The Float

Words of Wisdom

Two useful items from two of our favorite participant-observers: Mohamed El-Erian and John Hussman. Frist, from El-Erian's interview with Advisor Perspectives (bold text in original):

Another principle you advocate is the separation of alpha and beta in portfolio construction (something we have written about in our publication). Why has this principle gained in importance and how can advisors best implement it?

The dispersion of returns among actively managed strategies has become very large. In the old days, the dispersion resembled a "fan chart." It started with relatively small dispersion in fixed income classes, to larger ones in public equities and very large ones in illiquid asset classes. Today, we are seeing much more dispersion across all asset classes. The result is, unless you are absolutely confident of your active management choices, it is better to go passive.

The cause of this greater dispersion is that markets are more volatile. We came from a period (until the middle of 2007) that was very good to investors. Risk premia across all asset classes were compressing, delivering high returns and declining volatility. As long as investors were exposed and levered they did well. Now investors can get easily caught with the wrong position in a highly volatile environment. The hurdle for active management has gone up. You have to be sure you are actually getting something. You are paying higher fees and being exposed to more risk.

And here's Hussman, on the intertwined roles of government and Wall Street in the unwinding of the credit bubble:

As with the stock market bubble of the late 1990's, it is generally true that bad investments tend to go bad. There is little to prevent that from occurring. The only question is who bears the cost. Essentially, the Federal government issued hundreds of billions in debt, much of the proceeds which tax cut beneficiaries invested in mortgage bonds, without concern about loan quality because the debt had been tied to the good faith and credit of Uncle Sam, and now we've got to issue more government debt to bail out the losses from the bad investments.

One of the reasons that the recent credit crisis has been so wrenching is that the losses are being borne by institutions that have the explicit or implicit backing of the U.S. government, so it feels like the things that ought to be safe really aren't safe. But that is no accident -- bad credit sought out those institutions and their government backing, as the inevitable result of the swap markets (as described above). In the end, the implicit and explicit backing of the U.S. government -- which allowed all of this to occur -- is also what will be called upon to clean up the mess.

Read the whole Hussman comment, especially for his take on the making of the credit bubble. We think it's one of his best efforts.

Just How Terrible is Housing as an Asset Class?

For some time now, we've been noting that the recently-concluded housing bubble wasn't like most of the bubbles that preceded it. Unlike the railroad, telegraph, and dot-com bubbles--which, for all their short-term wreckage, created new infrastructure of immense economic value, as Daniel Gross argues in Pop!--the housing bubble has left behind virtual ghost towns, economically useless infrastructure (e.g., roads, water, and power leading to virtual ghost towns), and a brutal overhang of household and government indebtedness.

So we were pleased to see the (sometimes breathless, often prophetic) Nouriel Roubini make special note of the unproductive nature of the U.S. housing stock. Here are the key passages from Roubini, via Naked Capitalism:

Sixth, the existence of [Government-Sponsored Enterprises,] GSEs...is a major part of the overall U.S. subsidization of housing capital that will eventually lead to the bankruptcy of the U.S. economy. For the last 70 years investment in housing –- the most unproductive form of accumulation of capital -– has been heavily subsidized in 100 different ways in the U.S.: tax benefits, tax-deductibility of interest on mortgages, use of the FHA, massive role of Fannie and Freddie, role of the Federal Home Loan Bank system, and a host of other legislative and regulatory measures.

The reality is that the U.S. has invested too much – especially in the last eight years – in building its stock of wasteful housing capital (whose effect on the productivity of labor is zero) and has not invested enough in the accumulation of productive physical capital (equipment, machinery, etc.) that leads to an increase in the productivity of labor and increases long run economic growth. This financial crisis is a crisis of accumulation of too much debt -– by the household sector, the government and the country –- to finance the accumulation of the most useless and unproductive form of capital, housing, that provides only housing services to consumers and has zippo effect on the productivity of labor. So enough of subsidizing the accumulation of even bigger [McMansions] through the tax system and the GSEs.

We're not sure that the subsidization of housing capital "will eventually lead to the bankruptcy of the U.S. economy," but we're pretty sure it's not a very good use of currently-finite resources in growing the country's real wealth. But aside from that non-trivial quibble, we think Roubini gets this under-appreciated story exactly right.

No Rosetta Stone For This Fed

We've picked up on some interesting crosscurrents coming out of the FOMC lately. This makes sense in light of the complexity and uncertainty underlying the economic outlook, but it doesn't make the fast money crowd's job any easier (which is just fine, in our view). Consider Greg Ip's piece in Monday's Journal. Widely assumed to have a special kind of access to the Fed, Ip concluded his story with this (emphasis added in bold):

The risk for the U.S. is that weakness goes beyond the correction of housing excesses and begins to feed back into the financial system and then, again, hurts the wider economy.

By contrast, says Nouriel Roubini, an economist who heads RGE Monitor, a financial- and economic-forecasting service, the U.S. financial system has adjusted only to the losses on mortgage loans. He predicts that a wave of defaults on industrial loans, municipal bonds and consumer credit is coming, which will trigger another wave of financial-system distress.

Fed Chairman Ben Bernanke believes such feedback effects are what made the Great Depression great. Mr. Bernanke's awareness of such risks is why he cut rates last week and, despite signaling a pause, is still focused on the risks that the U.S. economy may deteriorate further.

That last paragraph is no accident, suggesting that Bernanke, however few rate-cutting bullets remain in the FOMC's revolver, knows the macroeconomy isn't out of the woods.

But then there's this pesky inflation problem, more incipient than insidious at this point, but worth worrying about for those whose jobs require them to do so. Today's example: William Hoenig, President of the Kansas City Federal Reserve Bank. Here's what Hoenig said last night in Denver (emphasis added in bold):

Some would dismiss these rising inflationary pressures as temporary. I believe they are more serious. Energy prices have been trending up for the past five years, and there are good reasons for thinking that higher food and commodity prices are not being entirely driven by temporary supply and demand imbalances. However, the bigger concern is that these increases are beginning to generate an inflation psychology to an extent that I have seen since the 1970s and early 1980s. Measure of inflation expectations in surveys and financial markets are moving higher, and businesses are increasingly passing on higher input and commodity prices to consumers and business customers. In this environment, in my opinion, there is a significant risk that higher inflation will become embedded in the economy and require significant policy tightening to reduce it.

(Note that Hoenig is not currently a voting member of the FOMC, but he will participate in the FOMC's upcoming discussions.)

A weak economy and non-trivial inflationary pressures? Makes for a narrow tightrope underneath the Bernanke Fed.

Sources

Greg Ip, "Economy May Face Prolonged Pain, History Suggests," Wall Street Journal, May 5, 2008

William Hoenig, "Monetary Policy, Financial Markets and Regulatory Reform: A Desperately Unpopular Undertaking," Remarks to the Economic Club of Colorado, May 6, 2008

Blunt Regulatory Instruments

Though we have a deep appreciation for market mechanisms, we aren't reflexively opposed to regulation per se. The non-ideological truth is that business and government need each other to function. Though reasonable people can disagree about the scope and reach of pubilc and private power, sensible policy is always a matter of tilting the balance a little one way or the other.

But the history of regulatory innovation reveals a long tradition of (1) fighting the last war, (2) the development of (often but not always undesirable) unintended consequences, and (3) the practical impossibility of writing rules that treat similarly situated parties equally and accommodate the infinite subtleties of the real world.

Like pretty much all human undertakings, we're left to muddle through by weighing the expected costs and benefits of various policy alternatives, enacting some set of ideas in good faith, and monitoring outcomes for evidence of (1), (2), and (3) above.

So we were intrigued by the first half of this morning's BreakingViews column in the Journal. It's worth reading in full:

Christopher Cox is rightly concerned that the brokerage houses he oversees could be savaged by liquidity crises, as Bear Stearns was. The Securities and Exchange Commission chairman thinks it makes sense to reassess how regulators deal with the risk that firms' access to crucial everyday cash dries up, perhaps even by extending capital adequacy rules to deal explicitly with this risk. Unfortunately, that probably wouldn't work.

It sounds reasonable. Regulators have expanded the rules governing the capital banks set aside to cover an ever-greater variety of perils. They originally told banks to base capital reserves on how much credit risk they had. Then they added risks associated with market prices. The latest version of the rules added operational risks -- the possibility of loss stemming from human or logistical snafus.

So why not bolt on liquidity risk and require firms to raise capital when trading counterparties or lenders get skittish about dealing with them? One problem is that liquidity can evaporate in the blink of an eye. In congressional testimony Thursday, Mr. Cox noted that Bear's cash pool fell from more than $12 billion to $2 billion in a single day. It usually takes weeks or months to raise new capital.

Also, forcing firms to raise capital would raise red flags that could accelerate a crisis -- even if a firm in the midst of a cash crunch could persuade investors to pony up capital in the first place.

Firms might try establishing contingent capital facilities before disaster strikes so they could draw on them when needed. But that would be expensive, eating into and perhaps obliterating earnings.

Mr. Cox and his confreres at the Fed and the U.S. Treasury would clearly prefer to avoid having to cobble together responses like the one that rescued Bear. But forcing firms to raise capital as liquidity declines isn't practical. The sentiment governing bank runs is too volatile to be tamed by the blunt instrument of regulatory capital rules.

Food for thought.

Source

Dwight Cass and Ian Campbell, "Regulatory Rules Fall Short," Wall Street Journal, April 4, 2008

"A Measured Basis"

In Monday's reading post, we linked to a Barry Ritholtz item concerning a recent opinion letter from the SEC on the valuation of Level 3 assets. Here's Barry's take:

An SEC opinion letter advising companies how to deal with their Level 3 assets made a rather curious suggestion. They advised that if the prices of mark-to-model crappy paper are underwater, well then, declare it the result of forced  liquidation -- and then you can simply ignore them.

It truly boggles the mind.

Would someone please explain to me how providing an official mechanism for allowing companies to ignore market values of the bad investments they made help investors? Instead of working towards transparency, the SEC is providing a mechanism to allow banks to hide losses from their shareholders. This is nothing short of an invitation to commit fraud.   

...

This is a directive to banks to make the situation much, much worse. They can clean up their own books by forcing liquidations elsewhere.

We see where Barry's coming from here, and we appreciate his willingness to call it as he sees it. The world needs more such determination to cut through the fog of ignorance and newspeak. But we think he may have pushed this mini-argument a little too far.

Transparent, accurate marks are desirable--indeed, indispensable--elements of functioning financial markets. And it's clearly true that the opacity of certain assets, and of the vehicles in which those assets have been held, has been part of the problem over the last several months. There's always uncertainty about what current and future asset prices should be, but markets break down when interested parties can't agree on what current prices actually are.

But just as markets can get ahead of themselves to the upside, they can also spiral down in ways that reflect forced selling more than underlying asset quality. Which leads us to the central premise of the Fed's recent activities: Not to prop up asset prices per se, but to give market participants time to adjust in a relatively orderly process--or at least a process that's less disorderly than would otherwise be the case. The Fed's Term Securities Lending Facility is rooted in this premise.

Just a few minutes ago on Capitol Hill, Ben Bernanke noted the importance of time in this process. Here he is responding to a question from Senator Bob Casey of Pennsylvania concerning whether Bear's assets have been marked to the firm's own models (emphasis added in bold):

The primary evaluation was done by Bear Stearns on March 14th, so, currently, using the best available market information, and including adjustments for the fact that those markets are quite illiquid, which is important.

We have had our investment advisor, BlackRock, go through those assets, and they are confident, or at least reasonably confident, that we will be able to recover the full amount if we dispose of these assets on a measured basis, rather than to sell them all at once.

Market adjustments are, as always, functions of price and time. But those two dimensions aren't unrelated. Effective policy-making--and, for that matter, effective implementation--will recognize the connection between them.

Stubborn Credit Markets

Good piece in this morning's Journal on stubborn credit markets. This isn't exactly breaking news, but the story makes an important Big Point, and provides a couple nice graphics, which we've included below:

The Federal Reserve's efforts to heal broken credit markets have diminished worries about a big financial failure, but wariness about lending remains in bond and loan markets.

This wariness shows up in the movements of many interest rates and in a commonly watched measure of risk known as a spread. A bond's spread is the difference between its interest rate and the interest rate on a relatively risk-free investment, like a Treasury bond or a Federal Reserve loan. When spreads get bigger, as they have in recent months, it shows that investors are reluctant to own anything but the safest investments.

In many markets, ranging from short-term money markets, to mortgage markets to junk-bond markets, spreads have improved since the Fed's actions of last week. But they remain elevated compared with a few months ago.

Bankers and Federal Reserve officials are watching carefully to see if these spreads come down as a sign of a return to normalcy.

Other measures of risk in credit markets, such as the cost of insuring bonds against default, have improved, particularly for bonds issued by financial institutions, but they aren't out of the woods yet.

Source

Liz Rappaport, "Bond, Loan Markets Remain Wary," Wall Street Journal, March 27, 2008 (subscription required)

Assorted Thoughts

Wow. Even after a +54-point day, this market still has plenty to prove. But let's be honest: The environment appears more bullish for the time being.

As we noted last Wednesday, long-term bottoms are more often formed by indifference and resignation than by euphoria and short-covering, and are more often characterized by u-shaped patterns rather than sharp v's.

Though we think that logic still applies, the last few days reminded of another recent post: "Faster Markets." Here's a key excerpt from that item:

[T]he key point is this: The Feiler Faster Thesis doesn't stipulate accelerated events or processes so much as faster responses by market participants. Have equity investors already taken asset values to their recession-expectant lows? We don't know. It's conceivable. But faster markets don't necessarily imply a faster economy.

Appropriate adjustments to asset values will always be functions of price and time. Recent bouts of volatility--not at all historically unprecedented, but clearly more pronounced than we've seen for several years--suggest that market participants may be operating in a faster world. But wringing longstanding excesses out of the financial markets will take a while, Feiler Faster Thesis or no.

Last night, sane/sensible technician Carter Worth appeared on CNBC's Fast Money to suggest that any incipient base-building would probably take some time, as the recent legs down have taken an unusually short period relative to the 5-year bull that ran from late 2002 to late 2007. But even if it's not off to the races--and by all rights it shouldn't be, as too many market and economic fundamentals remain decidedly weak--a little stability in the financial markets would be entirely welcome.

Much unwinding and deleveraging remains, but it'll work better for just about everyone if it proceeds gradually--not violently, as at Bear Stearns.* 

Here's another point we made last week: Last Tuesday's furious rally was the biggest percentage advance since July of 2002. Today's move? Biggest single-day gain since October of 2002. So last week's open-on-the-low/close-on-the-high move (note the chart above, where two open black candles were formed last Tuesday and today) had a classic bear market rally in its 2002 analog. Today's analog had a major reversal as its 2002 analog. Faster markets? Perhaps so.

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

*Speaking of Bear: Lots of chatter out there today about whether the Fed's intervention alongside JP Morgan amounts to a "bailout." We won't restate any of the obvious claims or counterclaims here. Instead, we'll simply note that we don't know yet. With BSC closing at $5.91, up almost 23% on the day and nearly $4 above JPM's offer (if that's the right word for it), we simply can't say what will happen to the investment bank, its balance sheet, or its shareholders. Like you, we'll have to stay tuned.

A Voice of Reason

We've been bashing CNBC a little of late, but this morning we have to give credit where it's due: to Howard Simons of Bianco Research, whose appearance on Squawk Box was a model of simple, powerful clarity.

The topic on the table was commodity prices as we pick up the conversation among Simons, Becky Quick, and Joe Kernen:

Quick: Gold nearing $1000; what happens today if we get a weak jobs number?

Simons: If the market believes the Federal Reserve is going to keep doing more of the same that hasn't been working and driving inflation higher and the dollar lower, we could go over a thousand today. If not, we're going to go over a thousand soon. After all, it's the same thing when the Dow hits a round number, you get a little resistance, but it's going to go through. The only question is when.

...

Quick: Howard, what has to happen to actually stop this slide in the dollar, and maybe stop some of the gains we've seen in commodities. Is there anything that, that could happen?

Simons: A restoration of monetary responsibility would go a long way toward that.

Quick: Well, how do you get that?

Simons: Well, how about having central bankers that say something in public other than "we don't care about inflation" or "we don't care where the dollar's going to go" or "we don't care about anything other than stopping the short-term pain." If you have somebody say "there's an adult here in the room," that might go a long way toward stopping [unintelligible].

Kernen: They tried that. They tried that when they should have been--they tried that August through December. They were talkin' tough on inflation and not talking, they were, you know, in denial about the slowdown in the economy. Now, I mean, it's real. Did you...were you happy back then, Howard?

Simons: Actually, no, I wasn't.

Kernen: Why?

Simons: Because the problem was never that the federal funds rate was too high. The problem was you had a dislocation in credit.

Kernen: Yeah, it wasn't high interest rates that got us into this mess. It was a whole [unintelligible].

Simons: It wasn't high interest rates, right. And so everybody said "Oh, if we can just get the LIBOR rate down." So we created the TAF auctions, we got the LIBOR rate down. Well, then what happened? You found out when you drove short-term interest rates too low that you were kneecapping the lenders who were fleeing out of risky assets to short-term safe assets. And all of a sudden they got no return. So you killed the leveraged loan market. You found out you killed the auction-rate preferred market. If you're going to try to solve the problem by inflating the currency, we have several thousand years of history on that. It doesn't work and it ends very, very badly.

That's some cold-blooded stuff. One wonders how soon Mr. Simons will be invited back.

Thomas Palley Gets It

We've argued repeatedly that the U.S. economy has become fully dependent on credit expansion...which makes a period of deleveraging and credit contraction an especially stubborn foe for policymakers.

For more on the debt-driven business cycle, we urge you to read Thomas Palley's Tuesday post. Here are two key excerpts:

[T]here is a deeper problem that has been overlooked: the US economy relies upon asset price inflation and rising indebtedness to fuel growth.

Therein lies a profound contradiction. On one hand, policy must fuel asset bubbles to keep the economy growing. On the other hand, such bubbles inevitably create financial crises when they eventually implode.

This is a contradiction with global implications. Many countries have relied for growth on US consumer spending and investments in outsourcing to supply those consumers. If America's bubble economy is now tapped out, global growth will slow sharply. It is not clear that other countries have the will or capacity to develop alternative engines of growth.

...

[T]he Fed contributed to creating the sub-prime crisis. However, in the Fed's defense, low interest rates were needed to maintain the expansion. In effect, the new cycle locks the Fed into an unstable stance whereby it must prevent asset price declines to avert recession, yet must also promote asset bubbles to sustain expansions.

So, even if the Fed and US Treasury now manage to stave off recession, what will fuel future growth? With debt burdens elevated and housing prices significantly above levels warranted by their historical relation to income, the business cycle of the last two decades appears exhausted.

It is not enough to deal only with the crisis of the day. Policy must also chart a stable long-term course, which implies the need to reconsider the paradigm of the past 25 years. That means ending trade deficits that drain spending and jobs, and restoring the link between wages and productivity. That way, wage income, not debt and asset price inflation, can again provide the engine of demand growth.

Now go read the whole thing.

Market Rates Matter

Ben Bernanke has heard some version of the following question from multiple members of the House Financial Services Committee: "If the Fed's cutting rates so aggressively, why are mortgage rates not falling or, worse, actually rising?" (See the adjacent chart from this morning's Wall Street Journal.)

This gets at something that's been a recurring theme over the last several months: Market participants skewing certain actual interest rates away from official targets. Think of the persistence of elevated LIBOR rates through most of the last third of 2007, credit card issuers raising rates as we type, auto loan rates remaining elevated, and, of course, the stubborn mortgage rates members of Congress have noted this morning. (It's important to note that variable rate HELOCs and other instruments pegged to banks' prime rates have gotten cheaper since the Fed started clashing rates in September).

Bloomberg's Shannon D. Harrington and Christine Richard add another brick to this particular wall this morning by noting that even as the rating agencies sustain the fantasy that MBIA deserves the AAA stamp of approval, real-world investors aren't buying it. Literally.

Moody's Investors Service and Standard & Poor's say MBIA Inc. has enough capital to withstand losses and justify its AAA rating. MBIA's debt investors aren't so convinced.

Credit-default swaps indicating the risk that Armonk, New York-based MBIA's bond insurance unit won't be able to meet its obligations are trading at similar levels to companies such as homebuilder Pulte Homes Inc., which is rated 10 steps lower.

The discrepancy illustrates the skepticism debt investors have about the safety of MBIA's rating after the company posted $3.4 billion of losses on subprime mortgages last quarter. Moody's and S&P both said that while at least $4 billion of writedowns lie ahead, MBIA's management has made enough changes to warrant the top rating.

"Pardon me if I find this a little hard to believe,'' said Richard Larkin, director of research at municipal-bond brokerage Herbert J. Sims & Co. in Iselin, New Jersey. "This is basically the same management that put MBIA into this hole in the first place.''

This is a big part of the dilemma facing legislators, regulators, and central bankers. Try as they might, all the king's horses and all the king's men can't summarily put broken markets and shattered assets back together again. Price and time? They'll do the trick, but not without some further patience--and almost certainly some further pain.

Sources

Kelly Evans, Serena Ng, and Ruth Simon, "Decline in Home Prices Accelerates," Wall Street Journal, February 27, 2008

Shannon D. Harrington and Christine Richard, "Moody's, S&P Say MBIA Is AAA; Debt Market Not So Sure," Bloomberg, February 27, 2008