important decline in revenue from rating residential mortgage-backed securities as the very strong refinancing activity of the past two years declines. In the public finance ratings business we expect approximately 20% revenue decline in 2004, reflecting projected slowing of issuance related to both refinancings and "new money" borrowings.

now, I am not sure why they said residential mortgage backed securities would decline. I don't believe that happened. but, we do see that Moody's was viewing structured finance as a growth area, which it was.

here's something from Moody's 2002's 10-K annual report:

Operating income of $538.1 million in 2002 was up 35.0% from $398.5 million in 2001. Moody’s operating margin for 2002 was 52.6%, up from 50.0% in 2001. The strong operating income growth in 2002 principally reflected the Company’s high revenue growth without a proportional increase in expenses.

again in 2003, the magically language appears:

Moody’s operating margin for 2003 was 53.2% compared to 52.6% in 2002. The increase reflected the strong growth in revenue in the Moody’s Investors Service business without a proportional increase in expenses.

in essence, these guys' were bringing in more revenue, but their costs didn't go up. everything was pure margin... why? because they were the gatekeepers sitting a top hundreds of trillions in debt issuance, and took bigger cuts when a deal was structured. all they had to do was hire a few more analysts and put in a few more computers... peanuts compared with the amount of revenue coming in. (this phenomenon is called "operating leverage.".. unlike making physical products with raw-material costs, the rating agencies just collect revenue when bonds are sold. if strong demand allows issuance to increase from $100mln to $150mln, the agencies get 50% more money for doing 0% more work... that makes the commission on $50mln pure profit.

and, the rating agencies' fees were almost certainly higher on these newer products. (I should emphasize there is no really definitive way to PROVE this, but it's a reasonable assumption given the chart above showing that the company's profit margin expanded when its product mix turned in favor of structured products.... furhermore, in any environment when something is new, with high growth potential, margins are ALMOST ALWAYS wider than a sector like sovereign debt, which has existed for centuries.)

and, of course, Moody's and S&P don't disclose their fees publicly.

this collapse of overall issuance, led by structured products, has been accompanied by a collpase of the share prices at both moody's and S&P parent McGraw-Hill this year.

even Fitch Ratings discussed how the weak structured-product market at its rival S&P could hurt McGraw hill's credit profile (which happens to be a plain vanilla corporate issuer in its own right, and the owner of S&P):

Rating concerns include dramatic slowdown in structured finance rating fee revenues, and the declining issuance of commercial mortgage-backed securities (CMBS), collateralized debt obligations (CDOs) and residential mortgage-backed securities (RMBS).

finally, as public companies serving shareholders, Moody's and S&P have no incentive to look at the macro economic/financial picture. no one stopped and said: debt in the overall economy is growing too fast-- make it stop. they continued giving the nod to individual securities without any sort of concern for the bigger system. they remind me of careless fishermen who overexploit an area just to make money, only to destroy a population's long-term viability. these rating agencies have eaten at the trough of the american financial system long enough. while they can produce a million excuses for why they misrated subprime debt, they can offer no explanation for allowing our household sector to take on so much debt except "it wasn't our problem." in truth, it wasn't their problem ... their only responsibility is to make money for shareholders. this renders them incapable of thinking about the broader financial system.

if we're going to give Moody's and S&P such an important role in the economy, maybe we should expect something more from them. maybe their mission should be brought into line with the needs of the country.

it's clear the rating agencies were at the center of this mess... and it's also clear that the mess began as early as August 2007 when asset-backed commercial paper came unglued and longer-dated issuance collapsed. that is what killed the bid for credit and unleashed the cascade of price declines, which subsequently caused bank writedowns. the problem began in the capital market, and that's where it needs to be fixed.

Saturday, October 18, 2008

foreigner, don't go home

summary: after years of pumping cheap money into our economy, foreigner investors may exit our market. this could translate into a long-term drain of liquidity that will make it harder to borrow, and resemble a tax on business that increases the cost of capital.

last week, the Treasury Department reported that overseas investors sold more than $13bln of corporate bonds in the month of august. it was the second negative month in a row, and the third to show a precipitous drop off. after averaging more than $40bln a month in purchases during 2006 and 2007, foreigners are suddenly fleeing the US credit market.

this is not the sort of event americans are used to seeing. we are accustomed to being the world's preferred borrower -- the highest quality credit. for years, our debt grew faster than the rest of the economy, allowing us to spend a little more than we ought, and letting companies borrow a little more than they normally could ...

two conditions allowed us to live beyond our means like this for years. the scary thing is that both of them seem to have reversed, so conditions could get a lot worse.

the first thing that made foreigners into our willing lenders was the trade deficit:

the U.S. has helped other countries develop for years by eagerly buying every barbie doll, pair of sneakers, or barrell of oil they produce. by 2004, the U.S. trade deficit had climbed to more than 5% of GDP, compared with the 1.3%. between 2003 and 2007, sucked a net total $3.3 trillion from our economy.


as the clothes, fruits and consumer electronics flooded the U.S., foreigner economies built vast stockpiles of dollars...

these dollars wound up at banks and financial institutions around the world. these same countries had policies of promoting exports, so they naturally wanted those dollars to stay as strong as possible. they didn't want to SELL THEM to buy their own currencies. so if you have a few hundred billion dollars you need to invest safely, where do you go? THE U.S. BOND MARKET.

the bond market is a place where anyone can lend money. you can chose between municipalities, companies, governments, and, of course, people.

established bond investors are very cautious by nature, so they research investments thoroughly and don't take stupid risks. but, unlike a being a loan officer at a bank, bond investors don't have to pass tests and answer to state regulators (who make banks stay conservative). bond investors don't have to know their borrower, the borrower's income or finances. all you need to buy into this market is a couple of hundred million dollars.

until about 30 years ago, only major organizations with long-term assets and cashflows sold bonds: governments, railroads, utilities, etc. but then came securitization. it started with fannie mae and freddie mac.. the GSEs ... in 1975, they issued $9bln of debt, while traditional corporates sold $27bln... GSEs were only 33% the size of corporates ... three years later, GSEs had blown past corporates.. by 1982, they sold two twice the amount ...

the GSEs purchased mortgages and assembled them into pools, which then issued bonds. this kept money flowing to the banks, promoting the general post-WWII trend in favor of homeownership. using structured finance, they transformed millions of loans into homogenous financial products. it was all for a good cause, and most importantly, it proved to be quite safe.


then came salomon brothers, which created the first private-label mortgage pool in 1983. the technology worked and soon spread to credit cards and auto loans. importantly, it passed through the S&L crisis of the late 1980s unscathed -- validating the belief that it was possible to structure a bunch of small consumer-based assets into a predictable source of cash flows... it was a new homogenized product in the market where everyone was looking for yield... salomon had invented a new widget, and it spread.

in the late 1990s, companies like worldcom, qwest, bell atlantic, time warner, comcast, etc, were building out the information superhighways, issuing hundreds of billions of dollars in the process. general motors and utilities others joined as well...

in 1998, the trade deficit started to widen sharply .. right around the same time china joined the World Trade Organization....

as investment declined and americans responded to 9/11 and the recession with furious spending as houses and cars grew bigger and retailers across the nation "went upscale" ... factor in the rising cost of oil imports, and the U.S. was consumed $700bln+ more than it produced in 2005 and 2006... a trade deficit of 5.75% of GDP both years.

as I explained above, most of those dollars were then recycled back into U.S. bonds, including corporates and asset-backed securities.

we do not know which kinds of bonds foreigners buy. the treasury department combines corporates bonds and all asset-backed securities under the same group. (the bonds related to fannie mae and freddie mac are not counted.)


in general, foreigners will buy a broad smattering of everything that's coming to market. in the late 1990s, they surely bought all the bonds from GM and worldcom... by 2002, companies didn't need the money, and most capital expenditures were finished.

but this was the same time the trade gap exploded wider, and the foreigners had more money than ever to put to work.

issuers of asset-backed securities stepped in to fill the breach. they basked in the liquidity, spoiled like children as the market gobbled up deal after deal.

investors loved ABS because they yielded a nice 10-30bp more than corporate bonds with comparable credit ratings.

bankers loved ABS because they generated underwriting fees. I am not sure, but I would believe they charged a higher commission than would have been standard for corporate bonds. (I say this because ABS were a newer market with a shorter history of competition.)

Moody's and S&P loved ABS because they generated much bigger fees. like investment banks, the credit-rating firms take a cut of issuance volume. they won't disclose their commissions, but moody's does report its revenue from structured products and corporates. combining this dealogic's data on annual debt issuance, I have calculated my own measure of their commissions... I found that that Moody's earned about 0.04% of all structured debt issued... compared with 0.02% for corporates... this was a cash cow.

credit card companies loved ABS because they allowed them to keep churning over more money and collecting fees and interest on the way.

mortgage brokers loved ABS because that's where they got their money. they grew increasingly reckless, and came to realize they could sell any kind loan to the market. they also got a percentage of issuance, like the credit rating agencies and the investment banks.

all of these groups benefitted from ABS and had a vested interest in churning more money through the system. then came a flood of foreign capital, and the mortgage-lending orgy was in full swing.


I have reached two important conclusions about this period:

1- the problems happened because the capital markets took over for the banks. loans were issued to people, not because they needed a house or were able to pay back. loans were issued because the money had to be invested.

the capital market was doing the job of the bank, but without any of its regulation or accountability. but everyone was getting rich, so it continued .

because the originators didn't hold the loan to maturity, there was no incentive make good loans.

the loans wound up on a trust, backing thousands of different bond offerings.

for credit quality, everyone essentially deferred to the moodys and S&P, which provided the necessary spectrum of ratings.

2- trade can concentrate huge amounts of money to financial assets, like mortgages. history provides many unhappy examples .... in the 1970s, where US banks channeled arab oil money to latin american governments... in the 1980s, japanese export earnings were recycled into tokyo real estate. both ended in bubbles and years of anguish.

so, imagine what would have happened if those $700bln+ had stayed in the USA in 2005-7. that money would have filtered through the economy in the form of wages and tax receipts. most of it would have been spent on normal consumption... only a small fraction of it would have wound up on the bond market (probably via some retirement fund)...

in contrast, when that money leaves the country and returns, almost half of it goes to the bond market. (in the 1985-2007 period, an average 44% of the trade deficit was invested in the "corporate bond" category.)

this was a big part of the credit bubble. by far not the only cause, but the single strongest single event that made the bubble inflate.

the economic problems originated in the capital market. unfortunately, few people of influence, whether reporters, economists or government officials, seem to appreciate this. they are trying to fix it by tinkering with overnight lending rates and emergency liquidity tools... these are all tools designed to deal with banks. no one at the Fed is talking about the sick bond market -- even though issuance has fallen off a cliff.

even if ben bernanke and hank paulson aren't paying attention, plenty of people seem to understand this. economists, investors and traders have told me that the government should be either guaranteeing or simply buying corporate bonds. one big ABS investor told me "people have no idea how large and important the asset-backed market is."

it started coming apart in august 2007 when SIVs unwound (they borrowed using short-term commercial paper and bought longer-term ABS). this dumped large amounts of ABS onto the market, which drifted about at discounted prices. this extra supply made it difficult for credit card companies and other lenders to securitize their assets. this caused a net reduction in the financial system's liquidity, which caused more problems -- each of which makes the situation worse ... the collapse of bear, lehman, AIG, etc. all of it started when the SIVs unwound in august 2007.

we're suffering from a sudden reduction of liquidity in the capital market. this has created a series of implosions. I fear it could cause a severe decline of credit in the entire economy, which could be much more devastating.

it could be like the great depression in one, big depressing way.

the common understanding now about the great depression was that the fed made things worse by raising interest rates and reducing money in the economy. they correctly observed that the fed was too worried about inflation. (it really didn't make any sense because commodity prices were plunging in the late 1920s...)

this year commentators such as paul mcculley at pimco invoked this memory to argue in favor of low interest rates.

I believe they were right in spirit, yet reach the wrong conclusion. the answer is not for the Fed to cut rates or provide easy money to banks. the answer is to fix the problem in the capital market: NO ONE IS BUYING BONDS. that is tightening the noose around our credit system. THE ENTIRE SYSTEM IS POTENTIALLY INSOLVENT if this contagion spreads.


NO ONE UNDERSTANDS HOW MUCH MONEY THIS COULD BE. at the end of june, foreign investors owned $2.86 trillion of corporate bonds -- exactly 25% of the market.

as late as 2005, life insurers were the largest holders of credit securities. but foriegn investors blew past and now exceed them by a full TRILLION DOLLARS.

and, as I pointed out at the top of this entry, these foreigners are already selling their trillions.

two things that made them buyers before now make them sellers.

1-fewer are dollars streaming in.

2-their currencies are now falling too fast, so they might sell dollars and dollar assets. after all, corporate bonds are now their top holdings, surpassing treasuries and stocks.

the scariest thing of all may be that the government plans to stimulate the economy and borrow to do it... that means trillions of dollars of brand new, safe treasuries will come to the market, at the same time foriegners are dumping their own trillions of corporate bonds...

this will be devastating for credit, and could cause companies throughout the entire economy to freeze up.

the government's inability to see how this chain of events could play out is frightening. this is why I think bernanke's Fed is actually a lot like it was back in the 1930s. it's like terminator 3... even if you think you can stop it, the catastophe is almost destined to happen. our efforts play right into it.

finally.. I had some other observations about what caused this bull market in credit...

1-years of declining interest rates. since the Fed defeated inflation in 1982, long-term rates steadily marched lower.

2-improving corporate profitability, bolstered by higher worker productivity...
in addition to technology, globalized supply chains drove productivity gains... in other words: cheaper sourcing ... especially after china joined the World Trade Organization in december 2001.

... and once you have a surge in international trade, you get:

3-globalized capital flows: as the rest of the world sold more goods and services to the US, they accumulated dollars. those dollars were recycled back into the US, creating a boomtime in U.S. financial history I call "the foreign bid for credit."

many things happened during the great foreign bid for credit:

1-US treasury supply fell as budget deficits narrowed. (this deprived foreigners of places to park dollars.)

from 1985-96, the US government borrowed an average $201bln a year.
from 1997-2001, we paid back an average $80bln a year.

in other words....
treasury bond supply declined sharply starting in 1996. at the same time, corporate america globalized supply chains, leaving more dollars in the hands of foreigners. these foreigners generally wanted the dollar to remain as strong as possible (because that's how they get paid). loath to sell their dollars, they bought dollar-denominated bonds.

but because there were so few Treasuries, they started buying US corporate debt. over time they grew accustomed to it.... by June of 1998, a new trend had emerged.

between June 1998 and may 2007 corporate bonds were the leading destination for overseas money 56% of the time, compared with 22% during the previous 20 years (1978-98) ... (there are 4 categories under which the Treasury reports foriegn purchases of U.S. long-term securities: Treasuries, Agency/GSE, Corporate bonds and Corporate Equities. "corporate bonds" include asset-backed securities linked to everything from mortgages, credit cards and auto loans.)

this buying reached a fever pitch at the height of the US credit bubble:

just to round it out, you can see US home prices rose along with the foreign capital flows, and started falling only earlier.

looking at these charts, it's clear what drove the housing bubble: a vast surge in foreign demand for "corporate bonds" .. this was the great foreign bid for credit. it was a market trend that seems to be ending... this is why I fear a potential bear market in credit .. the possible implications of such a bear market have not yet been fully grasped... everyone now assumes credit will just "get better" ... but can that happen with foreigners turning into net sellers?

I put "corporate bonds" in quotations because it comprised both normal corporate bonds, issued by telecom companies and utilities, and asset-backed securities, which are dominated by mortgage debt.

during the great foreign bid for credit, both kinds of issuers had their day...

normal companies like GM, worldcom, qwest, ford dominated until about 2001 as they built networks and funded long-term pension liabilities...

by 2002, they fell off the map as the enron-worldcom credit crunch hit...

... at the same time, all this foreign money was flowing in and tens of billions of dollars cascaded through the system each month... before long, every half-witted mortgage broker from miami to las vegas had learned how to stick out a bucket...

thanks to them.... between 1998 and sept 2007, debt of banks, financials and structured entities rose from 40% of GDP to 110% of GDP.

given that US stocks were tacitly subsidized by foreign quasi-official purchases, what does the removal of that capital do to our economy?

Thursday, October 16, 2008

a possible improvement

we might be stepping back from the abyss. after flailing around and trying everything else first, hank paulson might have hit the right button.

this idea about the FDIC insuring bank debt might work... at least for a little while. bank spreads were generally tighter and libor declined. bank of america and credit suisse are now recommending financial bonds. furthermore, california succeeded in selling $5bln of its muni debt.

the sp-500 is hugely oversold. I think the risk to reward now favor buying stocks and credit now.

in the meantime, some issues with the paulson plan to use the FDIC to ensure bank debt incurred through the middle of next year ...

once banks are insured, what kind of incentive do the banks have to fix their books?

under my plan, they still have credit ratings and differential borrowing costs according to basic credit fundamentals. my idea is less intrusive.

paulson's plan will create a legal link between the govt and corp bonds. over time it could create unpredictable negative outcomes. if the govt is a buyer of corporate bonds, it just phases itself out of the market when needed. the current plan could create greater tensions as june 30, 2009 approaches and the coverage nears its end.

banks might profligately issue large amounts of publicly backed debt. this is hardly the way to hold the banks' feet to the fire. many of these companies were completely irresponsible and need to be unwoundnd tranquilly.

by owning their bonds, the government has true control. financials need constant access to liquidity, and washington will be their lender of last resort, as long as they maintain the right credit ratings.

this would be also allow them to raise new PRIVATE capital, which is what regulators would force them to do in a situation like this in normal circumstances. paulson doesn't seem to get that just because we're in a crisis, we don't need to swing all the way into the socialist camp. we're still americans.

once the credit backstop exists, liquidity will return. equity investors will look in and realize things still aren't so bad and the worst of the writedowns are over... knowing that the bank has access to real financing, they will buy the stock. the govt could work with moodys and s&p along the way to influence the credit ratings, and thus the fate, of each bank. this would give control without ownership. now the government has overpaid for partial ownership, and has no clear methods of control -- aside from paulson's menacing tea parties.

I think the treasury secretary doesn't realize that in the world of finance, creditworthiness is an asset. these guys have seriously damaged theirs. they need to earn it back before responsible adults will trust them again. forcing them to take cheap money and have their debt guaranteed, paulson is mixing incentives. it's like giving them a sour apple candy, deciding to call it yucky medicine, and washing it down with a 5-pound bag of sugar.

Wednesday, October 15, 2008

beware the trend

one of the most important forces in financial markets -- or human behavior in general -- is the TREND.

after decades of strength, the US credit market may be entering a long-term SECULAR BEAR MARKET TREND.

however, one step in the FDIC plan guaranteeing bank debt, might save the day.

trends occur when people move towards a new belief or idea. some principle -- whether it's prohibition of alcohol, or a bullish feeling in a stock -- offers an intellectual appeal. they can be "proven" and articulated. people's minds can take ownership over them and feel they're true.

the idea wins early converts. they see people getting drunk and beating their wives and neglecting their children, so they condemn liquor. they see computers spreading like wildfile through companies and households. they see microsoft beat estimates and some people start buying the shares. (money is how you express yourself in markets.)

in something like prohibition, the idea builds in a small circle over time. it then grows increasingly mainstream after the civil war, when millions of new adherents banned alcohol in about 124 countries, according to wikipedia. (jack daniels is distilled in a dry county.) during WWI, different groups such as employers, women's groups, religious and the military embrace prohibition at the same time. once it's broadly accepted, the constitution is amended and the era of the bootlegger began.

microsoft muscles its way into the computer market with an operating system that creates a single platform where software developers and computer makers competed to create more and better products. MSFT doesn't care if IBM sells more PCs than DELL, or anything else. they profit from everyone using windows-powered computers. MSFT shares become a vehicle to ride that broad societal trend and rise from 10 cents to over 70.

financial market trends can work in the opposite direction... an asset has appreciated for years, and everyone owns it. some people start selling it to raise cash... others start to notice it's not going up anymore. they also become sellers. it then moves lower over time as people come to assume that now it's going lower.

for many years, the credit of businesses, households, municipalities has been in steady demand. investments by pension funds, mutual funds, hedge funds, insurers, foreigners have crammed debt into every corner of our economy where it can go. it climbed every year since the 1950s at about twice the pace of GDP growth. it built modern america.

credit is widely owned and has been in a bull market for decades. now the prices start to weaken and people are increasingly assuming the worst and giving up hope. if we go into a real bear market, the bedrock of capital under our lived environment starts to crumble. houses, shopping centers, etc, all become worth less than their debt. stripped of equity, owners start to walk away. that's when the real collapse occurs. this started with home prices falling. that destroyed the mortgage market. now people can't get loans, and it's becoming a self-perpetuating cycle.

we've already seen a gradual slowdown in borrowing....

if this is a trend, it will accelerate and the lines on this chart will cross into negative territory.

it seems overall lending really started contracted after lehman failed in early september. so consumers and financials have now apparently turned negative. it will be interesting to check the next z.1 for data on how much companies and municipal issuers turned to bank lines and reduced term debt issuance.

a bona fide collapse in lending in the US could prove a major shift in the continuum of money, time and space.

we now face the real decline I have been fearing. all financial assets - stocks, bonds and commodity futures - are plunging in value as liquidity dries up.

some observations on the sp-500 stock index:

it took 23 months in 2000-2 to fall 45% from 1530 to 850.
this time, it has fallen about the same amount in just 12 months.

it posted a similar drop oct 73-74 and bounced back. but there was much less debt and people were forming families. today, people are downsizing homes and paying off debt.

reading some research: it seems that people are now assuming the worst instead of buying credit on dips. after the collapse of bear in march, demand returned for financials and other corporate issues. when in doubt, investors assumed the best and bought.

lehman destroyed that confidence. years of excessive trust became complacency. when the bliss ends, it's replaced by fear and paranoia. just as it was irrational to lend money to many people who got mortgages, the pendulum might swing back just as hard in the opposite direction and deny credit to worthy businesses. it seems to be starting now.

the assumption is increasingly that bad news is coming next. it's like a meteor striking in the middle of the ocean, with people knowing a tsunami is hours away. we know the economy will suffer, and now everything is becoming a self-fulfilling prophecy. now even with some evidence of improvement in commercial paper, the market is shooting first and asking questions later.

getting back to the sp-500: in 1974, it fell to a support level set 12 years earlier. if we span the same amount of time today, it puts the sp-500 around 677.

assuming we continue to fall, the next real support is about 813, an old high reached back in feb 1997.

one major thing that could undermine my fears about a collapse in credit is the government's apparent promise to insure financial bonds. it would target the same goals as my own proposed plan, and might accomplish the same goals of taking the pressure off the short-term debt markets. the more I read the research, the more bullish it makes me want to get...

apparently, it will provide a 3yr guarantee to new issues of senior unsecured bonds issued through june 30, 2009. if it works, this could take armeggedon off the table for a little while longer and result in a buying opportunity. still, there is so much negativity in the stocks now, and that trend might continue even as the funding picture starts to improve. and, how much else will be lost in the meantime... this is why they should just start buying corporates right now.

finally, let me just observe that the market for financial issuance seems to have shut down as early as May. was it actually the collapse in the PRIMARY MARKET that killed lehman?


creditworthiness is built at the long end of the curve

one more point on my theme about fixing the credit market:

creditworthiness is built at the long end of the curve: if investors don't trust a company enough to lend it money over the next 5, 10, or 30 years, is it a safe borrower? would you be willing to accept its short-term overnight paper as the equivalent of cash in money market accounts?
the answer is obviously NO. no borrower could ever get the needed A1-P1 ratings without a deep pool of assets and access to large amounts of liquidity (ie, open "bank lines").

A1-P1 is equivalent to AA/Aa, the highest realm of debt in the universe short of the sacred AAA. from my experience covering the debt market, I have never seen a major CP issuer lack a full docket of bonds scattered across the yield curve. therefore, it's logical to conclude that a solid CP issuer MUST HAVE functioning access to the longer-term debt market. while there are probably some exceptions, and no one has written this as a rule, this is generally how things work. we cannot at this point hope to stabilize the interbank market without first stabilizing the term debt market. that's why the government must provide support to the corporate-bond/ABS market right away.

also, this disaster is looking more and more like the great depression, where the policy makers focused on the wrong problems. in 1931, they fought the wrong war by worrying about recession. I believe that in 2008, we might be focusing incorrectly on the intrabank market rather than a functioning term-debt market. history repeats itself, but there is always a twist.

katrina in the financial markets

he's got an offer you can't refuse...

in a move straight from the Godfather, hank paulson is now telling bank executives "either your signature, or your bank's brains, will be on that paper."

once again, the New York Times brings the news so effectively:

WASHINGTON — The chief executives of the nine largest banks in the United States trooped into a gilded conference room at the Treasury Department at 3 p.m. Monday. To their astonishment, they were each handed a one-page document that said they agreed to sell shares to the government, then Treasury Secretary Henry M. Paulson Jr. said they must sign it before they left. (link)

the Treasury secretary invites men who probably control half the country's deposits, and serve as fiduciaries for millions of americans. in just 3 1/2 hours, the government gets them to make a huge decision that will affect their companies in unknown ways. boards of directors are barely consulted.

the bush administration has now thrown not only free market capitalism out the window. it has also flushed corporate governance down the drain. talk about imperial CEOs -- signing away their companies rather than endure another minute under the the Treasury secretary's glare.

was dick cheney standing nearby with his hunting rifle and an itchy finger?

this kind of all-or-nothing, with-us-or-against-us posturing is exactly what got us into Iraq.

today someone likened the current collapse to the chaos following katrina. I can think of few better analogies.

paulson went deeper down the rabbit hole by demanding that banks not "hoard" this new capital they're getting, but must "deploy it." while this would obviously help the economy, don't forget these same CEOs are enjoined by law to serve the financial interests of shareholders ... there is no patriotism clause ...

two big problems... first of all, there is a major risk this won't work. even if you strong-arm them into lending, they will not be willing participants, and will not do good jobs. second, it's downright third-world for major government officials to demand that CEOs ignore their sworn fiduciary responsibilities. this is a dangerous flaunting of the rule of law, and again reminds me of my time in Venezuela.

paulson makes things even worse when he apologizes ("we regret having to take these actions.”) now we should ask: why would anyone want to follow a leader who so quickly casts doubts upon his own actions? how can he have any credibility?

at this point, I am terrified. everyone has focused on the need to stabilize the markets in the short term, but something much more worrying has happened: we're trusting GW Bush --the same president who sought tax cuts that snap back after 10 years, invaded iraq on bad information, botched katrina, changed course multiple times on north korea and iran and ignored the credit crisis for over a year, but was willing to fly back to washington from TX to sign a law keeping terri shiavo on life support. (how many 10s of 1000s of dollars did that cost?)

this same illustrious leader will now shape the future of the american financial system with an idea he never liked and doesn't want to impose.... he hates it so much he's making everyone sign it. can anything good come from such a process?

this is katrina in the financial markets... the nine favored banks will get the nicest trailers. what will we get?

Friday, October 10, 2008

why bonds matter

I have been incessantly promoting the idea that the government must fix the price for corporate bonds or face a true collapse in companies and their shares. even though the corporate bond market is only 1/3 the size of the stock market, it's actually much more important.

why? equities are leveraged to debt. if bonds fall a little, stocks fall a ton.

consider these examples:

equities represent the "residual value" of a company after the bondholders are paid back. furthermore, bonds have to be repaid on certain dates -- unlike stock. so, when debt comes due, the CFO must find the money or declare bankruptcy. and, if bond investors don't want to buy more bonds from the issuer, companies cannot roll over their debt. that means they must either sell assets, use existing cash, cut dividends, or SELL MORE STOCK. none of those choices are good for shareholders.

this is what's happening in the bond market right now. companies are incapable of rolling over debt. so far, the effort has only focused on the short-term commercial paper market. I argue it would be better to fix the long-term corporate bond market because if companies can term out debt for 3+ years, they don't need to roll it over every 30 days. it's scary that the shutdown of the long-term market is forcing more debt into the short-term market at the same time banks are collapsing and incapable of lending. it's different from the 2002 recession when the debt market remained open for most issuers, aside from the failing telecom and utility names. now it's shut for almost everyone. this is also scary because corporate America currently relies more on the debt markets to run operations than in the past.. see my posting below.

excluding debt issued by asset-backed trusts, there was about $7.2 trillion of corporate bonds outstanding at the end of 2007, and about $21.8 trillion of corporate equities outstanding, according to the Fed. that 3:1 ratio has held roughly steady over the last decade or so.

that implies if the bond market loses $100bln of value, more than $300bln of equity will get wiped out. this is why the only way to save the stock market is to unfreeze the bond market. otherwise, we'll all wind up looking like Charter Communications:


(this also poses long-term dangers to leveraged companies like AT&T and Verizon. when their interest rates inevitably rise, they will have less money to pay dividends.)

Thursday, October 9, 2008

the Fed's shrinking lever

the more I watch our response to the ongoing credit meltdown, the more I question the judgments and assumptions of our financial leaders. as a mere journalist equipped with nothing but the Fed's own Flow of Funds report (Z.1) and microsoft excel, I have discovered some startling realities that may in the long run prevent Ben Bernanke from successfully navigating this crisis.

the basic argument: THE FED IS A LOT LESS IMPORTANT THAN WE THINK. the Fed controls the economy via the banks... but, banks have significantly lost relevance in the US economy over the last 35 years. this could leave central bankers much less powerful than we believe.

some numbers:

in 1974, checking, savings and "time deposits" (certificates of deposit) represented 46% of the total credit-market debt in the US economy. this mass of deposits was the bedrock of the financial system and provided the basis for all other lending. for instance, total mortgages represented just 65% of the deposits in US banks in 1974. and commercial bank loans were 22% of U.S. credit market debt.

fast forward to 2007: checking, savings accounts and CDs are now just 18% of total credit market debt. and now, mortgages represent 160% of all deposits. commerical bank loans fell to 14% of total credit-market debt.

these numbers show bank deposits and bank loans declining relative to the overall system, while mortgages break out on their own program.

traditional banking did, of course, grow over those years. but during the same period, banks increased their reliance on capital markets for funding. furthmore, many other kinds of non-bank borrowing and lending developed -- basically asset-backed entities that functioned like banks, but without the rules.

in 1974, corporate bonds were mainly used by railroads and utilities to finance long-term assets like tracks and transmission lines. this is the traditional use of bonds, and dates back by centuries. in 1974, these non-financial companies accounted for 77% of all corporate bonds. banks and finance companies were just 16%.

fast forward to 2007, and non-financial companies had shrunk to 32% of the market, while financials grew to 52%. (foreign companies and governments account for the remaing issuance.)

again, the financial sector develops its own source of money, independent of deposits...

corporate bonds have gotten bigger over the years, reflecting the growth of the non-bank financial system.

in 1974, corporates were 12% of total credit market debt.

by 2007, they were 22% of credit market debt.

also, in 2007, issuers of asset-backed securities represented 35% of the corporate-bond market. that almost doubled from just 18% in 2000. an increase like this, reflecting debt growth of more than $3 trillion in seven years, is staggering by itself.
keeping the comparison with 1974, ABS issuers were a whopping 0% of the corporate bond market.

in other words, a huge, unregulated sector grew apart from the balance sheets of banks and securities firms. it ran up vast amounts of debt, most of which was funneled into reckless mortgage lending. wall street wunderkind transformed a class of securities dedicated to long-term productive assets into a cheap and easy way to plow money into home mortgages and consumer debt. (with huge fees along the way.) and, a sector of lending previously dominated by the banks, under the watchful eye of the Fed and other regulators, was thrown to the law of the jungle.


this leads to two major conclusions:

1-the basic principles of monetary economics and central banking need to be questioned. the idea that you can control liquidity by manipulating interbank rates looks increasingly incorrect. the Fed has actually been losing this control for years... they raised rates in 2004-7 and liquidity continued to expand and inflate the credit bubble. why? because the liquidity was coming from the capital market, which was awash in money. (I know because I covered corporate bonds deal by deal as it happened.)

NOW THE ILLIQUIDITY IS ALSO COMING FROM THE CAPITAL MARKET. prompted by the collapse of Lehman Brothers, the demand for corporate bonds and commercial paper has collapsed. that's what killed credit. it's not like the great depression, when bank runs pushed the system over the edge. TODAY, THE RUN IS IN THE CAPITAL MARKET. when bond investors refuse to rollover the debt of financial institutions, it's the same thing as when depositors pulled money out of the banks in 1932.

for years, the experts at Pimco have spoken about the "shadow banking system". for years, greenspan spoke about the "conundrum" of how interest rates defied the Fed's rising overnight rate. it's time we recognize the tools of monetarism have lost much of their power. banks matter less, capital markets matter more.

2-solutions to this problem must be found in the capital market. that's why I am promoting the idea of the government stepping in and creating "official" prices for bonds. this will revive the issuance of these securities and allow debt to be refinanced. without refinancing debt, companies will drop like flies.

3-banks need the credit market now more than ever because they rely more increasingly on debt capital markets for their money. in 1974, commerical banks had less than $11bln of corporate bonds outstanding. that was just 1.3% of their total liabilities.

by 2007, that proportion had almost quadrupled to 6.3%.

one of the dirty secrets now is that banks and financial companies have 100s of billions of dollars in debt maturing in the next year. now that the corporate bond market is effectively shut down, so now they are getting all the money they need from the Fed's slew of liquidity facilities.

in other words, the public sector is already helping banks pay their debt. we might as well just get above board with this and let the government buy the corporate bonds outright.

it's time to rethink our rescue efforts. trying to fix the problem in the interbank market misses the mark. our age is dominated by capital markets, not banks. our policies need to catch up with the times.

Wednesday, October 8, 2008

the spectre of debt maturities

A spectre is haunting the markets -- the spectre of maturing debt.
All the powers of the finance have entered in a holy alliance to exorcise this spectre: Fed and Treasury, ECB and BOE, Liberal Democrats and Conservative Republicans. Where is the liquidity package that has not already been extended by its opponents in power? Where is the repurchase agreement that has not tried to hurl back the branding reproach of a frozen interbank market, against the more advanced stages of asset-price declines, as well as its reactionary writedowns? Two things result from this fact:

1-Maturing debt has been acknowledged as something that comes due.

2-It is high time that corporate bond investors should openly, in the face of the whole world, refuse to buy new issues. They have long been jammed with every forced renegotiation (a la Charter Communications), insulted with every credit-rating-ruining LBO (sungard), and left out in the cold while activist shareholders take their money and rebuild capital structures in their own image (home depot, time warner).

this little imitation of the opening lines in Marx's Communist Manifesto is dedicated to the logjam developing in the primary market for corporate bonds. if left unsolved, it will turn into a catastrophe in 1-2 months. I spoke to several market insiders today. "it's all anyone talks about," said one. in the last 2 weeks, the corporate bond market as we know it has shut down. normally we would see $10-15bln of issuance per week this time of year. now the only companies that dare the market are AAA-rated suprantionals like the European Investment Bank, or utilities that pledge their physical assets as collateral. in other words, investors are willing to lend to only the highest quality issuers. banks and financials, with 100s of billions of debt coming due, are locked out of the market. they are now turning to the Fed as a true lender of last resort... but this can only last for so long.

most people have no idea how menacing this spectre is. for the last 30 years, they have simply taken the bond market for granted. companies borrow billions everyday, and most financial reporters and stock investors don't even think twice. well, now the time is coming to get worried.
one strategist at a major investment bank told me that if the deal flow doesn't revive by the end of the month, issuers will start attaching all kinds of incentives -- such as put features and stricter covenants -- to bonds to get them sold... and that would be in addition to selling them at rock-bottom prices. all of this will drive the value of existing debt lower and force them to take growing losses. that means buyers are now on strike... they fear lower prices, so they demand cheap prices on new deals, creating a self-fulfilling prophecy and a vicious cycle.

interestingly, the Fed is going to lend AIG about $38bln, and will accept AIG's holding of investment-grade corporate bonds as collateral. this is apparently some kind of emergency power to support AIG, but not the bond market itself. this is a single step in the necessary direction, which I discussed in the posting immediately before this one. basically, the government needs to buy straight corporate bonds to get issuance moving again and to take pressure off the beleagured banks. it's a needed step to precent the next closet full of shoes from droppping in the credit market.

I have been arguing that instead of buying toxic mortgage assets, henry paulson should announce broad price supports in the corporate and municipal bond market. he should simply declare "official levels" at which he will buy bonds. .. maybe something like this:

AAA debt is "worth" t+100bp
AA is "worth" t+150bp..
A is "worth" t+200bp
and all the way down the rating spectrum.

once this happens, other buyers will be confident and the money can flow again.

interestingly, this would give the taxpayer garranteed upside because the government borrows at the treasury rate (here denoted as "t".) imagine I say you can borrow at T, and lend it at t+2%. no matter what T is, you make money. it's simple "carry trade"... the only risk becomes default risk... while this is a cost, it's already something the government must worry about... if a company fails, tax revenue goes down and unemployment goes up.

right now, companies have been forced to draw down bank lines to pay off their maturing bonds. that is putting more pressure on the banks at the very same time they cannot lend, creating a huge logjam at our banks and overnight financing market.

US banks are already troubled and look increasingly insolvent. fixing them will take years. that means we need to find ways to reduce their importance in the economy. we must help companies roll over their massive looming maturies. this spectre of maturing debt is haunting the market but has not yet inflicted its real turmoil. in 2-3 months, it will. and, the damage is beyond anything people can grasp. when companies run into problems with bondholders, their shares quickly approach 0.

look at the chart below of RH Donnelley, a printing company that took on heavy debts to expand. things didn't work out very well and investors worry about its ability to service its debt over the next few years... that drove the stock from over 80 to less than 5 in less than a year. it's now under 2.

every stock that runs into debt problems looks the same ... just a straight line down to 0 as investors dump shares wholesale. after all, the bond investors have a contractual right to get their money back first. they own the company and the shareholders only have what's left afterwards ... the so-called "residual" rights. (it's like if you paid $200,000 for a house and put $40,000 down. if you sell it for $150,000, your $80,000 equity is now worth precisely $0...leverage works in both directions.) in fact, judging by the complete death of hope in recent trading days, I think this process is already starting.

I heard former Fed governor and princeton professor Alan Blinder just say something very worrying on charlie rose. speaking of the Fed:

"they are going to keep at it doing things until the crisis is over."

since when is flailing about hopelessly, casting off liquidity in every direction, a valid policy?


Blinder also observed that the fed's rate cuts are having little impact on the economy. I think he misses the point that the Fed's rates have been disconnected from the economy for years now. when the bubble was inflating, greenspan decried the "conundrum" ... he would raise interest rates and long-term rates would continue to fall.

now we cut rates, and borrowing costs continue to rise....

the Fed has lost control of the US economy. I think we might actually be seeing the death of monetarism... this is the belief system of milton friedman.. the idea that "inflation is always and everywhere a monetary phenomenon."

in economics, the words "always" and "everywhere" make me nervous. they smack of religious faith or revelation. I fear we need to go back and check some assumptions, and realize that some major cracks are appearing in the monetarist altar.

first, I think monetarism doesn't appreciate international capital flows. it views economies as little fiefdoms in which central banks rule as absolute authorities. it assumes that they have complete control over money supply, or liquidity. that's why liquidity INCREASED in the US economy in 2005-6, even as the fed was "tightening"... why? because foreigners were flooding our country with money as they recycled huncreds of billions of dollars they had from selling us barbie dolls, fresh salmon, pharmaceutical chemicals, and of course oil.

second, monetarism seems too focused on official banks. for the last 5-10 years we have allowed hedge funds and asset-backed issuers to create a shadow banking system. what good does it do to raise the Fed funds rate when they can borrow for free in yen and plow that money back into the US economy? the big story in the last 5-10 years is that financial markets have taken over much of banks' important role. policymakers should not confine their actions to the banking system. the bond market is more important to the economy now than ever before.

I fear we will cling to the same religious tenets of monetarism, trying to "inject liquidity" into the banks, when the real danger is now growing in the debt capital market. companies have real liabilities coming due. we need to address this looming spectre of maturing debt.. the longer we wait, the harder the solution will be and the greater the stock price declines. the government needs to buy corporate bonds soon, or we could face the collapse of many leveraged companies in the stock market.

I will end on one final medical anology... our economy has cancer... the banks are going insolvent. it's a long-term disease that can be treated. but now the cancer has caused nausea and the patient vomits... as he throws up, he inhales some of the vomitus back into his lungs and cannot breathe.

any doctor would immediately focus on clearing the airway ... he wouldn't just stick with the regular regimen of chemotherapy. our economy now is starting to choke on all this maturing debt. it's happening at the state, local and corporate levels. these entities employ tens of millions of people and pay trillions of dollars to workers and vendros . these guys ARE the economy. we cannot let them choke. we might be able to cure the cancer, but the patient needs to survive the next 5 minutes, or much more will be lost.

Monday, October 6, 2008

A credit-market solution that WILL work

This posting includes some of the ideas discussed below on my blog, but I have organized it into a single memo that I am distributing to policymakers:

Dr. Sir/Madam,

I am a financial journalist who covered the credit market deal-by-deal as the bubble was inflating the last few years. I have an idea for a solution to the current problem that would help much more quickly and cheaply that anything else discussed so far.

What: The Treasury Department should buy corporate bonds, commercial paper and municipal debt. Why: Mortgage securities have been turning toxic for more than a year, but have only posed a truly systemic risk in the last 2-3 weeks. Now the entire credit market is in danger of shutting down. Mortgage securities cannot be saved quickly because many were issued with two basic assumptions that are no longer in place:
1-Home prices don't decline.
2-Borrowers can always refinance to lower rates.
Now that these assumptions are out the window, mortgage securities will remain under extreme stress. The Paulson plan will be a wasted effort.

It's time to do triage. Two patients have moderate injuries and can be saved with care. A third patient has a 20% chance of survival, and will require so much time and attention that the other two will die from their injuries while we treat him. It's not a hard choice who should get the care in this scenario. The first two patients are non-financial corporations and state & local governments, while the third is the mortgage sector.

The credit market is grinding to a halt: Despite all the noise about the bailout package in Congress, the biggest news on Friday came out of Sacramento, which said it may need a $7 billion loan to keep funding basic services.
Observers across all spread-based asset classes -- corporates, high-yield, commercial mortgages and municipals -- see the same problems: A frozen primary market and a daunting accumulation of maturing debt. Total debt-capital market issuance in the Americas fell 47% in September from a year earlier, according to Dealogic, and the commercial-paper market posted its largest contraction ever last week.
This logjam needs to be fixed quickly, or otherwise healthy companies will turn sick. Last week, the head of a moderately sized steel company told me he had his first layoffs since the period after 9/11 because his customers couldn't get financing. He expects things to get much worse.
Corporations and state & local government account for tens of millions of jobs and trillions of dollars of economic activity. For the most part, they "did nothing wrong" in the housing bubble and still have relatively solid credit fundamentals (especially corporations). It's the external factors that are hurting them now.

How my plan will work: The Treasury needs to set levels for bond spreads. It should declare that it will buy AAA 5yr paper, for instance, at +100bp, AA at +120pm, etc... all the way down the ratings spectrum.
This will put a floor under prices and stop the vicious cycle in the new-issue market: Companies need to sell bonds, but investors demand huge concessions, making it impossible for companies to issue. The buyers aren't demanding concessions to be cruel, but because they know a lot of new supply is coming that will push their own holdings wider. This is the mirror image of a bull market, when people think they need to buy now or miss out on the upside. Only in this situation, people are afraid to buy because they expect prices to get even cheaper. A government “put” would remove that fear and allow the market to return to life.

Why it will work: The frozen term-debt market has pushed more financing into the bank loan and commercial paper sectors, which by definition are much less risk averse, even in a good market. If companies and municipalities could sell debt with tenors of 3+ years, it would take pressure off the short-term markets, reduce loan demand and insulate borrowers from turmoil at the banks. It's a painful irony that companies must now rely more on banks at the same time those institutions face their own worsening capital constraints.
Once the government establishes "official" prices for these securities, we'll see a dramatic improvement in the credit market and halt the spreading paralysis. It will do nothing to help the mortgage market, but it will draw a line around those assets and prevent the infection from spreading to the rest of the body. It's like amputating a gangrenous limb, to use another medical analogy. Furthermore, it would likely cost less and offer a bigger chance of "taxpayer upside" than the current program.

One final point: In the 1930s, US farms were producing too much grain, so the government took deliberate steps to support those prices. After all, those prices were key to rural incomes and farmers' ability to pay their debts.
Instead of a glut of corn, today we have a glut of credit securities. If their prices continue to plunge, they will drag down most of the economy with them. That's why my proposal is the only idea that could succeed quickly enough to stave off calamity.

Thursday, October 2, 2008

betting on the wrong horse

I have criticized the "bailout" plans for many reasons, so why stop now?

it suffers some basic philosphical problems, as I have mentioned -- such as being a confused muddle of capital-injection and price support.

furthermore, as I speak to credit-market watchers, I have also come to believe it will ultimately fail because it bets on the wrong horse.
my plan is radically different: instead of buying distressed mortgage securities that no one wants to touch with asbestos gloves, THE GOVERNMENT SHOULD BUY STRAIGHT CORPORATE DEBT. many ordinary companies that never committed any subprime sins are now facing a complete liquidity paralysis. this could cause them to freeze up, stop paying each other and lay off millions of americans. to prevent this 1931-style event from occurring, I say the government should intervene in this market. unlike mortgages, it can still be saved.
let's start by looking at some of the damage that has occured in just the last 2-3 weeks. while things were shaky before, I think many people don't realize that september 2008 was probably the worst month in the post-depression history of the U.S. credit market. (it was the worst month in the history of the long-running lehman credit index, based on excess return.)
everyone knows mortgages were in trouble, but this month, serious damage was done across the board:
look at the bonds of a nice solid credit like AT&T:

or tech giant cisco:

price declines like this for solid investment-grade bonds are simply unheard of.
these are companies that can weather economic downturns and generate vast amounts of free cash flow to service their debts. yet their bonds have gotten crushed. and, it's important to note that this didn't happen at the other moments of panic, such as march or july. something is different this time.
let's look at a company that's less fortunate than AT&T or Cisco: Pilgrims Pride, a much lower-quality credit. like their chickens and cows, they've gotten slaughtered as they struggle to renegotiate bank loans:

now, these are all companies with thousands of employees. they had nothing to do with mortgages, yet they are suffering. the real danger right now is that the spreading credit crisis will bring down thousands of other solid companies that "did nothing wrong". it's looking increasingly likely this might happen.
the next chart shows the rate at which these very companies borrow money under 30-day "commercial paper" programs. these are essentially very short-term bonds that companies normally roll over every month as part of the normal course of doing business. (kind of like ordinary people use credit cards so you don't have to always have the cash available at the moment you spend.) almost no one ever talks about the CP market because it's usually an extremely boring place where everything functions smoothly. let's look at the interest rates investors are demanding on CP (30 day non-financial A2/P2):

I also included the federal reserve's overnight target interest rate. under most normal circumstances, these two rates follow each other pretty closely. the spread between the two is now flirting with 4 full percentage points, an unheard-of level. it's too bad the data only goes back 12 months, but I am sure that's the highest level in at least the last 10 years, judging by comments many in the market have made to me.

the biggest concern is that debt is piling up and not getting refinanced. companies issued a mere $72bln across the american debt markets in September... that's 66% lower than a year ago, according to dealogic.. august and september are the first months since at least 2005 with total debt issuance below $100bln. in other words, this market is shutting down...
similar things are happening in the municipal market, according to a banker in that sector I spoke with today. ordinary companies and municipalities have TENS OF MILLIONS OF EMPLOYEES who would be hurt if they can't issue bonds to rollover debt.
let's look at another chart... this one compares the average Baa-rated corporate bond to the 10yr Treasury yield... another example of "spread".. when it goes up, it's bad.

at the far right, we see a huge spike to the place where we are now. this is near all-time highs reached in late 2002 or the early 1980s... it's not significantly above those highs, so it's not that big a deal, right? wrong... a couple of very important things are different now.
in both previous cases, the spike in yields happened deep into a recession, or after many many companies had already gone bust. for instance, in 2002, enron and worldcom had both failed and the overall default rate was more than twice the current level. in 1982, the economy was in a severe recession after paul volcker raised interest rates to kill inflation.
in october 1982, the economy had lost jobs over the previous 14 months before the Baa-10yr spread peaked.

in october 2002, most of the job losses had already occurred and the economy was already beginning to rebound...

in contrast, this time, it occurs after only 9 months of job losses ... and the losses this year have been much less severe. (I am assuming september, which comes out tomorrow, will be negative.) and, we're still not even officially in a recession.
in both previous cases, this spike in spreads came at the very tail end of slowdowns as months of defaults worked their way through the system. this time, it's happening at the very start of the contraction.. which means it will only get worse.... the global economy is only now really slowing down... usually defaults are a lagging indicator.
furthermore, in both previous cases, spreads had been climing slowly over several years. that means companies had time to adjust to the higher rates and they weren't planning to have cheap debt financing. this time, the change has been sudden and jarring and will be a severe shock to many companies that are accustomed to easy credit.
even those these companies didn't commit the sins of subprime, they are feeling the pain as the entire financial system shuts down. as I discussed previously, banks don't want to lend to each other, companies are giving each other less credit and asking for payment more quickly.
now ordinary companies that did "nothing wrong" like issue subprime mortgages are getting punished.

instead of helping them, henry paulson wants to prop up the failed mortgage market. somehow he thinks if we buy a bunch of bad mortgage bonds, we will make it easier for companies like GE and Pilgrim's Pride to roll their debt. at least that's the argument.... "main street needs the financing system to work again."
to me, this is simply too indirect. instead, I propose that paulson use his money (I mean "my/your money") for something a little more useful: buy corporate debt.
I think the government should step in and say "we will not allow innocent companies to go bankrupt because of the collapsing mortgage market." he should establish actual government levels were certain kinds of debt "should trade". he should say the government will ensure that BBB debt trades at +300bp, AAA at +100bp, etc. he should establish some clear bands and say the government will be a buyer in both the primary and secondary market to provide support.

he should also offer to buy commerical paper and municipal bonds under a similar arrangment.

of course, this isn't how free markets work, but we are beyond that at this point.

everyone I talk to now describes a seizing up of the corporate-bond market. many companies have maturing debt. normally they would issue new bonds... now investors won't buy any sort of new issuance at all because they insist on huge price concessions. and, if price concessions are made, it will depress the value of bonds they already hold. it's a vicious circle that is killing the bond market.
this doesn't have much to do with the mortgage market. but in many ways, that is my point. I think the mortgage market is already too diseased to be saved. almost every security in that market was priced with 2 fundamental assumptions in place:

1-houses never lose value

2-you can always refinance

neither of these scenarios are true anymore, so these bonds will wind up being close to worthless. it's better to just accept that now and to move on. the next step is to prevent the damage from spreading to the rest of the economy. and spreading is exactly what it's done over the last 2-3 weeks.

imagine our credit system was once a normal, healthy person. at some point in 2005 and 2006, he was bored with living the normal life, so decided to try heroin. being discreet, he shot it up between his toes.
it felt great at the time, and he didn't think twice about the fact he used a dirty needle.
by 2007, it started getting red and swollen. but then a doctor gave him some tylenol and told him not to worry about it.
by early 2008, the lower half of his foot was purple and black. again the doctor came and told him the problem was contained and gave him more tylenol. this time he also rubbed some neosporin on it and nodded reasurringly.
by july, his entire foot was swollen and gangrenous, but the doctor again assured him his health was sound. after all, this doctor was tenured at princeton.
but now it's september and the infection has spread halfway up the leg and the patient is suffering a fever of 103. he's so delirious he can't remember his own name.
again the doctor tells him we can stabilize the situation.. it will only have a small cost... and congress needs to approve it first....
ok, enough of the anology... the point is clear. at this point, the only way to save the patient is to tie a turniquet at the knee and just saw the rotting leg off. if not, it will only be a short time before the infection spreads to the rest of his body and finishes him off.

that's what we need to do in the credit market. we need to draw a line around mortgage assets -- like a turniquet -- to keep them from infecting the rest of the patient.
we must give credit investors confidence the problem will not spread from mortgages to other assets. that's why I say the government should become an active player in the non-mortgage credit market. it should be buying corporate debt to put a real floor under it.
(interestingly, the Fed may be doing a poor man's version of what I suggest.. today's balance sheet release by the Fed indicates it dramatically increased its loans to banks at the same time that commercial paper balances plunged by more than $90bln. what's happening is that companies unable to borrow in the CP market are drawing on bank lines, and the Fed is supporting those same banks with its own lending facilities such as the asset-backed commercial paper money market mutual fund liquidity facility and the Primary Dealer Credit Facility.)
my plan of buying corporates would make investors realize THESE ASSETS are not going to become toxic as well. it would restore confidence and allow companies to do essential things like roll over their debts, pay employees and pay each other. and, I think it would cost a lot less than $700bln, given the fact that these corporate bonds do not have real inherent problems -- they are being disrupted by market conditions.
nouriel roubini says we need to triage the banks to decide which will survive. I find that even a little off the mark.. I think we need to do the triage at the asset level. all of the banks face problems of different degrees, but we must not forget that banks themselves are nothing more than portfolios of assets. you cannot save the banks if its assets become toxic.
unlike prof. roubini, I am not a big student of international banking crisis. but I question the idea that the government should take over the toxic assets. he says it will prevent the infection from spreading, but I don't think there is a clean way to do this... furthermore, not only will it be a waste of money, but everyone else in the credit market will be on pins and needles waiting for the market to come back to life. imagine that.. for months, as the government buys up these assets, everyone will be waiting for the liquidity to trickle-through ... during that time, companies will be shutting down, firing workers and leaving vendors unpaid.
I think it's better to make clear to the market what kinds of assets CANNOT fail. that would be like issuing a giant put under 90% of the economy. I think it would be much easier, much more direct, less expensive and IMMEDIATELY EFFECTIVE. corporate issuance could come back and the pressure would be removed from the CP market overnight.

for another example of how non-mortgage credit is under pressure, consider these huge price declines in the last 2 weeks for normal bank loans from B of A and S&P Leveraged Commentary & Data:

note that even during the telecom/utility debt crisis of 2002, these loans didn't drop anywhere near these current levels. one thing I worry about, although am not sure will happen, is that this may trigger an entirely new round of writedowns in the Q3 earnings season that's about to begin...

another advantage of my plan is that I think it would put the government in a much better position to make a profit than it would buying toxic mortgage securities.

I think the $700bln paulson plan is government thinking at its worse. many people have observed that government allocates resources in the opposite method of the private sector: when a program is struggling, it gets more money. if it succeeds, no one thinks about it. in private companies, those areas that are most successful and most profitable get the most attention and follow-on investment.

yes, this is not a totally fair comparison, because the government does some activities that no one else wants to do and don't generate "profits". but it does reflect the basic problem with government as an allocator of resources... without the profit motive, there is no institutional incentive to succeed.

these mortgage bonds are failing. instead of trying to drive them back up in value, we should look to prevent them from infecting others. we shouldn't reward failure with money. corporations are much healthier and much more important to the long-term health of our economy and employment. they should be rewarded.