The Float

Friday Reading

Just another mellow week in the financial markets...

• Yesterday we noted the privileged position of Goldman Sachs. When Fortune's Peter Eavis digs into yesterday's Q3 report, he comes away astonished...and a little perplexed [emphasis added]:

One of the figures that didn't seem to make sense in Goldman's earnings was a number that estimates the market risk on a broker's balance sheet. This indicator, called Value at Risk, or VaR, moved up only 5% in the third quarter from the second. If Goldman was placing big bets in volatile markets--like the short trade in mortgages--VaR might be expected to move up by more.

In other words, Goldman seems implausibly immune from the general rule in investing that higher returns almost always carry higher levels of risk. [Goldman spokesman Lucas] Van Praag responds that VaR didn't go up by much because Goldman reduced positions as volatility in the markets went up.

Goldman does seem to have institutionalized a higher level of trading savvy--the third quarter numbers bear that out. The market recognizes that in awarding the broker a valuation that is higher than that of its peers. Quarter in, quarter out, Goldman posts a return on equity in excess of 30%, even though it's highly leveraged, like all brokers. The high leverage should translate into at least some rough quarters. That was the case for Goldman's ailing hedge funds in the third quarter. Why is it never the case for Goldman itself?

• At Minyanville, Mike Shedlock takes note of what has and hasn't changed since Tuesday.
• Bloomberg's Mark Gilbert asks who's in charge around here anyway...and suggests it isn't necessarily central banks.
• Speaking in Germany, Fed Vice-Chairman Donald Kohn disputes the premise of a Greenspan/Bernanke put.
• With long bond rates moving higher in response to the Fed rate cut (or cuts), this item from Calculated Risk seems especially apt.
• This Jon Markman piece on the perils of structured finance extends an argument summarized by CLSA's Christopher Wood (via Barry Ritholtz): "This is not a sub-prime crisis. Sub-prime has merely exposed the bigger scam of structured finance, a scam that is about pretending that bad credit is good credit."

Let It Happen

In Wednesday's New York Times, David Leonhardt asked a very good question: "The Federal Reserve sent the stock market soaring yesterday. So can it stop the decline in home prices, too?" We think Leonhardt is right to answer that question with a relatively resounding no and we recommend that you read his story--twice.

But there's another important question lurking here: Whether the Fed can stop (or slow) the housing slump, should it try?

Before anyone suspects us of taking a cold-hearted, let-them-eat-cake approach to the problems created by housing weakness, we should add that we fully recognize the financial and emotional strain suffered by individuals, families, and communities in hard-hit markets. Stripping away all the caveats, though, sober observers should be more interested in reaching sustainable long-term equilibrium levels in residential real estate than in preserving the sort of unsustainable short-term imbalances we've seen over the last few years.

Consider the chart at right, which depicts the remarkable rise in the ratio of home prices to median household incomes. Is that 21st-century spike desirable? Does it make economic sense? Should policymakers seek to preserve it? Our answers: No, no, and no.

First, as we argued last week, "the last few years saw a gross mis-allocation of resources to economically unproductive assets (that is, the housing stock--the creation, remodeling, buying, and selling of which create economic activity, but the existence and use of which do not)." This is the heart of the matter, and it goes to resource allocation, productivity, and long-term economic growth.

Second, home price inflation has led many homeowners into a deeply dysfunctional borrow-and-spend relationship with their home equity. The point here isn't that homeowners should never borrow against home equity. The wisdom of such borrowing depends on a number of factors: interest rates, the percentage of equity withdrawn, the purposes to which the borrowed funds are put, &c. With the household saving rate fluctuating between zero and worse, consumers' belt-tightening won't help their short-term spending but will help their long-term solvency. We're pretty sure we know which of those is more important.

Third, there's a generational issue underlying residential real estate, as younger Americans find themselves either priced out of the market or "owning" homes only by stretching household balance sheets to the breaking point.*

There's room for policy to address some of the worst fallout from the ongoing housing recession. And there's certainly room for policy to regulate some of the worst practices of the recent bubble (though some regulatory interventions will undoubtedly amount to "fighting the last war").

Home prices need to come down in many (most?) areas of the country. Monetary and fiscal policymakers should attend to the near-term implications of declining real estate values, but they should not intervene to stop this overdue and--in the long term--very healthy adjustment.

~~~~~~~~~~~~~~~~

*We put owning in quotation marks here simply because many loan terms have allowed people to occupy homes without in any meaningful way owning them. And as always, the universal real estate caveat applies: Local and regional markets vary widely. Where some markets (e.g., parts of the sun belt) have been absurdly bubblicious, others (e.g., parts of the auto belt) have been stubbornly deflationary. But those persistently weak markets have been weak for a reason, namely that job and income growth have been anemic at best, which means some of the imbalances described in this post apply even in long-depressed markets.

Source

David Leonhardt, "Will the Fed Reverse the Housing Slump?" New York Times, September 19, 2007

Goldman: Well-Placed

With Goldman Sachs reporting a blowout third quarter this morning, we feel compelled to offer up one more snippet from yesterday's Squawk Box on CNBC. The following exchange between host Joe Kernen and guest Vince Farrell came at the end of a discussion of Morgan Stanley's disappointing Q3 numbers:

Kernen: Lemme know when Goldman misses...I'm tellin' you, they know somebody in high places.

Farrell: They are high places.

Enough said.

Source

Christine Harper, "Goldman Net Rises 79 Percent, Lifted by Mortgage Bets," Bloomberg, September 20, 2007

What Kind of Fix Was It?

Early this morning, CNBC's Rick Santelli intimated that yesterday's Fed move looked as much like the kind of fix a heroin addict needs as the kind that might actually break the underlying addiction itself. That sounds about right to us.

If we had to summarize our view of yesterday's policy shift, it's this: We've been concerned about housing-led economic weakness for a few months now, so it's not as if we can't see the logic of recession-fighting policy change.

But we'd append two important caveats to that: (1) If recession is coming, even sustained Fed policy change is unlikely to avoid it, though it might shallow it out on the margins, and (2) the Fed's apparent/emerging damn-the-household-balance-sheet approach to sustaining consumer spending growth seems especially shortsighted.

After all, excessive borrowing against inflated, non-productive residential real estate is not conducive to long-term micro- or macroeconomic strength. Encouraging more of the same just isn't wise.

Looking ahead to future Fed meetings, one might ask what sort of logroll allowed the FOMC to maintain its unanimity behind such a bold move. Last night the Financial Times offered a plausible answer [emphasis added]:

By frontloading monetary easing--rather than opting for an incremental 25 basis point cut--the Fed could make a splash in the markets without tying its hands on future rate moves.

Following the 50 basis point cut, the Fed did not retain a bias towards further easing. Instead, it promised to act "as needed" to pursue its goals--price stability and sustainable growth.

Bruce Kasman, chief economist at JPMorgan Chase, said: "The Fed is front-loading. It is not necessarily signalling it is going to deliver a lot more."

Ben Bernanke, Fed chairman, may well have persuaded reluctant hawks at the bank to vote for a 50 basis point cut by arguing that a hefty cut up front would reduce the likelihood of having to do a lot more later.

For what it's worth, The Wall Street Journal's Greg Ip suggests the current composition of the FOMC contributed to its unanimity yesterday:

Some Fed officials may have shared similar concerns either about inflation or about the risk of stoking further speculation. Only seven of the Fed's 12 reserve banks requested the half-point cut in the discount rate. Four of the five absent banks are headed by presidents who have raised such concerns. None of the four, however, have a vote on the Fed's policy-making Federal Open Market Committee this year, and that may be why the vote to cut the federal-funds rate was unanimous.

The Fed has re-filled the punch bowl, but the potential for a nasty hangover still looms.

Sources

Krishna Guha, "Bank acts boldly to avert recession risk," Financial Times, September 18, 2007

Greg Ip, "Fed Cut Aims to Contain Damage," Wall Street Journal, September 19, 2007 (subscription required)

Daniel Gross, "The Punch Bowl Caucus," Slate, August 27, 2007

Psychology and the FOMC

No question about it: The initial impulse from yesterday's Fed decision is overwhelmingly psychological. Since the Fed's mid-August takedown of the discount rate, market participants have rekindled a buoyant combination of hope, optimism, and, after yesterday's policy shift, outright euphoria. That's not to say the Fed's move doesn't have real economic implications; of course it does. But the immediate impact is primarily manifested in market participants' (re-)heightened risk appetites.

In related news, this morning two frequent CNBC guests--Hovnanian Homes boss Ara Hovnanian and AutoNation CEO Mike Jackson--spoke directly and revealingly to the question of market psychology.

Here's an exchange between Squawk Box host Joe Kernen and Hovnanian [emphasis added]:

Kernen: Any weekend sales coming up like the last one?

Hovnanian: Uh, no, we're very thrilled with what happened. It just shows there are customers out there. They just need that psychological boost to get out and pull the trigger.

Well, that's true, if by "psychological boost" Hovnanian means massive price cuts and financial incentives. By our lights, "psychology" in consumer and investor behavior is pretty much a synonym for confidence. Rational buying and selling of goods, services, and real and financial assets--i.e., economic behavior--is partly a function of confidence, but it's also a function of rational calculations of utility, price, and value. So slashing prices is less an indirect psychological boost as a very direct economic concession to rationally cautious buyers. That may seem like a fine distinction, but the difference matters for how we think and talk about what's driving what in the economy and the financial markets.

And here's another interesting moment from CNBC's morning air, this time featuring AutoNation's Mike Jackson [emphasis added]:

"Let's face it, I agree with Joe that the Federal Reserve has a responsibility to fight the scourge of inflation. But it has an even greater responsibility to avoid the destruction of a recession. And clearly that's on the horizon, clearly psychological factors are involved, and that's what's behind the half-point rate cut."

Yes indeed. Psychological factors are very much involved. One of those factors might be the tendency of CEOs in semi-deflationary industries--say, automobile sales--to prefer expansionist monetary policies in the face of demonstrable, still-unwnding credit market excess. Another might be economic elites' remarkable belief in the capacity of the guardians at the Fed to pretty much vanquish the business cycle. As we wrote last week, the business cycle ain't all bad:

When good credits can't borrow for economically useful purposes, market failure requires a policy response. But it's important to remember that inflated asset prices--when fully detached from underlying production or productive capacity--can themselves be evidence of a kind of market failure.

At such times, letting asset prices--for debt, equities, real estate, commodities, derivatives, &c.--return to something approaching rational equilibrium levels is itself conducive to the efficient allocation of economic resources. And that allocation of resources is what markets should do best.

Source

Daniel Taub, "Hovnanian Says Weekend Sales Event Beat Expectations," Bloomberg, September 17, 2007

Wednesday Reading

The day after...

• CNNMoney's Chris Isidore on what the Fed cut won't do.
• Bloomberg's Shobhana Chandra on August's predictably ugly housing starts.
• August CPI numbers came in moderate (down 0.1% on the headline, up 0.2% on the core), but of course those numbers printed before crude topped $80...but then again, that elevated price may or may not prove sticky.
• Bloomberg's Christine Harper on Morgan Stanley missing already-lowered earnings estimates. We'll try to dig a little deeper into the Level 1/2/3 accounting issue in the Morgan numbers.
• The Wall Street Journal's Real Time Economic blog compiles Fed reactions from the usual suspects.
• LIBOR came in overnight, falling from 5.33% to 4.94%.
• Looking for more evidence that defined-contribution plans are slowly and surely replacing defined-benefit pensions? Check this out.

Preliminary Fed Post-Mortem

Wow. The FOMC pulled out most of the stops, no? 50 bps on fed funds, 50 bps on the discount rate. Remarkable stuff. We'll have more say about this in time, but here we'll simply note that the game now reboots to this: Is this big shift a one-off fix? Or is it the beginning of a sustained series of cuts?

With so many moving parts, there will be plenty of fodder for analysis, second-guessing, and expectation-forming. A couple interesting questions: What sort of logroll did unanimity require? Beyond the typical statement boilerplate, how significant is the FOMC's recession fear? And did you hear that giant whoosh at 2:17 EDT? Yes, that was the shorts scrambling for the exits.

Okay, we can't help ourselves: CNBC's pre-announcement chyron--"What Move Keeps America Great?"--was one of the most overwrought, faux-serious, Fed-mythologizing we've ever seen. Surely the network can do better than that.

Accounting Standards and Earnings Quality Revisited

Four weeks ago we posted an item on the effect of new accounting standards on corporate earnings, with special emphasis on the financial sector. Here's a key passage from that post:

The issue here is the role of new accounting standards in the plausibility--and sustainability--of corporate earnings. Wells Fargo takes some heat from [Bloomberg's Jonathan] Weil, but the real story here is corporate accounting standards more broadly, with, perhaps, special emphasis on the financial sector, which may be under especially acute pressure to deliver decent current-quarter results in the face of so much market dislocation.

The crux of all this is the distinction between Level 1, Level 2, and Level 3 assets. Here's a summary of the categories from an August 22 story by Weil:

Level 1 means the values come from quoted prices in active markets. The balance-sheet changes then pass through the income statement each quarter as gains or losses. Call this mark-to- market.

Level 2 values are measured using "observable inputs,'' such as recent transaction prices for similar items, where market quotes aren't available. Call this mark-to-model.

Then there's Level 3. Under [Financial Accounting Standards Board] Statement 157, this means fair value is measured using "unobservable inputs.'' While companies can't actually see the changes in the fair values of their assets and liabilities, they're allowed to book them through earnings anyway, based on their own subjective assumptions. Call this mark-to-make-believe.

As we get Q3 reports from investment banks this week, with Lehman delivering its report early this morning, this issue is back with a vengeance. Consider this from a David Reilly story on Wall Street's asset-marking practices in last Friday's Journal:

The firms began breaking down their financial assets into these "levels" at the start of their current fiscal year, which began in December, when they early adopted a new accounting standard related to fair, or market, value measurement. All U.S. companies will have to begin using it for financial years starting after Nov. 15.

During the first two fiscal quarters, investors didn't pay that much attention to this new data, which break financial assets down into three valuation categories. Now, with pricing -- or marking -- a big concern on Wall Street, skittish investors are expected to pore over the information.

The biggest area of concern will be the category for asset values based on estimates, or Level 3. These assets made up about 10% or less of overall financial assets at Goldman, Morgan, Lehman and Bear at the end of their fiscal second quarters. Including Merrill Lynch & Co., which doesn't report results until next month, the firms designated $331 billion as Level 3 assets, or about 6% of total assets.

Of the nearly $270 billion in financial assets on Lehman's balance sheet at the end of the fiscal second quarter, for example, about $22 billion, or 8%, fell into what is called Level 3. The firm said in its financial filings that values in this category "reflect management's best estimate of what market participants would use in pricing the asset." At Bear, about $18 billion of the firm's $220 billion in financial assets fall into this category.

At both firms, the bulk of their financial assets -- $152 billion for Lehman and $163 billion for Bear fell into the mark-to-model category, or Level 2. Assets in Level 1 trade in active markets with readily available prices.

CNBC's Mary Thompson just reported that the Lehman conference call indicated 90% of the firm's assets fall in Level 1 or 2, leaving 10% in Level 3, Weil's "mark-to-make-believe" category. But what's the split between Level 1 and Level 2? We'll try to dig that up as soon as we can.

Also: Lehman wrote its mortgage and leveraged loan holdings down by $700 million. That's number isn't small; the question is whether it's right. Keep an eye on all this as Morgan, Goldman, and Bear report later this week.

Sources

Jonathan Weil, "Wells Fargo Gorges on Mark-to-Make-Believe Gains," Bloomberg, August 22, 2007

Yalman Onaran, "Lehman Beats Estimates, Limits Losses on Mortgages," Bloomberg, September 18, 2007

David Reilly, "Marking Down Wall Street," Wall Street Journal, September 14, 2007

At Last

The long-awaited, much-anticipated September 18th has finally arrived, and with it, an incredibly fraught psychological web woven by market participants over the last several weeks. Given the complexity of market expectations concerning what the FOMC will do, what it will say about what it does, what it will say about what it might do in the coming months, &c., prudent investors aren't making big Fed bets today. Of course prudent investors don't make big single-day bets anyway, but this strikes us a time where restraint and perspective are especially apt.

This morning's news flow probably doesn't affect today's Fed decision, but it's noteworthy as part of the unfolding economic story:

• August foreclosures spike higher, led by the usual suspects: Nevada, California, Florida. In general, the list of "leading" states is a mix of bubble-to-bust Sun Belt states and straight-up-bust Auto Belt states (Ohio, Michigan, Indiana). Housing apologists offer up some version of "Yes, but if you strip out the handful of states at the top of the list, foreclosures in the rest of the country have actually fallen." That may be true, and it's not immaterial. But that's a little like spending the last five years saying "Yes, but if you strip out the top ten states, housing prices haven't really risen by all that much." Local and regional variation matters, but only to a point in our interdependent, national economy.
• August producer prices printed -1.4% headline and a 0.2% core (i.e., ex-food and energy) numbers. Why the 1.6% gap? A drop in fuel expenses. Tell that to the traders in the oil pits who are now staring at $80+/barrel. And here's the rub, as described by B of A's Peter Kretzmer: "'The weakness in the economy is making it difficult for companies to pass along increases. That bodes very well' for inflation in coming months." 
• Lehman Brothers played beat-the-number to perfection this morning. We haven't dug into the numbers yet, but the big questions will be (1) transparency and accuracy of the company's marks and (2) Q3 earnings from the other three big investment banks reporting this week (Morgan, Bear, Goldman).

Now all eyes are on the FOMC. Should be an interesting afternoon.

Sources

Les Christie, "August Foreclosures Zoom," CNNMoney.com, September 18, 2007

Courtney Schlisserman, "U.S. Producer Price Index Drops More Than Forecast," Bloomberg, September 18, 2007

Yalman Onaran, "Lehman Beats Estimates, Limits Losses on Mortgages," Bloomberg, September 18, 2007

Index Funds in 401(k) Plans

Last week we posted a two-part series on the current and potential role of exchange-traded funds in 401(k) plans (Part I, Part II), a discussion prompted by Diya Gullapalli's September 10th Wall Street Journal story on ETF providers scrambling to win 401(k) business.

Hard on the heels of Gullapalli's piece--which prompted us to suggest that "mutual fund companies' insistence that 'they already offer plenty of low-cost mutual funds that track stock- and bond-market indexes' in 401(k) plans doesn't pass the laugh test"--came the following item in the Saturday Journal: "Index Funds Play Limited Role in 401(k)s." Indeed.

Here's an extended excerpt from this important Eleanor Laise story:

Most investment options added to 401(k) plans are pricier actively managed funds rather than cheaper index funds, according to a recent study by researchers at the University of Illinois at Urbana-Champaign and the Federal Reserve Board.

In fact, only 11% of U.S.-stock funds added to 401(k) plans between 1998 and 2002 were index funds and Jeffrey Brown, finance professor at the University of Illinois and co-author of the study, says he's seen no evidence the trend has shifted since then.

Employers may be adding more actively managed funds to their plans simply because those are the funds recommended to them by brokers -- not because those funds are the best options for employees, says Bud Green, a 401(k) consultant at Fortress Wealth Management in Santa Monica, Calif. Such advisers may try to prove their worth to clients "by boasting about how they can choose the best active managers," Mr. Green says.

As more actively managed funds are added to plans, participants tend to direct more of their investments to those funds, even though they're often more expensive.

Even in plans run by indexing giant Vanguard Group, index funds don't always play a prominent role. A recent survey by Vanguard of plans for which that firm provides recordkeeping services found that, though nearly all participants were offered a U.S.-stock index fund, only half invested in it.

Behind the Inflows

Workers may see the addition of actively managed funds as their employer's endorsement of that investing strategy, Mr. Brown says. And many workers simply spread their investments evenly among all the options in the plan, so as more actively managed funds are added, they invest more in those funds. Having more plan options may also confuse participants, making it more difficult for them to choose the cheapest options, Mr. Brown says.

We've written it before and we'll write it again: The 401(k) marketplace is plagued by non-fiduciary practices, sins of both omission (plan sponsors who simply don't know any better than to offer expensive, underperforming mutual funds) and commission (Wall Street's plan providers who do know better--or should!--and sell high-margin products that are better for their own bottom lines than for plan participants' long-term outcomes). And yes, the "commission" pun is very much intended.

Sources

Diya Gullapalli, "ETFs Seek Room in Your 401(k)," Wall Street Journal, September 10, 2007 (subscription required)

Eleanor Laise, "Index Funds Play Limited Role in 401(k) Plans," Wall Street Journal, September 15th, 2007 (subscription required)