The phases of contraction

The US economy contracted 1% in the last quarter, a third straight contraction. But the recession really started much earlier according to NBER: from CNN (12/1/2008)

The National Bureau of Economic Research said Monday that the U.S. has been in a recession since December 2007, making official what most Americans have already believed about the state of the economy.

If one looks at the components of the GDP however, different sectors of the economy started contracting at very different times. The first component of the GDP to contract was residential housing. That contraction first appeared as early as the beginning of 2006, as the Fed's 13 consecutive rate increases started taking effect.

Gross private fixed investment - residential (% changes)


This can be seen also from the private residential construction spending history from the US Census:




But the consumer bubble continued to expand for some time with all the easy credit that was available. The first real signs of consumer based contraction appeared in early 2008, two years after the residential housing contraction.

Consumer goods


Toward the middle of 08 we started seeing a contraction in non-residential construction spending. The delay was also driven by available credit as well as longer-term projects.

Gross private investment fixed - nonresidential

source: US Treasury

One could argue that any recovery should take place in reverse order, given these components are on a different cycle. First one needs to see a pickup in housing, then the consumer, and finally at a later time, investment in the non-residential fixed assets. Based on this, a precursor to any recovery should be improvement in residential construction. Housing prices may be stabilizing, but so far there are no signs of any improvements in construction spending.

The hazards of believing in invincibility

At what point does a man's success go to his head? What does it take to go from being an overachiever to thinking you are invincible? Well here is a guy that has reached that point. His name is Mikhail Malyshev. He achieves tremendous success in quantitative trading at the $11 billion hedge fund, Citadel. He is the star who makes money at Citadel when the rest of the fund is down 50+% and has to put up gates to halt redemptions (at the end of 08). He makes a sick amount of money for himself - but clearly that's not enough.

As Citadel starts marketing their quant fund as a stand-alone strategy (as opposed to their main multi-strat fund) with their star trader - Malyshev, he figures he can raise the money himself, without Citadel. He leaves Citadel with the usual 9-12 months non-compete that Citadel always imposes. All he has to do is wait until his little non-compete vacation is over to collect a really nice sum of money from Citadel, and he is free to go do whatever he wants. Take a trip around the world, enjoy your vacation.

But no, that's not good enough for Malyshev. He has to be in the game, he has to make his first billion. He's better than other traders from Citadel who have to wait (like the fundamental credit trader Joe Russell, who is taking his time after leaving almost 12 months ago). Screw Ken Griffin, Citatel, their army of lawyers, and their noncompete. Malyshev quietly launches his own firm called Teza Technologies. He figures he's so smart, he can do it behind Citadel's back and bring with him the software he developed at Citadel. But that's not good enough. He goes out and hires another quant trading guy, Sergey Aleynikov from Goldman. But that's not good enough either. Aleynikov brings Goldman's software algorithms with him.

So Goldman and the FBI go after Aleynikov and Teza for software theft. Citadel finds out about Teza from the news and sues Malyshev for violation of the non-compete and - you guessed it - taking Citadel's proprietary software. For those who don't know Citadel, they are notoriously litigious and will extract blood from Malyshev. His business is over, his star employee was arrested for theft by the FBI, and his personal assets may soon become the property of Ken Griffin. You can't make this stuff up! What a wonderful lesson on the hazards of believing in your own invincibility.

Home equity at historical lows

The drastic deterioration of home equity is a well known fact, but it's still amazing when one looks at the numbers. Below is a chart from Goldman that shows just how little equity on average people have in their homes. The loan-to-value ratio is at staggering 93%.



This makes it increasingly easy to for the homeowner to walk away from the house.

Non-agency prime mortgages foreclosure rate computed
by Bloomberg:

Oil futures are pricing in a slower recovery

With the unexpected increase in US crude inventories (particularly during the driving season), crude oil futures took a beating today. Dollar strength and mixed economic data had an impact as well.

US Department of Energy US crude stockpiles


There is actually more to the story in the futures market. The crude oil curve has steepened considerably in the past month. The market is expecting a pickup in demand in the longer term, but for now the realization has hit that the economic recovery is slow and it will take a while to work through the existing crude inventory. The huge natural gas oversupply in the US puts additional downward pressure on crude. The commodity bet that played out so beautifully for many a year ago is not working out too well this time around.

WTI crude oil futures curve


The demand fundamentals continue to be weak, keeping prices in check and the curve steep.

Fresh signs of China's asset bubble

As we discuss earlier (Pegged renminbi will be hard to internationalize and Asia, the next big bubble), China's loose monetary policy is starting to manifest itself in signs of an asset bubble. Part of the reason for the policy is driven by the need to keep the renminbi from appreciating (unsterilized foreign exchange interventions). As we know from the US experience, bubbles can grow for prolonged periods of time. Once an asset bubble gains momentum however, even a more restrictive monetary policy may not be able to curtail the growth.

Below are some examples of this excess liquidity making it's way from the banking system into China's economy. The first two illustrate the rapid rise in lending activity, while the second two are indications of the frothy equities markets.

1. Loan activity: From the FT:

...banks advanced Rmb5,840bn ($855bn) of new loans in the first five months, almost triple the amount a year earlier. As for June’s lending, at $220bn it was a blockbuster as banks pumped up their quarterly loan numbers, just as they did in March (to $280bn).

2. Interbank lending activity. In the US (and Europe as well), banks are only now starting to actively lend to each other. However the liquidity is "trapped" in the banking system, and so far is not making it's way out into the real economy, i.e. there is no "multiplier effect". That is why USD interbank lending rates (LIBOR) have been dropping. In China, the interbank rates have gone up, indicating that banks are moving liquidity out into the real economy, creating demand for interbank loans. The multiplier effect is definitely in play.





3. The liquidity is making it's way into the equities market: The Shanghai Stock Exchange volume chart below tell the story.




4. Frenzied IPO activity: From the NY Times:

China State Construction Engineering, whose $7.3 billion initial public offering last week was the world’s biggest in a year, jumped 90 percent to an intraday high of 7.96 yuan, or $1.17 — more than analysts had expected — as investors ignored the company’s relatively high valuation to pile into the stock on the first day of trading.
...
China Construction opened trading at 6.70 yuan Wednesday, a level that valued it at 42 times its forecast 2009 earnings per share.

Leveraged loan rally continues

The leveraged loan market continues it's unprecedented rally in spite of the maturity wall we've discussed earlier (Leveraged loans - a race against time). Here are some reasons for the rally:

1. Dedicated capital: A great deal of capital had been raised to take advantage of the "dislocated" senior secured product. As the market started moving, that capital had to be put to work to avoid missing the rally.

2. Leverage is back: Banks are out there selling the Total Return Swap (TRS) product (more on the topic later). TRS allows investors to put up 1/4-1/3 of the capital for a portfolio of leveraged loans, with the rest financed by banks.

3. Little new supply: There has been little activity in the LBO market, so very few new syndicated loans are hitting the market. The few deals that have been done recently were structured with better terms and have rallied to levels above par such as loans to finance some of the $23 billion Mars acquisition of Wrigley (with Buffett's help).

4. Existing supply reductions: Supply is being taken off the market as firms default or issue bonds to pay down some of their loans. These paydowns leave CLOs with cash, forcing them to buy more loans (CLOs can't run large cash positions because not having enough asset/liability spread may cause them to violate their interest coverage tests).


The S&P/LSTA US Leveraged Loan Index (weighted based on dollar outstanding amounts):


On a yield basis, with LIBOR below 50 bp, leveraged loans are now yielding 6.75% (according to LPC).

Leveraged loan yield history:


So full speed ahead for leveraged loans. For now.

Ameritrade and Schwab take alternate paths

A while back the New York Attorney General Andrew Cuomo went after a number of brokers who had sold Auction Rate Securities (ARS) to clients. Clients have lost money on these securities, not due to credit defaults of municipalities, but because these securities have become illiquid and now trade with significant discounts. On Monday we learned that the retail brokers TD Ameritrade and Charles Schwab have taken completely opposite approaches to dealing with Andrew Cuomo. First here is some background on ARS from Moody's:

The ARS market became illiquid nearly two years ago when large broker-dealers – firms that historically supported secondary-market ARS auctions – stopped doing so as the credit crisis got progressively worse. Because the auctions were the primary mechanism for investors to sell their securities, the entire ARS market, estimated at that time to be over $300 billion, became illiquid. Since then, the major broker-dealers, which in addition to their auction market-maker role, also underwrote ARS and sold them through their retail brokerage franchises, have bought back at par over $60 billion of ARS.

TD Ameritrade is making investors whole on their ARS purchases. From the WSJ:

TD Ameritrade Inc. agreed to buy back $456 million of auction-rate securities from about 4,000 clients as part of a settlement with New York Attorney General Andrew Cuomo, the Securities and Exchange Commission and Pennsylvania securities regulators.

The online brokerage firm intends to return the money to customers, including individuals, charities, nonprofit entities and businesses, by March 2010 but could need until June 30 to complete the buybacks. TD Ameritrade said it will buy back the debt from clients with accounts of under $250,000 within 75 days.

Schwab on the other hand decided that investors took the risk on their own and are responsible for the losses. It fired back at the New York Attorney General with the following (from Charles Schwab

The Attorney General’s allegations are without merit. They unfairly lay blame on our company for an illiquid market and improper behavior by the large Wall Street firms that created and then, despite their obligations, stopped
supporting Auction Rate Securities.

Schwab did not create the products and had no involvement in the events that led to the collapse of the ARS market, events brought about by the Wall Street underwriters who manufactured, marketed and then simply abandoned their responsibility as lead managers for the auctions.

The NYAG presumes that Schwab somehow knew of a risk that the entire ARS market could seize up at any time, and failed to disclose that risk to its clients, which is preposterous.

....

Additional Background:
- Schwab did not know until it occurred that the market for ARS was in danger of freezing up or that the underwriters could, and would, walk away from their obligation to support the liquidity of these securities.
- In fact, just days before the collapse, Schwab was told by one of the major Wall Street underwriters that investors would have access to liquidity; days later they simply walked away from the market.
- Schwab did not know that other broker dealers were routinely propping up the market for ARS, creating an artificial impression of liquidity.
- Schwab was not involved in the withdrawal of supporting bids for ARS that precipitated the market’s freezing.
- Based on the facts available and over two decades of historical precedent with ARS performance, Schwab, like other third-parties and the market regulators themselves, could not anticipate there was a risk of system-wide paralysis.
- Schwab’s limited participation in the ARS market was driven by client demand, not a desire for investment banking fees; roughly 90% of purchases were unsolicited trades.
- Schwab did not underwrite ARS or serve as an auction agent for ARS.
- Schwab did not trade in ARS on a proprietary basis or have an inventory of ARS that we then sold to clients.
- Schwab did not place proprietary bids in or artificially prop up the market for ARS.
- Schwab did not develop marketing materials or provide research to promote auction rate products.
- Schwab did not offer sales incentives relating to ARS transactions; indeed, Schwab did not compensate its Financial Consultants at all for ARS transactions.

The rationale for such different approaches may have to do with Schwab having a stronger case. The outline above makes their posture fairly clear. Nevertheless Andrew Cuomo is gearing up for a fight with a pending legal action against Schwab.

Disclosure: no positions in SCHW, AMTD

Economists jolted by housing data

Economists are getting jolted by positive surprises on the housing front. William Wheaton's forecast of household formation demographics stabilizing housing prices (see Housing prices, a different perspective ) may be in play now, but skeptical forecasters continue to ignore the signs. They obviously have good reasons to be skeptical. The two forecasts from JPMorgan (below) are well thought out and backed up by other data, but completely off the mark.

The New home sales forecast from JPMorgan:

New home sales are expected to fall 2.0% M/M to 335K annualized in June. New housing demand appears to be stabilizing at a very depressed level as June’s expected sales results are within the recent 330-355K range that has been established over the past five months. Several housing indicators are pointing to a decline in new home sales for June. The 30-year mortgage rate jumped 56 basis points to 5.42%, the highest since last November. The rising stock of foreclosed properties (primarily in the resale market), which are priced to sell, will continue to weigh on new home sales. The National Association of Homebuilders housing market index fell in June with unchanged readings for both traffic and current sales activity. And finally, due to affordability concerns, the Conference Board and University of Michigan survey attitudes on home buying were also softer in June. Going forward, tighter credit conditions and rising unemployment are expected to restrain demand. Excessive inventories and a rising stock of foreclosed homes available for sale will weigh heavily on new home sale prices. In addition, with completed new homes taking a record 11.5 months to sell, further price concessions by home builders will be necessary to move properties.

The actual number was up 11% to 384. Here is the chart of the number of new one-family home sales:




The Case Shiller forecast from JPMorgan:

After sliding 0.6% in April, the Case Shiller home price index for the 20 largest cities likely fell 1.0% M/M in May for an annual decline of 18.3%. April’s decline and May’s expected fall are improvements over the prior six months, when the average monthly decline was 2.4%. However, May’s accelerated rate of deflation is due to the rise in foreclosures in the Nevada, California and Florida markets where inventories are already excessive and in the Detroit and Chicago markets, where the automobile industry is experiencing more intense difficulties. Areas where sub-prime lending was less pervasive (Denver, Dallas) will do relatively better. Home sale prices are expected to remain under pressure as a glut of distressed properties are coming on the market, inventory levels remain excessive, mortgage underwriting standards have tightened considerably and unemployment is expected to drift higher over the remainder of the year. We expect a further decline of 5-10% in the Case Shiller index over the next year.

The actual number was a M/M increase of 0.45% and a YoY decline of 17.6%. Here is a chart that shows the Case Shiller index (composite of 20 cities):



On a month-over-month basis it's easier to see signs of stabilization.

In addition to the sales and price data, the BAS-ML housing conditions index (below) is showing stability.


Source: JPMorgan

It's difficult to see housing prices going back to their peak levels for years (possibly decades) to come, and we may be at a "false bottom". However the data showing stabilizing sales and a slowdown in price declines are hard to ignore.

Moody's pounding CLOs with downgrades

Moody's has become a downgrading machine. Just in the second quarter of 2009 alone, Moody's downgraded 510 CLO tranches from 93 transactions ($33 billion of paper). These are structured deals with mostly corporate loan collateral. 74% of the Aaa-rated (AAA) tranches that were on review got downgraded.

From Moody's (click to enlarge):


Moody's is trying to compensate for it's destructive mistakes with AAA RMBS of years past. They are expecting to downgrade "a majority" of the CLO senior tranches by year-end.

Looking at the vintage of the deals, as expected, the 06-07 deals are the most vulnerable.

Tranches on review for downgrade by year of origination:

Here is what the ratings transition matrix looks like over Q2-2009:

And here is the matrix showing credit migration life-to-date. Subordinated tranches have been hit the hardest, but the senior downgrades are coming in quickly.

So what's been driving these downgrades? Here are some of the trends from Moody's. The chart below shows the weighted average rating factor (WARF) for CLOs with rapid escalation earlier in the year. Higher number means lower average rating, and at 2900 the CLO average rating is worse than B2. The collateral was rapidly getting downgraded earlier in the year, but in Q2 the managers started rotating into better credits, trying to improve their WARF.

CLOs also have a limitation on their Caa (CCC) or below basket. Most are at 7-10%, and as the graph shows, most are violating their limit. This doesn't cause a default of the deal, but creates other nasty issues. The overage of the CCC basket is carried at market value rather than par (the bulk of the collateral in CLOs is carried at par), which creates problems when the market for loans tanks.

The next graph shows the pace of defaults, which continues on it's upward march. This is what made Moody's really nervous, forcing them to quickly downgrade the subordinated tranches.

As defaults and the CCC basket overages increased, the overcollateralization (OC - the amount of eligible collateral over the liabilities) had been dropping rapidly. As the OC hit certain triggers on it's way down, the deals were forced to trap net interest income cash, usually distributed to equity (and fees distributed to the manager - see CLO managers forced into bad behavior), and use that cash to pay down the senior liabilities. That cash along with the recent rally in bank debt helped reduce some of that OC pressure, as the average OC has begun to stabilize.



Even with high default rates on the collateral, it's highly unlikely many CLOs will experience an "event of default" and be forced to liquidate collateral. These transactions are much more stable than the CDOs with RMBS collateral. Of course to Moody's that's all not very relevant. They are on a war path to repair their tarnished image, and the motto these days is - downgrade first, ask questions later.

Money markets have reached a level of stability not seen since 07

As banks reach for more yield, they are starting to lend to each other longer term. In fact banks are trying to lock in term rates that are still significantly higher than the overnight rate. We’ve come a long way from interbank lending being limited to overnight only. In the Fall of 08, term LIBOR was merely a quote – nobody was actually lending term.

As the Fed floods the system with cash, the Fed Funds effective rate has dipped below 16 bp.

Fed Funds Effective rate


Banks are placing term funds and borrowing overnight, which is a fairly profitable trade with low risk. Usually the risk with these trades is that the Fed suddenly raises rates, making overnight financing more expensive than term. There is little likelihood of such an event these days, and with the overnight rate staying under 25 bp, the 1-3 months term trade will generate 25-35 bp. The Fed wants it that way to improve interbank lending, reduce reliance on TAF, and boost bank profitability.

This willingness to lend longer term has brought 3-month LIBOR below 50 bp, which is a record low. The one and three months LIBOR rates have converged, flattening the short-term yield curve.

1-month and 3-months LIBOR


The 3 months LIBOR-OIS (overnight index swap) spread has dropped below summer 2007 levels. This spread compares actual LIBOR to the level LIBOR would be based on projected overnight rate. The higher the spread, the higher the perceived credit/financing risk. Money markets have reached a level of stability not seen for some time, which is critical in order to keep the credit markets open.

(3-month LIBOR) - (3 months OIS)

Harvard's lesson in asset/liability management

Any day now the Harvard Management Corporation (HMC), who manages Harvard's endowment, will release it's 08-09 school year annual return. Even though their performance in calendar 09 has stabilized, the new performance graph is likely to look something like this (dashed line):



It's certainly not the type of performance one should be proud of, but Harvard is by no means unique. Other institutions' portfolios, including endowments, pensions, insurance companies, etc. didn't fare significantly better.

Harvard's mistake was not as much in their asset allocation, but in their asset/liability management. They ran into a serious liquidity problem. Here is what the endowment's balance sheet looked like going into the financial crisis:


Source: HMC

Note that the "negative cash" number means they have been running some leverage for a while. That in itself is not necessarily an issue. Harvard's financial problems can be summarized as reliance on the endowment for operating income and on the continuous liquidation of private investments.

Recently as much as $1.2 billion of Harvard’s total annual operating income was coming from the endowment. The university came to rely on this and planned accordingly, building, hiring, expanding. Here is the latest publicly available breakdown of Harvard's operating income:



The endowment was effectively viewed (and used) as a fixed income annuity. It's amazing that a bunch of really smart people would manage their resources this way. It's equivalent to a retiree who has her pension in a hedge fund. Again, Harvard is by no means unique in this - they are just he largest.

The investment profile (see chart below) looks more like an aggressive portfolio with a 10 - 20 year time horizon.

HMC's non-cash portfolio

Source: HMC

The second problem Harvard (in particular HVC) ran into was their reliance on the steady flow of cash from "harvested" private investments. Using historical experience with private equity and real estate funds HVC made the assumption that each year some of these private investments will be monetized by private equity firms with which they had invested. The older the fund "vintage" the more "harvesting" one would expect, and HVC projected some nice monetizations for 08-09 school year.

The "harvest" was poor to say the least, given what we just went through. Monetizations rely on strategic acquisitions, LBO (or CMBS based) acquisitions, and IPOs. The first two generally rely on debt financing, which as we know had collapsed. The IPO market hasn't been exactly active either.

What made things really difficult for HMC was that going into the crisis, they had some $10 - $12 billion of unfunded commitments. Normally these would be financed with monetizations, but this time cash wasn't coming in. With leverage, HVC had no real cash reserves and was forced to liquidate some equity and fixed income investments in the worst possible time. HVC also got out of some hedge funds, but many funds had put up gates or had lock-ups.

In addition to capital commitments to private equity funds, the university had commitments to construction projects and other programs that it couldn't easily get out of. Harvard desperately needed additional liquidity. HVC put $1.5 billion of fund investments with unfunded commitments for sale. Secondary private equity funds were bidding 50-60% to take that off HVC's hands. Not clear how much was actually transacted.

This liquidity crisis sent shock waves through the university. Harvard had to raise funds in the capital markets at arguably the worst possible time, December - 2008. They issued $3 billion worth of bonds half of which were privately placed:
$1 billion @ 5.0% maturing 2014
$1 billion @ 6.0% maturing 2019
$1 billion @ 6.5% maturing 2039
It is rumored that some of the issue was placed below par and some was retained by Harvard. This forced them into a fairly high cost of debt capital for a AAA issuer.

In addition to "resolving" their liquidity problems, Harvard also proceeded to restructure HMC. Rather than having numerous business areas, Jane Mendillo (who took over HMC in mid-08) created two divisions - one responsible for all external investments (effectively a fund of private equity funds and hedge funds) and the other for the internal portfolio. The internal portfolio team follows a set of allocation guidelines across "liquid" bonds and equities with a hedge fund-like trading overlay. HMC is active in interest rate spread and volatility trading, taking positions globally. The internal fund is also active in emerging markets, equity long/short and volatility trading, commodities, as well as some currencies.

Latest HMC org structure:

It's a decent setup assuming they have worked out their asset/liability problem. Feeding the university and committing to private investments requires much larger cash reserves and a more active liquidity management process than what they had in place going into the crisis.

This has been a superb risk management lesson for Harvard. Successful endowment management means more than skillful trading, hyper-charged portfolio allocation, and aggressive performance targets.

The fork in the road

There comes a time when the views on the economy by the various experts become completely divergent and existing techniques to understand the economy's direction no longer make sense.



That time is now as we are looking at what some people call a fork in the road toward extremes - a deflationary spiral or a hyperinflation. Getting this right for the Fed will be critical.

From Bloomberg:

At stake in the debate: Whether the central bank can steer a course that avoids repeating past policy errors. In 1936, policy makers prolonged the Depression by raising borrowing costs before a recovery was entrenched. In the 1970s, inflation soared when they held off on rate increases.

For example when it comes to the Taylor Rule, there is no shortage of diverging views, including Taylor himself. The rule as interpreted by many shows that the current Fed policy is NOT accommodative enough: Fed funds at 0-25 bp is too tight.

From Bloomberg

At the San Francisco Fed, researchers did similar calculations and found the Taylor rule would call for the equivalent of a negative 5 percent funds rate by the end of this year.

San Francisco Fed President Janet Yellen, 62, said she is worried about the parallel to 1936. “We should want to do more,” Yellen said June 30. “If we were not at zero, we would be lowering the funds rate.”

Jan Hatzius, the chief U.S. economist at Goldman Sachs in New York, is particularly pessimistic. His projections show policy makers should plan for policies equivalent to a fed funds rate of negative 9 percent by December.

Negative 9%? Ouch. It's probably time to look for alternative measures to be able to interpret the economic signals. For many market practitioners, one place to look is in the capital markets directly.

Let's start with TIPS (Treasury Inflation-Protected Securities). The spread between TIPS yield and the equivalent treasuries' yield gives one a good measure of inflation expectation:

IE (inflation expectation) = (5yr notes yield) - (5 yr TIPS yield):


The chart shows how inflation expectations changed form positive to zero or even negative after Lehman collapse, and now back to positive.

Now let's define a measure called Market Based Real Rate (MBRR).

MBRR = (Fed Funds effective rate) - IE

This is a market practitioner's measure of the real interest rate (vs. nominal rate). Normally one would use the Fed funds effective rate and subtract CPI from it, but CPI tends to be a lagging and infrequently measured indicator. So instead we are subtracting the inflation expectation (IE) that we extract from TIPS yield.


MBRR has been at about -1.5%, which based on history seems fairly accommodative.



One might argue that it's different this time. Credit is in such poor shape, that even at -1.5% real rate may be restrictive. But remember that this is using the market expectation of inflation, and the market is pricing in some positive inflation. The market already takes into account the expected credit conditions and how they will translate into inflation. So when we compare now to 2002-2003, it's a fair comparison. The market is telling us we are not too restrictive, and in fact we have a very accommodating Fed. Maybe we have more stimulus than we need?

So what does this mean for asset levels? Let's compare MBRR to equity levels.

MBRR vs. the S&P500


The asset bubble formation started in 2003 as stimulus of 2001-2002 took effect and continued to grow even as the Fed tried to take the stimulus away. The policy was too loose for too long. What the chart above is implying is that we are entering that phase again, and if the Fed doesn't act in a timely manner (see James Bullard's lonely battle), the fork on the road may lead us onto the inflationary path - at least with respect to asset inflation.

James Bullard's lonely battle

James Bullard, president of the St. Louis Fed has been pushing to develop a plan to de-lever the Fed's balance sheet. He is concerned that without a transparent plan to start taking liquidity out, inflationary (including asset bubble) pressures may show up. His view doesn't seem to be widely shared within the Fed. From Bloomberg:

James Bullard, president of the Federal Reserve Bank of St. Louis, wants the Fed to adopt a plan for taming the inflation he expects may follow the end of the recession. Unless the central bank puts a strategy in place and presents it to the public, inflation expectations may run rampant, Bullard says.

The Fed's balance sheet doubled from a year ago. Here is what worries Bullard:

This chart shows the changes from a year ago in the Fed's balance sheet (in $ million). Note that something like Maiden Lane was put on more than a year ago (Bear Stearns), so it shows a small reduction between Jul-23-2008 and Jul-22-2009.


Source: The Federal Reserve

A number of people outside the Fed are skeptical about the Fed's ability to start taking stimulus out on a timely basis.

From Bloomberg:

Meltzer is skeptical that Fed policy makers will act, even if they figure out how. In the 1960s and 1970s when inflation was rising, the Fed set out goals to fight it at least four times only to back down under political pressure. Paul Volcker, who became Fed chairman in 1979, was the exception. He ignored politicians and pushed the benchmark fed funds rate as high as 20 percent in the early 1980s.

Bullard's concern is that even the perception that the Fed lacks the will to fight inflation may create problems, including potentially the worst possible outcome - stagflation.

The burst of the mini Nasdaq bubble

Looks like the mini tech bubble is about to burst. Let's take a quick look at Nasdaq.

A rally like this in an economy that is still in shock is just not sustainable. According to Bloomberg, Nasdaq trailing PE ratio is 32, and the estimated PE is 24. Yes, these are growth companies, but you are buying them at 24 times earnings! It's true, some corporations are overdue to upgrade their hardware and systems, and there seems to be an insatiable appetite for iPhones. But with unemployment approaching new highs, the type of growth that is built into the market is unrealistic.

This evening we saw the first signs of the bubble bursting with Microsoft's earnings results. From the NY Times:

On Thursday, the world’s largest software company reported its worst fiscal year since it initially sold stock to the public in 1986. Year-over-year revenue and full-year sales of Microsoft’s flagship Windows software dropped for the first time.

MSFT after the close

Amazon released earnings that are worse than expected as well. From LA Times:

Amazon.com Inc. reported a decline in second-quarter profit and sales that missed estimates after discounts failed to spur as much growth as predicted. The stock dropped in late trading.

Tomorrow the market should get back to reality.

Disclosure: the author does not hold any positions in MSFT or AMZN

Also we would like to thank the reader from Deerfield, Illinois for their support.

GE Capital wants the market to know it's not CIT

GE Capital CDS levels spiked recently after a deep decline, driven by the events with CIT. All of a sudden the realization set in that CIT wasn't the only middle market and ABS lender.

GE Capital CDS

To address this concern in the market, GE Capital announced that it is pulling out of the FDIC insurance note program. The GE Capital FDIC notes now trade at sub-LIBOR yield levels (close to US government paper).

GE Capital 1.8% FDIC notes ($4 billion outstanding)

Of course it's a gimmick, because GE Capital is not in any way obligated to use the program. They can issue unsecured paper if they wish (the way Citi has done recently) while leaving themselves the option to use the FDIC program later. But they are trying to send a message to the market that GE Capital liquidity is strong enough to stand without any government help. Plus issuing more paper at near government rates (when you don't exactly need it), will make a few taxpayers unhappy.

From CNNMoney

GE Capital, the massive financing arm of General Electric, announced Wednesday morning that it had received approval from the Federal Deposit Insurance Corp. (FDIC) to exit a program that had allowed GE Capital to issue debt at super-low interest rates backed by the government

Overall GE has more wood to chop, beyong reparing GE Capital. It's a misconception that GE underperformance is entirely driven by it's large finance subsidiary. The underperformance vs. the S&P500 started back in 2006 (when GE Capital's business was considered solid), and over the past 5 years had reached 56%.

GE shares vs. the S&P500

Disclosure: the author has no positions in GE

Hedge funds managing redemptions

The latest analysis from Credit Suisse/Tremont shows a changing dynamic for hedge fund liquidity between Q4-2008 and Q2-2009. Here are some observations:

1. Suspended redemptions have been reduced somewhat, but still remain at 6.4%. Funds that suspended redemptions (vs. putting up gates) tend to be those who are really in trouble. Many of these funds are now in liquidation mode.

2. The bulk of the "gates" have been lifted. Gates were put up by some of the top funds including D.E. Shaw, to protect the non-redeeming investors (and themselves) from a fire sale. Now as the performance improved and the wave of redemptions has slowed, these funds are opening gates and redeeming investors who wanted out.

3. The use of sidepockets has increased considerably. Funds who had sidepocket capacity, used it to the fullest, putting as much of the illiquid or hard to value assets into their sidepocket account as possible. Investors can not redeem out of sidepocket accounts until assets are monetized, which could take years.

December 2008

June 2009



From Credit Suisse/ Tremont:

As a result of the forced selling and de-leveraging process that occurred in 2008, many hedge funds were forced to impose liquidity constraints in an effort to manage or restrict a surge in client redemption requests. We currently estimate that by assets, 9.6% of hedge fund AUM can be classified as “impaired,” meaning suspended redemptions, imposed gate provisions or sidepocketed assets. This is down from the estimated 11.6% of total industry AUM which was impaired as of December 2008.7 As the market sees a return to what many consider to be more favorable conditions, we expect to see the liquidity profile of the overall industry improve.

Housing prices, a different perspective

From Bloomberg:

Prices declined 5.6 percent in May from a year earlier and rose 0.9 from April, the Federal Housing Finance Agency in Washington said today. Economists expected a 0.2 percent drop for the month, according to the median of 16 estimates in a Bloomberg survey.

Below is the month-over-month price index from FHFA.



The index has been highly volatile recently, showing a rapid overall depreciation. But one may interpret the recent data as a possible stabilization in prices. Of course this index has been challenged before because it may not be constructed from a fully representative sample.

From the WSJ:

the index contradicts other popular home-price measures, including the closely watched Standard & Poor’s Case-Shiller index. One possible reason: the FHFA uses the prices of homes backed by mortgages sold or guaranteed by Fannie Mae and Freddie Mac, excluding refinances. That means it’s only looking at homes sold within the conforming loan limits...

This chart from the WSJ shows the comparison to the Case-Shiller index.

After all even the designer of the index, Robert Shiller wrote in the NYTimes that he does not see housing price recovery for years:

Even if there is a quick end to the recession, the housing market’s poor performance may linger. After the last home price boom, which ended about the time of the 1990-91 recession, home prices did not start moving upward, even incrementally, until 1997.

But what if there is something to this housing price stabilization? Is it possible we are at the bottom of the first dip in the "W" type recovery? An intriguing article was recently written by MIT's William Wheaton, who argues that net new household formation will soon create significant demand by using up existing inventory in the housing market. That demand may be sufficient to stabilize prices and stimulate new construction. It's a matter of demographics.

From VOX, William C. Wheaton:

During the last decade, net new household formation averaged approximately 1.4 million per year. Last year, the Census reported that the US added only 544,000 new households – during severe contractions the young stay at home, singles “double up”, and household formation (normally) slows. Even with declining demographics, however, most analysts foresee new household growth resuming to a level of at least 1 million by 2010 and beyond. If we conservatively add 200,000 demolitions per year, the US economy will “need” at least 1.25 million new units yearly in the near future. With today’s currently depressed construction, this generates a yearly deficit of 750,000 units.

At that rate, the current excess inventory of units for sale or rent will be back below normal by 2011. Prices historically have a strong relationship with sales “duration” – the ratio of inventory-to-sales. Hence under reasonable conditions, in two years we will have to increase construction considerably and prices will have to justify the cost of that construction.

CIT loan gives a new meaning to "being taken for a ride"

With the new loan, CIT was given an offer they "couldn't refuse" by PIMCO, Centerbridge, and others. GE had a better offer over the weekend, but by the time GE's funds would be available, it would be too late.



The loan terms are as follows:



This will move practically all of the the unencumbered assets into the security package for the new loan. This loan is already trading above par in the secondary market.

What's amazing is that CIT, knowing darn well they have debt maturities coming up didn't try to do something earlier, waiting until they were desperate. Apparently they were convinced that the FDIC will let them effectively use their expanding deposit base (at the bank they've set up) to pay down some of their debt. Another lesson in reliance on a government intervention - it's all about which way the wind blows.

The story of AIGFP, CDS, and regulation

Here is a useful write-up from Merrill on derivatives regulation, particularly with respect to CDS. The paper discusses impetus for regulatory changes and the various proposals to regulate OTC derivatives currently in play, including the piece of legislation in the Clean Energy Act (see ISDA sends a letter to the House on the sneaky provision in the Clean Energy Act)

As a side note, this stuff upsets many readers: Merrill/BofA discussing CDS regulation!!? So take it with a grain of salt. But before you listen to more angry, paranoid verbal diarrhea from bloggers and commentators online, read this as well as other materials. Remember, bloggers out there often try to infuriate rather than inform, to make you come back and click on their ads. Don't automatically buy it (including stuff posted here). Check the facts. Think for yourself.

A section in the paper touches (as an impetus for derivatives regulation) on AIG Financial Products (AIGFP), the derivatives sub of AIG that brought the whole firm down. Most assets they held were marked down, but the number circled in red was the real culprit (other stuff actually did OK this year). It's the CDS protection on the" AAA" tranches of "multi-sector" CDOs. A significant portion of that protection was written on sub-prime CDOs (CDO's whose collateral consisted of junior tranches of sub-prime ABS - confusing enough yet?), or on CDOs containing partial sub-prime exposure.



The $30+ billion "Fair Value loss" number represents the unrealized losses on these positions in September. Note that by the end of last year those losses were realized (plus much more) as AIG unwound these trades with some dealers.

On another side note, unwinding at ridiculously distressed levels was a bad move. The US government as the newly proud owner of AIG should have negotiated with the protection buyers. If these negotiations had been even close to the type of settlement that took place with the Chrysler creditors, the taxpayer would be in decent shape now with respect to AIG. Why the two firms (Chrysler and AIG) were treated so differently is a source of much debate, but this is exactly why the government should not own private companies. Their approach to negotiations is arbitrary, often driven by political pressures/ populism, producing an outcome which is rarely in the best interest of the taxpayer (the shareholder).

What allowed AIGFP to put on such massive positions was the lack of requirement to post much margin or allocate capital. Ironically it was AIG's AAA rating that gave them this opportunity. From the ML report:

In our view, this error in loss estimation which led to insufficient margin or capital at AIGFP stands as the fundamental source of AIGs failure. If AIGFP projected higher losses or a regulator had demanded more capital regardless of their internal loss assumptions, the company would have been less incentivized to enter into such a large positions as the projected return on investment would have been lower. Even if they had done such large size, the company would have had more funds to apply to the losses.

What's sad is AIGFP made only 30 basis points on much of the protection they had written.

The chart below shows how you can turn 30 bp into 30% return - using leverage. Posting only 1% in margin (or allocating 1% capital) allows you to leverage 100:1. At an even slightly higher margin (or capital) requirement, the returns would have been much lower and AIG would not even have been in this business.



That's why you never see hedge funds writing massive amounts of CDS protection - for them it's highly capital intensive.

The 4 regulators that oversaw AIG didn't see this problem, and the protection buyers didn't ask for much margin because AIG was "AAA". From the regulatory perspective it's a simple problem to solve. As a regulated institution, when you buy protection, ask for a proper amount of margin. When you sell protection, allocate appropriate amount of capital.


Enjoy!