Saturday, October 31, 2009

Leveraged ETFs - the rules of the game

As volatility returns to the markets, it's worth revisiting leveraged ETFs and the tracking error associated with these products. The rules of the game are simple:

1. Leveraged ETFs do well relative to the underlying index in trending markets,
2. underperform in mean-reverting markets,
3. underperform significantly in mean-reverting high volatility markets,
4. underperform over longer periods of time,
5. inverse (bear) leveraged ETFs underperform more than the equivalent leverage bull ETFs. The tracking error for a bear ETF is equivalent to a bull ETF with an extra turn of leverage. That is an inverse ETF tracking error is equivalent to that of a 2x bull ETF. The error for a 2x inverse ETF is equivalent to that of a 3x bull ETF, etc.

The chart below shows a potential underperformance (in a mean-reverting market) for leveraged bull ETFs over a one-month period (roughly) as a function of daily volatility.

The chart below shows the same for inverse ETFs (bear ETFs).

Here is an example of what happens with leveraged ETFs over a longer period of time. The chart below compares TNA, a 3x Russel 2000 ETF with the performance of Russell 2000 (small cap index). The index is up some 12% YTD, while TNA instead of being up three times that is actually up less than half for the year.

So if you really like risk, by all means take advantage of all the leverage available out there (before the SEC takes some "anti-derivatives" action against these products), but keep mindful of the nasty tracking error.

Friday, October 30, 2009

I love the smell of volatility in the morning

The markets stopped caring about 09 volatility and had been focused on 2010. The thought was that 09 will leave with a whimper because of the (government stimulus driven) benign economic data and Fed's inaction. And that's what the shape of the VIX futures curve was implying as participants bid up longer dated options relative to short dated ones.

Next year is when all the action was supposed to take place. But the reversal of the Risk Trade brought the volatility back into 09. Many got caught short vega with near-term maturities (some were long 2010 vega and short 2009 vega). Forced covering flattened the VIX futures curve in a day. Maybe Q4 markets won't be as boring as some had expected.

Borrowers' mantra: Can't refinance? Just stop paying interest.

Some recent numbers from the US treasury a showing a continuing decline in the total amount of interest paid on residential mortgages in the US. The question is what is causing the decline. The most obvious answer is the tremendous drop in mortgage rates in 09 as well as LIBOR or Prime linked short-term rates on floating rate mortgages. Luckily the Treasury provides us with some history of average rate paid on mortgages (see chart below.)

Given that mortgage rates are at around 5% (and short-term rates are even lower), why is the average rate above 6%? This says that a large proportion of the borrowers out there are unable to refinance.

The total interest payments have dropped 5.2% from the peak in Q2 of 08. The rate drop explains 4.1% of this reduction and some would say that the remainder can be explained by de-leveraging. But the bulk of that de-leveraging is not borrowers voluntarily paying down their loans. It's the defaults.

The chart below only goes to Q2, but it more than explains the reduction in interest payments.

source: Bloomberg

In fact the drop in mortgage interest payments would have been significantly steeper if it wasn't for new home buyers (taking out new mortgages, adding to the total interest paid). The answer these days to having too much debt seems simple - if you can't refinance, just stop paying the interest.

Thursday, October 29, 2009

US consumer goes shopping

Spurred in part by Cash for Clunkers, the consumer went shopping again. Personal consumption increase was 67% of the jump in the GDP number announced this morning (42% came from durable goods).

Some other areas showed improvements as well. Residential construction was up 23%, driven to some extent by the first-time home buyers tax incentive. It contributed another 0.53% to the GDP increase. There are clear fingerprints of government support in these GDP numbers. When the support programs are withdrawn and taxes (state and federal) increase, it's questionable whether this rate is sustainable going forward.

Wednesday, October 28, 2009

FAS 167 - an asset manager's nightmare with little purpose

FAS167 is a new FASB ruling attempting to tease out disclosure on what's called "variable interest entities". It forces consolidation of entities controlled by a corporation. The goal of the ruling was to force banks to disclose their CP conduits holdings, which were generally off-balance sheet. Banks would set up a company and give full ownership to a charity. Then they would have the company set up a commercial paper program which the bank would guarantee. The company would issue commercial paper to finance purchases of various assets, often structured credit tranches. The guarantee required far less regulatory capital than holding the assets directly on the balance sheet.

But this was a failure of regulatory capital rules rather than accounting rules. The 167 approach of "consolidate first, ask questions later" will have some bizarre unintended consequences that will cause more confusion and less transparency. It will force balance sheets to balloon, mixing assets that pose risk to the firm with those that do not. Analysts and rating agencies will end up paying less attention to balance sheet disclosures, as the salad of balance sheet items for complex institutions will become far more difficult to sort out.

As an example, consider asset management firms. A large firm may manage multiple funds with various product mixes. 167 will force the firm to consolidate the fund holdings because the firm controls these funds. Imagine a firm that normally has a $50 million dollar balance sheet forced to consolidate it's funds, creating a multi-billion dollar balance sheet. And if the funds have control of the portfolio companies, those will get consolidated as well. Let's say a portfolio company owns a tour boat - that boat will now show up as an asset of the management company. An analyst will have a real tough time figuring out what a fund management company is doing with a tour boat. And those who invest in the management company (but not in it's funds) will get far less useful information from the bloated financials. This is an example of FASB, zealous regulators, and accounting firms (who love the extra business) actually reducing transparency.

Tuesday, October 27, 2009

Roubini blasts the risk trade

The emergence of the risk trade on a large scale, which we discussed earlier is starting to get some attention.

Bloomberg: Investors worldwide are borrowing dollars to buy assets including equities and commodities, fueling “huge” bubbles that may spark another financial crisis, said New York University professor Nouriel Roubini.

“We have the mother of all carry trades,” ... “Everybody’s playing the same game and this game is becoming dangerous.”

One disturbing component of this pattern is gold becoming part of the risk trade as well - it's now highly correlated with equities. This is in part due to pending commodity "anti-speculation" regulation, which doesn't apply to gold. That makes gold the ultimate proxy for the liquid commodity risk trade. But a high correlation between gold and equities is somewhat absurd, because generally what's good for gold is not that good for corporations. The only rational explanation is that the weak dollar benefits both.

The risk trade is now showing signs of fatigue. As the year draws to a close we may see more of the carry trade reversal - as traders convert risk back into dollars.

But the only thing that can truly slow down the risk trade momentum in the months to come will be a change in direction for the US monetary policy. And that looks unlikely for quite some time.

Commercial real estate valuations and office jobs

Commercial real estate valuations seem to coincide quite well with the overall number of office jobs. It's not necessarily obvious that this should be the case, because commercial properties include retail, multifamily, and other non-office properties. Nevertheless the relationship is striking.

source: Moody's

This doesn't bode well for commercial real estate going forward. Job creation, particularly office jobs, may lag significantly any recovery the US might experience. Commercial real estate valuations therefore may end up lagging even more.

Monday, October 26, 2009

Rough road for munis

Even with the advantage of paying tax free interest, municipal bonds in many instances are yielding more than their corporate equivalents.
Bloomberg: State and local governments that sold $43.8 billion of taxable Build America Bonds this year will pay $385 million a year more in interest than similarly rated corporate borrowers, based on data compiled by Bloomberg.

The spread between corporates and munis varies along the yield curve. In the short end the tax advantage keeps the spread (corporate yield minus muni yield) positive, but for the longer maturities the spread reverses.

This means that in spite of the tax advantage of municipal bonds, given the choice between two equally rated long duration bonds with the same coupon, investors prefer the corporate paper. Clearly unlike corporate bonds, munis have lower analyst coverage and are viewed as a specialty market. Buyers of longer-term munis tend to be specialized muni funds, while corporate paper is held by institutional investors, fixed income funds, etc.

But that's only part of the story. If the risks were truly equivalent, over time the spread would tend to zero. The spread however shows incremental credit risk of municipal bonds over the longer time periods. But how is that possible, given that unlike corporations, municipalities "can raise fees or taxes to make up for deficits. Corporations are at least 90 times more likely to default than local governments, according to Moody’s Investors Service"? (Bloomberg)

The reason given by Bloomberg is poor transparency of municipal issuers.
The public paid extra costs for borrowing with tax-exempt bonds because local governments resist providing investors the same level of disclosure as corporate borrowers, which file quarterly reports.

Municipalities typically file financial statements only once a year. Detroit, the largest U.S. city with a less-than- investment-grade credit rating, released its annual report for fiscal 2007 in March, more than 18 months later.

But other reasons include the deterioration of state budgets and the risk that in the long run munis may lose their tax-free status at the Federal level. But there is something else. Private investors continue to be nervous when dealing with governments as political risk enters into the picture. Who is to say that 10-20 years down the road, municipalities will not walk away from their obligations. There is only so much pain that angry taxpayers in various states may be able to take. And for now that risk is costing municipal issuers the extra spread.

No mystery in Goldman's claims against the Lehman estate

NY Post: ... during a Goldman earnings conference call on Sept. 16, 2008, a day after Lehman filed for bankruptcy, Viniar during Goldman's earnings conference call downplayed its exposure to both Lehman and American International Group, the insurance giant that back then was on the verge of collapsing

Despite telling Wall Street that its credit exposure to Lehman was, in the words of Goldman CFO David Viniar, "immaterial," the gold-plated bank late last month filed one of the largest and most senior claims against the bankrupt Wall Street firm.

That has raised the hackles of some Lehman creditors, who are noting the disconnect between Goldman's public statements and its actions.

"How can you say this on one hand, while making these claims on the other?" asked one creditor, who described the inconsistencies as "suspicious."

There is actually nothing "suspicious" about this. Goldman's exposure to Lehman included a large position in Credit Default Swaps on Lehman, which nearly neutralized their overall Lehman risk. That's why the conference call "downplayed" Goldman's exposure in September of 08. The CDS had settled last year, paying Goldman the amount equal to par less the implied recovery at the time. The recovery amount was determined by the auction on Lehman bonds, a standard procedure in the land of CDS settlement. Now Goldman will try to recover the remainder of their exposure.

For simplicity assume $100 of Lehman exposure hedged with $100 CDS. As Lehman failed, the recovery was say 10 cents on the dollar, or $10. That means Goldman gets $90 in cash on the CDS settlement and has $10 left to recover from Lehman bankruptcy (to get their full $100 back). They now put in a claim against the estate.

Goldman's exposure to Lehman however wasn't just in Lehman bonds that could be easily sold - and the CDS wasn't a perfect offset as in the example above. The exposure included things like the OTC derivatives replacement cost, repo replacement cost, and possibly senior financing. Depending on the amount they recover, Goldman may end up getting back more than their original $100 exposure. No mysteries here, just the mechanics of counterparty risk management.

Get ready for a sharp curve steepening

The US Treasury has been issuing enormous amounts of bills to finance the administration's efforts, keeping the average maturity of debt low. But it's all about to change:

Bloomberg: After selling $1.9 trillion of short-term securities to finance President Barack Obama’s efforts to end the worst recession since the 1930s, the Treasury plans to lengthen the average due date of its outstanding debt to 72 months from a 26- year low of 49 months. That may mean boosting sales of 10- and 30-year bonds by 40 percent over the next year to $600 billion, according to FTN Financial in Memphis, Tennessee, driving down prices of longer-term securities.

The Treasury is thinking that while the demand is high, let's term out as much debt as possible. The US government has effectively taken a 4-year mortgage from the world and is about to try rolling it into a much longer mortgage.

But this increase in duration will coincide with the winding down of the Fed's securities purchase program and will create a spike in longer term treasuries' supply. We may soon be facing a sharp curve steepening in treasuries, possibly the largest in recent years.

Saturday, October 24, 2009

UK GDP surprise gave markets a dose of reality

The UK GDP number for Q3 came in well below anything economists have expected. The UK economy, it seems, is less like that Germany and more like the US economy - driven by consumer spending and credit. The nation may also be lagging the US cycle - having entered the recession later and possibly taking longer to return to growth.

UK Real GDP %YOY (source: Bloomberg)

The currency reacted immediately, with a nearly a 2% GBP decline against USD. The UK quantitative easing will continue as the credit markets appear to be extremely tight. The chart below shows practically no growth this year in the UK's broad money supply, justifying the Bank of England money printing programs. This makes the British pound quite vulnerable, as the supply will continue to grow.

source: OECD, Bloomberg

The news propagated through the markets quickly. The dollar rose and commodities fell as traders lightened up on the carry trade. With that came the sell-off in the US equity markets. Is it possible the US GDP number will come in much weaker than expected as well? The UK numbers certainly left market participants quite concerned.

Friday, October 23, 2009

Consumer credit and deleveraging: who is wagging the dog?

Yes, everyone is talking about consumer deleveraging. It's a given. The US consumers are scared of job losses and foreclosures and they are using some of their income to pay down debt. The chart below shows total outstanding consumer credit that includes credit cards, student loans, and other non-real estate related debt. It's the standard number the Fed publishes routinely (G.19), and most analysts use it as an indication of "deleveraging". Many are predicting the consumer deleveraging has ways to go.

Source: FRB, Bloomberg

Of course everyone assumes that deleveraging for the US consumer is a matter of choice. Boomers just decided to pay down their credit cards and here we are. Rational financial planning is back.

But how much choice do consumers really have in their deleveraging decisions?

It seems the consumer behavior with respect to credit is driven more by what banks have been doing. That is the US consumers have deleveraged only to the extent that banks wanted them to. Banks in the US have a specific exposure target they want to maintain to consumer credit. It turns out the sweet spot is just over 7% of total assets. Banks have the consumer exactly where they want her - with just enough card debt to keep profits rolling and risk at acceptable levels. The chart below shows consumer credit as percentage of total assets since the beginning of 08. It's amazingly stable.

source: FRB

So this idea that the consumer has wised up and is willingly paying down credit card debt may be a myth. Banks have been aggressive in reducing credit card exposure as they shrink their own balance sheet. As banks stop their own deleveraging, they may choose to keep their consumer exposure at around 7%. At that point all this "consumer deleveraging" may grind to a halt. So when you see consumer credit stabilizing, (which may be quite soon) it's not necessarily an indication that everyone decided to go shopping again. It just may be that banks are done with their own deleveraging.

Thursday, October 22, 2009

Learn Enterprise Risk Management from S&P

PRMIA, an organization for "risk management professionals" (whatever that means these days) generates some revenue by organizing courses. Among others they offer a course on Enterprise Risk Management (ERM). This type of course is meant to address risk management policies and practices across an organization (supposedly combining market, credit, and operational risks). James Lam (James Lam & Associates), who calls himself "the first ever chief risk officer”, is teaching the next ERM course for them. But there is more to this course:

PRMIA: Joining James Lam in discussing best practices in designing and implementing an ERM program will be Laurence Hazell, a director at Standard and Poor's in New York. Mr. Hazell, recognized in 2008 by Directorship Magazine as one of the 100 most influential people in Corporate Governance, will speak on Standard and Poor's ERM criteria and how they evaluate a company's ERM program as part of their rating process.

Wait, S&P will actually teach Enterprise Risk Management?

 Establishing a strong business case for ERM, and overcoming organizational barriers
 Developing an practical ERM framework and implementation plan
 Demonstrating tangible benefits from ERM adoption
 Implementing and integrating ERM into strategic and business decisions
 Establishing effective risk management policies and explicit risk tolerance levels
 Developing effective dashboard reporting for senior management and the board
 Creating an effective feedback loop for ERM performance

They have a great deal to contribute. After all S&P has been good at overcoming "organizational barriers" - when need be.

source: CNBC

Yet at other times organizational barriers persisted at S&P, as one could get a different rating depending on which group one approaches or how one describes the product being rated. And of course you too can learn how to deploy ERM to manage conflicts within your firm the way S&P did. You get both Mr. Lam and Mr. Hazell for a whole day (maybe) for only $1,200 per participant.

hat tip Ed

FDIC gets creative in bank liquidation

A typical FDIC transaction involves what's called "Whole Bank with Loss Sharing”. That means the bidder has to be a bank or be pre-approved for a bank charter. The acquirer takes over the failed bank, all of it's deposits and the bulk of it's assets. The FDIC shares in future losses on the acquired portfolio.

Banks willing to acquire other banks are few and far between these days due to significant capital constraints. Non-bank capital is sometimes easier to access. Therefore the FDIC decided to take a slightly different path with respect to Corus Bank in Chicago. The bank (11 branches) with most of it's deposits ($7 billion - mostly CDs) went to MB Financial Bank. The bulk of the assets however was sold to a consortium of private equity firms including Starwood, TPG, Perry Capital, and a JV between Wilbur Ross and LeFrak Organization. The consortium bought $4.5 billion of condominium loans and foreclosed properties.

By involving non-bank capital, the FDIC was able to get MB Financial to take over the bank. MB Financial did not have the resources nor the stomach to take risk on the $4.5 billion of condo assets. The FDIC will need to do more of this in order to place failed banks in the hands of someone who can operate them. It needs to be open for more non-bank capital to bid on bank assets in order to make it palatable for "healthier" banks to step in.

The question that still remains is how Corus (and banks like it) used taxpayer insured CDs to finance a concentrated condo loan portfolio and whether the condo developers "encauraged" the bank to lend.

Wednesday, October 21, 2009

The Fed's tri-party reverse what ...?

Much has been said recently about the Fed's activities in what the media refers to as "testing" of reverse repo transactions. This has caused a great deal of confusion because many have interpreted the "test" as a signal for the Fed to begin some sort of tightening.

The Fed definitely wants to be prepared to act, particularly to minimise the impact of new securities purchases. But repo transactions are nothing new for them - it's a typical tool used to add or take away liquidity in daily operations. What is new is the Fed's goal to expand repo counterparties beyond the primary dealers.

FT: The Fed also said the use of reverse repos could be extended further, with "the possibility of expanding the set of counterparties the [New York Fed's market] desk might employ for conducting reverse repos beyond the primary dealers".

But to face institutions who are not the primary dealers will create additional counterparty exposure for the Fed. It is also operationally difficult to execute direct repo trades with hundreds of counterparties (wiring cash back and forth and moving securities). To address these issues, the Fed has apparently been setting up and testing the "tri-party repo" arrangements.

FT: ... the Fed said it had been conducting reverse repo tests in the so-called triparty repurchase market, in which custodian banks such as Bank of New York and JPMorgan act as intermediaries.

In such an arrangement, instead of delivering securities directly to the counterpary, the Fed would place them at the custodian for the benefit of the counterparty. This way if the counterparty fails, the Fed could get a hold of the securities from the custodian.

The reason a number of counterparties may want to do this is that it will allow them to run a repo book directly with the Fed, including access to place cash overnight or term on a risk-free basis (which may produce a higher return than holding T-bills).

It's not clear how soon the Fed plans on using these programs actively. Some speculate this action will come quite soon but will be limited only to new securities purchases. That simply means that no new liquidity will be added going forward.

The voting members of the FOMC will be replaced by the new group (they rotate) in 2010. The new bunch looks modestly more hawkish as the chart from Credit Suisse shows.

It is highly unlikely the Fed will take any liquidity out before the end of the year, but they may begin to get a bit more aggressive in Q1. Much depends on the differential in the rate of change between the narrow and the broad measures of the money supply. The Fed wants to see more bank lending before it acts.

Tuesday, October 20, 2009

Implications of the feeble housing starts

The Commerce Department data showed that US private housing construction starts stalled on a month-to-month basis.

Source: Bloomberg/Commerce Dep.

Not surprisingly this spooked the US equity markets that were poised to rally this morning on positive earnings results. It's a subtle reminder that all is not necessarily well with this recovery.

One of the key reasons for the modest construction starts is lack of available credit. Construction is a capital intensive business. Stun by real estate exposure and undercapitalized, community banks are not lending to local construction companies the way they used to. And it may be a while before they are in a position to do this again. It also doesn't help that CIT has become incapacitated.

Since construction is a big driver of job creation in the current economy (as opposed to the old days when manufacturing was the driver of jobs), the weak starts number will likely translate into a worse than expected jobs results. That is in part why labor market recoveries have taken progressively longer in recent recessions.

Ironically this is not necessarily bad for housing price stability. Feeble construction starts allow the demographics to work through some of the existing inventory. We keep coming back to MIT's William Wheaton's analysis:
... 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.

Icahn's role in CIT's future and the firm's impact on broader economy

A great deal has been said recently about Icahn's letter to CIT (see attached). What exactly is he trying to do with this dying firm? Does he really care about CIT's board of directors, their contribution to the firm's ultimate demise, or their compensation? Is he really that interested in having a competent board at CIT to build shareholder value? From the letter:

I am reaching out to you to address what I view as the latest example of incompetent and unconscionable behavior on the part of the Board of Directors of CIT.

The answer is remarkably simple. Icahn is trying to achieve 3 goals with his letter:

1. He wants to take control of CIT and that's why he is targeting the board. The company's argument for keeping the board in place is that "change of control" may jeopardize CIT's small retail bank. But in fact the FDIC has already effectively closed the bank.

Even worse, the plan would leave a majority of the existing Board, or their chosen successors, in control of our company for years to come. The company argues that they must stay in control because a change of control at the company might cause the Federal government to close down our very small bank. Interestingly, the government has already effectively shut down the bank by issuing a “cease and desist” order. Ironically, based on the actions of the government concerning our present Board, we believe that a complete change in the Board would be a positive, rather than a negative, factor in influencing the government to resuscitate our bank.

2. He wants to stop the bleeding by refinancing the "Godfather Loan" and reducing fees.

In the proposed plan to “bail-out” the Board at the expense of most bondholders, the new term loan would amend and increase the company’s existing $3.0 billion first lien secured facility and would result in term debt of approximately $9.0 billion. The term debt would be secured by a first lien on virtually all of the company’s unencumbered assets, which currently total over $30 billion. In exchange for committing to and funding the term loan, the company is offering prospective lenders a total of 5.0% in commitment and funding fees, for a total cost to the company of $300 million in addition to an interest rate of at least 9.50%. In light of the gross over-collateralization and rich pricing being offered to investors, we view this upfront payment as excessive. (By way of example, when the company arranged its $3.0 billion existing term loan in July, 2009, lenders were also paid 5.0% for their commitment in the form of original issue discount. Once freed to trade in the secondary market the loan immediately traded to approximately 105% of par, indicating that a 5.0% OID was far greater than what was necessary to syndicate the facility. While the structure and pricing for the two facilities differ somewhat, it is obvious to us that the company is once again destroying value.)

3. He wants to shut down CIT, wind down its assets, and extract most value on the CIT bonds he bought recently - pure and simple. It amounts to nothing more than an orderly liquidation.

We agree with the Board on one thing, that CIT’s roughly $60 billion of assets should be allowed to be “run-off” or sold.

So Icahn's goal is not to improve CIT's corporate governance or rebuild their business. As any corporate raider, he simply wants to extract maximum value. There is a high likelihood that this was going to happen with or without Icahn - his role here is to make the wind-down more efficient and let CIT die with "dignity".

What does that mean for CIT and the economy as a whole? Most of CIT's small business loans will not be rolled when they mature. Trade receivables finance, leases, and other activities will probably shrink. But this wind-down has implications beyond CIT, who is a lender to some million small businesses. As we discussed before, small business, which in the US accounts for 75 percent of new job creation, is struggling.

The FDIC, watching community banks paralyzed and CIT on the brink is trying to get some TARP money to encourage lending to small businesses. The idea is to have FDIC co-invest side-by-side with private money in injecting new equity into struggling community banks.

Bloomberg: “We’ve suggested a dollar-for-dollar matching program,” Bair said. “This would be an additional validation of viability from the market if the market is willing to put additional capital in, help provide some additional protection to Treasury. Perhaps make the terms a little less onerous. This could perhaps be tied to increasing small-business loans.”

Whatever FDIC does, it will be difficult to replace the small business lending giant, CIT. And creating small business driven job growth is going to be that much tougher.

Icahn Letter to CIT

Monday, October 19, 2009

Death of a market

A few months ago in a post called The collapse of the CCX carbon emissions contract we discussed the hurdles faced by the carbon permits market, traded on the voluntary exchange named the Chicago Climate Exchange (CCX). Given that "cap & trade" process requires someone to pay money in order to emit what they need to emit, the only way such a process can work is with regulation that enforces caps on emissions. The "voluntary" thing was simply a preparation for the legislation, which ultimately never came and looks fairly dead right now.

Here is the latest on the CCX saga. The parent of CCX, the Climate Exchange PLC (traded in the UK) continues on, surviving on the European cap & trade legislation.

Price of Climate Exchange PLC shares

In the US however, the carbon contract has flatlined at 10 cents per ton (from over $7 at its peak).

And the volume has collapsed as well. The volume spike last year was a time when commodity prices and hopes for cap & trade were flying high. With democrats favored to take the White House, some form of carbon legislation was sure to come. But the world had changed quickly in the Fall of 08 and any thought of imposing new significant costs on US corporations fell out of favor.

Markets like this can't develop on their own. Nobody wants to pay for something they don't need unless they are forced to do so. And speculators/investors (which every market needs in order to function properly) won't participate in a market that has no natural buyers. This looks like the end of the CCX contract market - for now.

The contrarian views on the dollar

If you were to ask market participants about the dollar, its direction, and its place as the reserve currency, here is a typical answer you would get:

PIMCO: As the global economy recovers, it is likely that the 2008 surge in the net U.S. international liabilities will put downward pressure on the dollar for some time to come. In a post-crisis world the relative attractiveness of U.S. assets has and will likely continue to decline, and global investors may seek to rebalance away from the 60% increase in their net exposure to U.S. assets that occurred in 2008. This is negative for the dollar and, in the New Normal, also likely negative for the relative performance of U.S. equities, especially for companies without a global presence that must grind out profits in a world of 4% nominal GDP growth.

This is the standard, well accepted doctrine these days, particularly as the dollar continues on it's downward path. But if one digs a bit deeper, the level of certainty about continued dollar weakness becomes less pronounced.

With the dollar paying nearly nothing, it makes it a great candidate for the carry trade. Shorting the dollar is becoming everyone's favorite pastime (including retail investors). That trade is however quite vulnerable to rate increases.

Some folks from Barclays published a paper (see attached) that argues that dollar will strengthen next year as US rates increase. The chart below shows that in spite of record fixed income issuance in the US (particularly treasuries), the Fed has absorbed a large portion of that new paper. This low net supply resulted in continuing demand for US fixed income product, keeping rates low and dollar weak (in addition to the Fed keeping overnight rates near zero).

As the Fed slows down it's purchases next year, Barclays argues that the net supply of fixed income paper will rise sharply (chart above) putting upward pressure on rates. This in turn will reduce the dollar's appeal as the base currency for the carry trade (borrowing dollars will no longer be "free"). That may in turn stabilize the dollar (particularly a sharp carry unwind).

In fact some are becoming quite impatient with the Fed's slow response, arguing that near-zero rates foster asset bubbles:

Andrew Bary (BARRON'S, Oct 19th): IT'S TIME FOR THE FEDERAL RESERVE TO STOP talking about an "exit strategy" and to start implementing one.

There's no need for short-term rates to remain near zero now that the economy is recovering. The call to action is clear: Gold, oil and other commodities are rising, the dollar is falling and the stock market is surging. The move in the Dow Jones industrial average above 10,000 last week underscores the renewed health of the markets. Super-low short rates are fueling financial speculation, angering our economic partners and foreign creditors, and potentially stoking inflation.

The Fed doesn't seem to be distinguishing between normal accommodative monetary policy and crisis accommodative policy. There's a huge difference.

But what about the argument that the dollar will be soon replaced as the primary reserve currency as well as the primary currency for settling financial transactions (such as sovereign CDS for example)? Ed Grebeck (CEO of Tempus Advisors) argues (in an e-mail) that choices for alternatives continue to be limited:
* Euro ? - just another fiat currency, like the dollar, but worse: backed by 800,000 Brussels bureaucrats. It's not a "real" economy and putative political will.
* Yen ? -- neither the Japanese nor world are comfortable with Yen as reserve currency.
* "Exotic" currencies ? -- [Australian, Canadian, New Zealand $, Scandinavian, etc], too small.
* BRIC currencies ? -- illiquid markets and carry political risk... anyone trust Russia ? Brazil and hyperinflation history ? ... perhaps some decades/generations ahead after political issues resolved, China and/or ... India ?
* Sterling and Swiss Franc -- before they were "big" alternatives to USD, DEM, but now "too small" relative to USD and Euro.

So before plowing wholeheartedly into that short dollar trade, just remember that it sometimes pays to be a contrarian.

US Dollar Forecast

Sunday, October 18, 2009

Harvard's big swap unwind

As we discussed a few months back, Harvard's lesson in Asset/Liability management had indeed been costly. What has come to light recently is the pain Harvard took on their interest rate hedges. As the school went on their construction spree and undertook a variety of capital projects in the last few years, they were running exposure to short-term rates. This was due to the way the university was financing these capital projects (which is typical for such financing).

In order to lock in their short-term rates on the capital projects' debt, they swapped floating for fixed (agreeing to pay fixed rate and receive floating). Simple enough. But as the rates collapsed late last year, Harvard got a massive margin call on the swaps. Again, this is standard - the value of the swaps went against them (they continued to pay the same fixed rate but were expected to receive floating rate that's significantly lower) and banks called for margin. In principal, that should be OK as well, because the swap losses should be offset by Harvard's lower financing costs.

But a couple things went wrong. Some of their capital projects were put on hold, so they couldn't take advantage of cheap financing. At the same time their liquidity in the endowment became significantly constrained because of the nature of their illiquid investments. And with the economy collapsing, unencumbered donations nearly dried up. The margin call was much more than they could handle and Harvard ended up issuing bonds to cover losses. They ultimately decided to get out of their exposure (possibly at the worst time.) They unwound some $1.1 billion of swaps. However, rather than unwinding the remainder of the hedges (and paying the losses upfront), they simply locked in the losses with offsetting swaps, creating a long-term liability stream. Here is the statement on the offsetting trades:

Harvard (see attached): ... in fiscal 2009, the University entered into additional interest rate exchange agreements with a notional value of $764.0 million, under which the University receives a fixed rate and pays a variable rate. These new interest rate exchange agreements, or ‘offsetting’ agreements, were intended to reduce the risk of further losses in value (with associated collateral posting requirements) within the portfolio of interest rate exchange agreements.

In fact this unwind and others like it at the time caused the 30-year swap spreads to go negative. The overall impact on Harvard's financials was severe:

Bloomberg: Harvard paid $497.6 million during the fiscal year ended June 30 to get out of $1.1 billion of interest-rate swaps intended to hedge variable-rate debt for capital projects, the report said. The university in Cambridge, Massachusetts, said it also agreed to pay $425 million over 30 to 40 years to offset an additional $764 million in swaps.

So how can a bunch of really smart people run into so much trouble with a hedging program. The consultants out there are shouting - you should have hired us to do this. This is too complex for you Harvard guys.

Bloomberg: “It says that people don’t understand the complexity of the products they are buying and selling that doesn’t begin and end with mortgage securities,” said Robert Doty, a municipal finance adviser at American Governmental Services in Sacramento, California. ... “It shows that with these products that are so highly complex, people are a long way from knowing as much about these products as they think they do,” he said.

"so highly complex"? This is how this particular consultant gets paid, by making sure that everything in finance is "too complex" to do without his guidance. In fact this is not about complexity, it's about the practicalities and appropriateness of financial products. And this is when academia often fails - the rule of "we must hedge everything with swaps" was put in place by someone who is not only clueless about the simple mechanics of margin, but also doesn't understand the purpose of hedging.

What is the purpose of hedging here? For Harvard it was to avoid paying really high rates on their financing. But what is high? If LIBOR was at 4.5% when they started on their projects, would it be that difficult for them to pay 5% or 6%? Probably not. The real pain would kick in above say 8%. Hedging for this type of situation should be viewed as a form of insurance. And as we all know, when you buy insurance, the cost depends on your deductible. So Harvard instead of entering into swaps, could have easily bought some interest rate caps struck at say 8%, making sure they never have to pay above that level. It's a high deductible, making these caps reasonably inexpensive. In retrospect it would have been money wasted, but as with any insurance, you buy it hoping it will be wasted.

Alternatively, if they didn't want to pay upfront premium for caps, they could have put on cancellable swaps. The right to cancel would have made their fixed payments higher (depending on maturity, maybe a percent more). But they could have simply cancelled them last year with no breakup costs or margin call. It's a standard and fairly liquid product (in the category of "swaptions"). Of course some would say - oooo, this is too exotic. This concept is actually commonplace, as the "option to cancel" is built into most people's mortgage. When mortgage rates drop, most can refinance with no penalty of unwinding the old mortgage (something borrowers generally can't do in the UK for example). If you refinanced your mortgage before, you've exercised your "option to cancel".

The media is making this sound as though it's a "bad investment" gone wrong - mostly because they don't understand the situation, and it creates good hype. In reality it's simply an issue of sound asset/liability management, proper usage of financial tools, and a bit of common sense. Makes for a good Harvard Business Case study.

Harvard- Financial Report

Friday, October 16, 2009

CDO equity holders extract value by selling their votes

Imagine that you are a holder of a senior tranche of a CDO. You've been through hell and back, and now you have hopes of recovering some non-zero value from the bond. You value the collateral and figure that over time you may get say 50 cents on the dollar.

When you bought these specific bonds, you knew (maybe) that the subordinated note (equity) holders have some rights, including the ability to liquidate the collateral. But that's OK you thought, because the equity holders will have no incentive to sell the collateral at anything but the top price because they would be taking the first loss.

But what happens if the equity holders are wiped out anyway? Even if the collateral is sold at top current prices, the equity value is zero - all the residual value goes to the senior note holders and there is nothing left for the equity. That makes sense - if the senior note holder is hoping to get 50 cents on the dollar, the equity has to be worthless. But not so fast.

You wake up one morning and learn that the equity holders decided to liquidate the collateral at 5 cents on the dollar. And the reason they are doing that is that the collateral buyer has bribed them. Yes that's right, they have been paid to allow liquidation at rock bottom prices. They are wiped out anyway, so why not sell their vote? Now the 5 cents is going to you, the senior bond holder, because in a liquidation you get paid first. And that's it, you are not getting a penny more because there is no more collateral left.

Crazy story? Nope. This is real. The senior note holder is Citigroup. The collateral purchaser (at 5 cents on the dollar) is TPG Credit Management (part of TPG, one of the largest private equity fund managers.)

Bloomberg: A fund associated with TPG is exploiting an unintended wrinkle in the $650 billion market for CDOs by asking holders of the riskiest portions to allow asset sales in exchange for millions of dollars in fees. While equity holders have the right to decide which assets the CDOs sell because they’re first in line for losses, they may no longer have the incentive to ensure that assets are sold at fair value because their investments have been wiped out ...
Julie Braun, chief operating officer of TPG Credit, said in an Oct. 9 letter to Tropic CDO V noteholders that Trust Preferred Solutions LLC is seeking to buy $115 million of securities issued by 20 finance companies including Centra Financial Statutory Trust II and Forstrom Capital Trust II for 5 cents on the dollar. Investors must agree by Oct. 23, the letter said. Trust Preferred Solutions is a TPG Credit investment vehicle.

In this particular case TPG Credit is targeting CDOs (called TruPS) that have trust preferred securities as collateral (see primer below). The interest on these securities in the collateral pool is often deferrable for up to 5 years and maturities go out to 30 years. With the shakeup in the banking sector the securities aren't worth much, but are on average worth more than 5 cents on the dollar.

This maneuver by TPG is legal and follows the indenture documents. Citigroup is obviously not too happy and is preparing to fight.

Bloomberg: While Tropic CDO V’s [TruPS targeted by TPG] equity holders haven’t received payments in a year, they’ll get “a consent payment equal to half of the aggregate purchase price of the subject securities, unfairly benefiting the preferred shareholders at the sole expense of the noteholders,” Huang [representing Citi] said in the letter.

“We intend to hold the issuer, its directors and the trustee responsible for any transaction that improperly impairs our collateral or interferes with our legal and contractual rights,” Huang wrote.

Trust Preferred CDO Primer

Thursday, October 15, 2009

TLGP: "we bring good things to life"

One of the most successful government programs to stabilize the financial system has been the FDIC's Temporary Liquidity Guarantee Program (TLGP). It allowed banks to issue short-term notes that are backed by the FDIC. The media generally focuses on the fact that the guaranteed paper was significantly cheaper for banks than issuing notes on their own. This is correct - once investors realized that this is truly a government program, it started trading much closer to treasuries (although people felt that there was some political risk associated with the guarantee).

But many forget that at the end of 08, banks couldn't issue paper at all, even at historically high yields. TLGP effectively unclogged the frozen credit markets, allowing first banks, but shortly after other types of corporations to issue paper, leading to an incredibly robust primary debt markets today.

A total of $329.5 billion of notes have been guaranteed by the FDIC. The question of course is who has been most active in utilizing this program. The usual suspects are there: C, BAC, JPM, etc. But the largest user (and the entity to which the FDIC has the most risk) has been GE Capital (close to $90 billion). "We bring good things to life" means we bring lots of FDIC guaranteed paper to the market. Next time you screw in a light bulb, just remember your tax dollars have kept the lights on, literaly.

source: Bloomberg

Other "non-bank" users have been GMAC, American Express, MetLife. We also had some non-US banks participate such as HSBC. The program is about to end however, with the last date of October 30th to issue an FDIC note. This is one of those tools that the government will have available in case of another crisis in the future. Just dust off the old TLGP docs and you are ready to restart the debt markets.


Wednesday, October 14, 2009

Japan's sovereign CDS indicates higher relative risk

The US government debt is clearly growing out of control and will present some unprecedented challenges for the nation in years to come. But the US debt problems are not even close to what Japan is facing. We've discussed the issue of Japan's growing debt problem before. A great deal of the government paper in Japan (95%) is placed domestically as a form of savings, particularly retirement savings. As Japan's population ages, the domestic holders will increasingly become net sellers of government paper (JGBs). The international market for JGBs is quite limited and central banks have only a limited appetite for the paper. On the other hand the government will need to issue more, because as the workforce shrinks (as more people retire), tax revenues will be pressured.

The chart below shows a comparison of government debt to GDP ratio (including a near-term projection from IMF) for the US and for Japan.

source: Bloomberg/IMF

While the chart above shows the government debt ratio, Japan's gross national debt (including private debt) is currently 217% of its GDP, while the US is at about 81%. Both are obviously projected to rise significantly. There seems to be little focus on this in the media. Part of the issue has been the yen strength. Japan continues to rely quite heavily on exports. And even if they set up manufacturing in the US or China, they still have to bring the profits back into yen. The strong currency continues to have a negative effect on Japan's GDP, raising the debt to GDP ratio further.

The debt markets have taken notice. The sovereign CDS spreads (historical 5-year CDS levels plotted below) are now showing an increased divergence between the default risk premium for the US and the Japanese government bonds.

source: Bloomberg/IMF

The disparity would have been even higher if it wasn't for Japan's massive foreign reserves of about $1 trillion.

As a technical note (thanks for bringing this up Phil), the Japanese and the European nations' sovereign CDS is usually set up to settle in dollars. The US CDS however would generally settle in Euros (at least most contracts have traded this way so far) and would most likely be executed by a non-US bank. If any of the US treasury paper actually defaults, getting paid in dollars is probably not that meaningful.

Tuesday, October 13, 2009

After the Godfather Loan, CIT is trying another debt exchange

The unsecured bondholders have recently sued the lenders of the so-called "the Godfather Loan" (rescue package) lead by Barclays. They claim that the Godfather Loan was done with the knowledge that the company will default as a result of that "rescue package" (amounting to a fraudulent conveyance). The "Godfather" lenders have practically all of the unencumbered assets as the collateral package for their loan (5 x the loan amount). The unsecured lenders (the bond holders) filed a complaint that the $3 billion rescue loan subordinated their claims, making CIT unable to pay the bond holders next summer. This is going to be a long fight.

This chart shows (roughly) the CIT debt maturities going forward. It's not pretty.

To avoid default CIT has to bring down leverage. To accomplish this, they are trying to reduce the debt outstanding by at least $5.7 billion of face value (much of it at nearby maturities). They are offering to exchange existing bonds for new notes and preferred equity. According to JPMorgan, they will need 79% of the bond holders to participate. Not only do they need large numbers of participants to get to the $5.7 billion of reduction, but a number of debt holders have CDS protection against their CIT bonds (basis trade) and would prefer for CIT to default. A default would force convergence of the basis (the CDS would settle at the auction-priced defaulted bond level) and make these guys some money instantly. They are mostly indifferent to the recovery rate on their bonds (the lower the recovery, the more their CDS will pay them). The basis position holders would therefore vote for a for a prepackaged bankruptcy instead of the proposed exchange. The fact that they can't count on the basis holders means that CIT needs an even larger fraction (79%) of the debt holders to agree to the exchange.

But to get 79% of the non-basis holders to agree to the exchange (tender) is going to be rough. It looks increasingly likely that CIT is headed for bankruptcy, which is what the "Godfather Loan" guys (who want to grab the collateral) as well as the basis trade holders ultimately want. Welcome to the world of distressed debt investing.

Bernanke's next steps

Let's take a quick look at options currently available to the Fed and their potential next steps. With the dollar under pressure and bank reserves at historical highs, one would think the Fed is getting uneasy with all the liquidity in the system. Now that the short-term liquidity facilities are winding down, much of the new securities purchases will increase the balance sheet and grow the money supply. Many beleive this will surely lead to inflation.

To address this, the Fed has the following two tools (outside of outright securities sales):

1. Purchase new securities (RMBS, Agency paper, etc.) on repo (sterilized purchases). The Fed would effectively buy the securities and immediately lend them out for some period, taking in cash collateral. This takes these securities out of the market, but does not increase the money supply because the proceeds from these sales would not be available to the dealers (the proceeds become the cash collateral). This could be done not only with new purchases, but with securities already on Fed's balance sheet (about $1.5 trillion worth). To accomplish this on a scale that makes a difference, the Fed needs to set up repo lines with banks and dealers outside of the Primary Dealer group. The primary dealers may not have the capital to absorb such massive amounts of repo transactions on their own.

2. The Fed could also raise rates. But this wouldn't be simply raising the Fed Funds Target Rate. Instead the Fed now has the ability to raise interest rate on the reserves that banks keep with the Fed. That immediately creates a floor on rates because banks have no incentive of lending at levels at or below the reserve rate. Instead they can simply deposit the funds with the Fed on a riskless basis. This tool has been used by other central banks for decades.

The first tool may be set up relatively soon, particularly for new purchases, but it's usage should be fairly modest in the near-term. The rate increases however are months away. Here are two reasons for the Fed's dovish approach:

1. The Fed will not take any rate action until they see improvement in employment. And as we discussed earlier, this may take a while. This is particularly true because many recent jobs (the "bubble jobs") were created on the back of construction spending.

2. The Fed (among numerous measures available to them) watches one key indicator quite closely: the rate of change in "broad" money supply relative to the "narrow" money supply. It's a measure of how effective the liquidity injections have been in stimulating lending. Banks can be loaded with cash, but if they don't lend, the cash is not making it's way into the broader money supply (the banks effectively stay overcapitalized). And that means the broader economy is not benefiting from the liquidity the Fed had provided, which limits it's growth. The chart below shows the relative growth of M1 (narrow measure) and M2 (broader measure). Until M2 picks up significantly, the Fed will do very little in terms of tightening.

source: St. Louis Fed

Inflation is unlikely to pick up until credit is available in the broader economy to allow corporations and individuals to pay higher prices. With broader money supply responding this slowly, significant price and wage increases are unlikely in the near-term.

The possibility of the Fed actually selling securities from it's balance sheet outright is even less likely. Such sales may impact long-term rates, which may have a negative effect on housing and the consumer, and the Fed will categorically not go there. The RMBS securities, the agency paper, and even treasuries they have bought, will stay on Fed's balance sheet for years to come, possibly to maturity.

Monday, October 12, 2009

Learn structured finance from the best in the business

For a mere $4,095, you too can learn from the best in the business of rating structured finance securities - Moody's. Learn things like Moody's rating methodology for securitization, Moody's approach to rating RMBS, CDOs, and of course ABCP. Each session is followed by group exercises...

And people thought there is no more money to be made in structured finance. Entrepreneurship at it's best. It's impressive that Moody's has put this out there. It's probably a great course, but it is equivalent to having Enron sponsoring courses on how to set up off-balance-sheet SPVs and taking future revenues into income.

Moody's Course

Central bank foreign reserves currency allocations - a shift away from USD

As the dollar continues to get clobbered (chart below), it is helpful to see what central banks are doing with their reserves. This is particularly useful because central banks don't trade currencies (at least they are not supposed to), and the allocations are often indications of longer term policies/trends.

source: Bloomberg

A recent release from IMF shows the following allocation picture as of the end of Q2 (this is on a quarter lag, but still useful):

source: IMF

And here is the Q1 to Q2 change in the amounts allocated to each currency (shown as percent change from the Q1 allocation amounts). Note that the Swiss Frank (already a small allocation) continues to drift down as central banks begin to see Switzerland as too leveraged to it's financial services industry.

source: IMF

Looks like some allocation to the USD continued in Q2, but allocations to EUR, JPY, and other currencies have increased much more. That makes USD a smaller percentage of the overall foreign reserves. In fact the USD percentage has dropped to a record low of just under 63%. And that is looking more like a trend.

source: Bloomberg

If the trend continues, it will become particularly difficult for export focused nations such as Japan and Germany. Given the size of foreign reserves (foreign exchange holdings are now at $6.8 trillion), even small reallocations to EUR and JPY will cause sizeable currency appreciation.

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