So the bet should be not on deflation outright, but on the fallout from attempts to fight it.

TO BE NOTED: From Accrued Interest:

"Fed: Deflation? Over my dead body.

Many Accrued Interest readers will gafaw at the memory of John Ryding, economist at Bear Stearns from 1991 until the bitter end in 2008. Intelligent man, I'm sure, but also something of the Nouriel Roubini of the bond market. I think he was bearish on interest rates basically my entire career, which is ironic, since for most of my career, interest rates have been falling.

Anyway, the one really good piece of advice I heard from Ryding over the years was if you have a view on inflation, don't change your inflation outlook, change your Fed outlook. In other words, if you think forces are aligning toward higher inflation, bet on Fed hikes, not on inflation itself. I think this is a smart way to approach the bond market, because the Fed may actually short-circuit inflation itself (making a bet on, say, TIPs a loser).

Today St. Louis Fed President James Bullard declared that the Fed had averted a deflationary outcome, and is now considering an exit strategy. As readers know, I've been touting deflation as the Fed's primary concern for some time now. But in talking about deflation as the primary risk, I'm still thinking of Ryding's advice. I'm not necessarily betting on deflation per se, but on a Fed ready and very willing to fight it. That's why I've been willing to bet on massive rate cuts, unorthodox liquidity programs, etc.

But will we see CPI print below zero? Only if the Fed fails. In other words, sustained deflation remains a remote possibility. But sustained Fed interference in the markets in attempt to avert deflation is a strong probability.

So the bet should be not on deflation outright, but on the fallout from attempts to fight it. Weaker dollar. Higher commodities. Low short-term rates (including buying 2-year bonds as opposed to holding cash). Flat yield curve. Lower mortgage rates (at least from here).

That's is how I'm playing my deflation view."

Policy of the last 12-18 months has been all about eliminating a Great Depression style debt deflation.

TO BE NOTED: From Accrued Interest:

"SMACKDOWN WEEK: Epiloge: At that speed are you sure we'll be able to pull out in time?

So Accrued Interest has settled it once and for all. Inflation risk is low. The Poll proves it! I posted a new poll asking if readers like the SMACKDOWN format, where I spend several posts on the same subject in greater depth. If you liked it, vote. If you hated it, vote.

As a final point on the inflation subject, I wanted to look forward, to the future, the horizon. Obviously the dire consumer situation isn't going to last forever. Even though much of the wealth destruction I mentioned last week isn't going to recover in a V-shape, we will reach some sort of equilibrium in housing eventually. Even given a L-shaped recovery in housing, consumers eventually get back on their feet. Maybe they can't spend their home equity but they'll still spend their earnings. We will also reach some sort of equilibrium in personal savings, which I think will wind up in some relatively low, but still elevated level.

So inflation isn't dead. Not yet. And thus the Fed will eventually have to pull way back on its current policy accommodation. How and when will this happen, and what are the risks.

The biggest risk is Fed independence. You want to know what really worries me for the long-term? Fed independence.

I believe firmly that the men and women who are responsible for normal Fed policy actually learned the lessons of the 1970's. That inflation is an insidious problem, and once it takes hold, its is painful to wrench out of the system. I realize many readers will disagree, given the aggressive policy of the last 12 months, but spend a day going back and reading Ben Bernanke's old speeches, and I think you'll agree. Policy of the last 12-18 months has been all about eliminating a Great Depression style debt deflation. Once that battle is won, I believe the Fed's policy makers will want to wind down their non-traditional policy maneuvers. ( NB DON )

There are those who say they can't remove these policies in a timely manner. I don't get this argument, as it seems to be merely based on the sheer size of the programs. Remember that inflation is a rate of change, therefore stock measures aren't terribly relevant. Its all about marginal changes.

To see what I mean, consider the Fed's MBS purchase program. As of June 3, the Fed had $428 billion in MBS on their books. To simplify, let's call that $428 billion in incremental demand in period 1. If they Fed just held their position, no new buys or sells, what's the inflationary impact in period 2? None right? No marginal demand for MBS from the Fed, no money printed. So execution of the exit is relatively easy.

To me its all about timing and will. The timing is a bit of a guessing game. I think we have seen some legitimate green shoots since January of this year. Consumer spending is way down, but no longer seems to be collapsing. Thus there should be some commensurate slowdown in the pace of the Fed's policy actions. Its also clear that the Treasury buying program has been a major failure, in that it spooked foreign investors. I expect the Fed to let the Treasury program die a quiet death, and let that be their first removal of some accommodation.

But do they have the will? There are those that say the Treasury has made the Fed its padawon. The Fed is creating inflation to help solve the Treasury's debt problem. I don't think this is the case, but its a scary thought. It would represent a return to Nixon-era central banking, where the Fed was highly political and thus unwilling to tackle inflation with the steady hand necessary.

Consider this. Will a Fed with an expanded mandate, as the primary regulator of banking and possibly other elements of the financial system, becomes more political? Probably. Will Congress get more oversight of the Fed-as-regulator? Certainly. Will that translate into less independence on the monetary policy side? Its a very big risk."

Me:

Don said...

I prefer to think of Bernanke as a Sith, who will unleash Darth Drawdown when the time comes. That's why I've become a fan of his.

Don the libertarian Democrat

But remember, even printing money doesn't cause inflation unless that money reaches consumers.

TO BE NOTED: From Accrued Interest:

"SMACKDOWN WEEK: Now consumers are all but extinct

Today on SMACKDOWN we'll look at just how inflationary the Fed's programs have been to date.

My premise remains that consumer inflation occurs because consumer spend more nominal dollars. I won't go over the rationale for this viewpoint right now, you can read it here or here. Given this, any program will only be seen as inflationary if it puts cash into consumer pockets, or at the very least, results in goods being purchased.

The headline grabbers are stories like this one at the New York Times. They throw out numbers like $12 trillion and we all cry out inflation! But a large percentage of these figures are asset guarantees, such as the money market insurance program. These programs are clearly not inflationary as they never even involved any exchange of cash.

In order to see how much money may actually go into the economy, let's take a real look at the Fed's balance sheet. We know it has exploded in size:



We also know that most of the Fed's outlays have been funded by crediting bank reserves. That is, the Bernanke's old "electronic printing press." If printing money makes you shudder, you aren't alone.

But remember, even printing money doesn't cause inflation unless that money reaches consumers. I've said before: if the Fed mints a quadrillion new Sacagaweas and just sticks them in a vault at Ft. Knox, there is no inflationary impact.

Alright so what's in the Fed's balance sheet? What have they buying with all that printed money? (All figures represent an increase).



I've color coded this based on inflationary impact. The various shades of blue are non-inflationary. Starting at the top and moving to the left, the first is the Maiden Lane transactions. These are all related to Bear Stearns and AIG bailouts (note I added some AIG-related loans that technically aren't part of Maiden Lane LLC into this figure). Can't see how these impact inflation in any meaningful way. The next is related to dollar swaps with foreign central banks. Again, while I think this helps provide meaningful liquidity to the worldwide financial system, the impact on consumer inflation is minimal, even if the Fed is "crediting reserves" to help provide the cash. Finally we have "other" Fed activity, which involves stuff like the Fed's gold stock. Not an issue.

Term Auction Debt and the CP/money market programs are a little more nebulous. These plus the actual discount window is in green. The Term debt is mostly the TAF and the TSLF, both of which were meant as quasi-discount window loans to banks and primary dealers. Neither is as heavily used as it was in late 2008. I'd argue that the these term loans are merely replacing other types of borrowing that would otherwise have occurred in the capital markets. So while it is interfering in markets, it isn't inflationary. The commercial paper program is similar. If it just replaces private sector borrowing, it isn't inflationary.

Now wait a minute, you say, the market is over-leveraged. This kind of short-term debt is what helped get us into this mess! The private sector should be winding down! The Fed shouldn't be encouraging short-term borrowing of this nature. That's besides the point when you are thinking about inflationary impact. Inflation (or deflation) is caused by the change in effective money supply from one period to the next. If all the debt was suddenly drained from the system, it would surely be severely deflationary. So to the extent the Fed is substituting its own balance sheet for private lending, that's a neutral event in terms of inflation. Indeed, according to the Fed, financial debt grew at a 6% pace last year, down from 12% in 2007 and the slowest pace since 1991.

The other programs (in yellow) do have some inflationary impact. Securities held directly are, most notably, the Fed's mortgage, agency, and Treasury buying programs. (I've subtracted the decline in repo from this figure, since these new programs really replace the Fed's old repo-based programs.) When the Fed buys bonds, they are buying them from someone, and that cash eventually makes it into the system. I've argued that in fact, securities purchases are just a convenient means of pumping dollars into the economy. So it seems that an inflationary result is the goal.

Same with the TALF. The idea behind the TALF is to restart the ABS markets, which would provide cash directly for credit-based consumption. This is practically printing money and giving it to consumers. However, for better or worse, the TALF has been little used. It was supposed to be up to $1 trillion. It would be just as well to let him go, he's too far out of range.

Now let's add up the "inflationary" increase in the Fed's balance sheet. $528 billion.

Now let's compare that with some other key indicators of consumer behavior. The chart below compares the increase in the Fed's programs with the decrease in the other indicators. The decreasing elements have been inversed to illustrate the relative size.



The amount of inflationary Fed programs is slightly larger (in the scheme of the overall economy) than the decline in nominal GDP, consumer debt, and consumer spending. Now none of these figures are directly comparable, i.e., you can't say the inflationary impact is simply x - y. But comparing the relative size of each of these gives some sense of context.

Now if we add the decline in household assets...



Suddenly the Fed's activity seems like a drop in the bucket. And that figure is only through 12/31/08. We don't yet have the Fed's Flow of Funds report through 1Q. We know that household assets are continuing to decline, as evidenced by the continued drop in home prices.

Now we know that eventually consumers will regain their footing and start to spend (and borrow) again. So even if you agree that the Fed's actions aren't inflationary for now, they may become inflationary once the economy starts recovering. So its all about the exit strategy. That will be next time, on SMACKDOWN! "

when Bill Gross talks, he is always always always talking from position. So I'm assuming Gross is short Treasuries and today is adding

TO BE NOTED: From Accrued Interest:

"Bill Gross: Do you trust him?

No... but he's got no love for the Empire, I can tell you that.

This morning, S&P put the AAA rating of the United Kingdom on negative outlook. Generally when S&P puts a negative outlook, it merely means they leaning toward a downgrade without any particular urgency. In this case, S&P says they need to see some progress made by an incoming British government on their burgeoning debt.

Since the U.K. is generally seen as the third most stable (U.S., Germany) of the big western economies, its not a big leap to say that the U.S. could be next. Its a perfectly legitimate concern. S&P mentions their concern that British debt could rise to 83% of GDP by 2013. In the U.S., its already 80%!

What would happen if the U.S. lost its AAA? Very hard to say. Foreign investors would still have the problem of finding someplace to put their money. I'd be surprised if the U.S. would lose its AAA rating, but say, France and Germany hold on to their ratings. Japan is already AA. It might result in a revision of how foreigners view ratings in general.

In other news, how is General Electric AA+ and stable if the U.K. needs to be downgraded? How is Assured Guaranty still AAA and stable?

Enter Bill Gross, always eager to talk his position. He stokes the fire by saying that the Treasury market is selling off due to ratings fears. Maybe. Indeed, I've heard that Asia is selling today. But always remember, when Bill Gross talks, he is always always always talking from position. So I'm assuming Gross is short Treasuries and today is adding.

I don't think really think the whole ratings thing makes sense to explain the Treasury sell-off. Here is the intra-day on Treasuries. S&P comes out with their report on the U.K. at 4:20 AM.

Treasuries are actually higher all during the Asian and European sessions, and its only once the U.S. session really gets going that the bond market sells off.

A better explanation is the continued belief that the Fed is defending some level on Treasuries. Admittedly, I thought they would, but the evidence is clear that they aren't. Here are the Fed's Treasury purchases since the program began:

Traders keep hoping the Fed will increase their POMO buys, whereas this chart clearly shows they keeping to the $7-8 billion range in the belly and about $3 billion on the long end. Their reluctance to increase purchases shows they either have no particular target or their target is much higher than where we are.

No sense in getting in the way of the Treasury negative momentum here. I'm probably not a buyer until 3.60%."

Don said...

"But always remember, when Bill Gross talks, he is always always always talking from position"

If everybody knows this, how could it matter? And what good would it do him?

Don the libertarian Democrat

5/21/09 11:39 PM

Suddenly the Federal government would become the only source of municipal funding. The U.S. would turn into a true Federal state.

TO BE NOTED: From Accrued Interest:

"Municipals and Chrysler: What happens to one will affect the other

I've been notably absent in expressing my outrage over how the Obama Administration treated Chrysler's secured debt holders. Let it be known I'm sufficiently outraged on the inside, but resigned on the outside. We should all take it as a lesson: you simply never know what the government might do. The more they tighten their grip, the less I want to invest in any company which has taken government money. Especially in the investment-grade bond market, where, generally speaking, the potential for appreciation is limited.

This brings us to the municipal bond market. In Berkshire Hathaway's 2008 letter to shareholders, Warren Buffett had this to say about the municipal insurance business (the section starts on page 13 if you want the total context). Hat tip to downwithcapitalism who, despite his evil galatic moniker inspired this post.

"A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different.

To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belttightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial."

At the time the letter was made public, back in February, I thought it was mostly just Buffett's way of 1) Making sure he could keep charging exorbitant sums for muni reinsurance, and 2) Temporing shareholder's expectations for the muni insurance sector. After all, there is no record of insured bonds defaulting at a higher rate than uninsured bonds, controlling for all other factors. And the type of behavior Buffett warned of hasn't been evident with Jefferson County, where the overwhelming majority of outstanding bonds are insured. In fact, I'd bet that the insurers have better lawyers and other workout specialists at their disposal compared to what any ad-hoc group of bond holders could put together.

In addition, notice Buffett says "imagine all the city's bonds had been insured... by Berkshire." This isn't the case in reality. Any large issuer is going to have a mixture of insured bonds with various monolines. Given the state of XLCA, CIFG, FGIC, and Ambac, I'd say that de facto, most issuers have a fair number of bonds that are now uninsured. Certainly its fair to say that the local investors, who Buffett argues prevented politicians from ravaging bondholder rights, would suffer a large market value decline if any issuer fell into default, even if the bonds were insured, since all insurers are seen as weak.

Still, we've seen the precedent set by Chrysler. I've argued many times before that state and local governments can't choose to pay teachers and not bond holders. But can we universally assume this will remain the case? As readers undoubtedly have read numerous times, Chrysler's "secured" bondholders suddenly found themselves unsecured by Fiat (pun intended). Why? Because it was politically expedient.

Couldn't the same thing happen in a municipal bankruptcy? Especially if the Federal government gets involved? Absolutely it could.

I don't see this happening with some local school district someplace. Take Vallejo or Jefferson County, both of which are going on right now. So far it looks like the courts are playing a lesser role in both cases, with politicians and debt/swap holders negotiating directly. These are the kinds of bankruptcies I expect out of munis in the next few years.

But what if a really large issuer, like the city of Detroit, were to enter Chapter 9. Then what if the Federal government stepped in to provide some sort of bridge financing. Then suddenly the Treasury gets to dictate terms, and Obama has shown he's not going to make the unions bear the same burden as bond holders. I'd argue that the public employees unions are more powerful than the UAW!

If that happened, then immediately local governments would see bankruptcy as an expedient solution, solving structural deficits by punishing bondholders.

Ultimately, this would be an incredibly foolish course of action. Consider the consequences: the municipal bond market would shut down, with only the strongest issuers able to come to market, and maybe not even those issuers. Suddenly the Federal government would become the only source of municipal funding. The U.S. would turn into a true Federal state.

So I sure hope this isn't the direction we head. The long-term consequences would be devastating. You'd like to think the Administration has the sense to consider the long-term impact of their decisions, and wouldn't kill municipal bond holders. But then that's what I said about letting Lehman go bankrupt..."

an increase in cash available should cause the price level to rise, but only if you hold the savings rate constant

TO BE NOTED: From Accrued Interest:

"Inflation: Not this ship, sister

Alright so the Fed isn't going to defend the 10yr at 3%, and in fact appears to be targeting the belly of the yeild curve. That doesn't change the fundamental problem of deflation. Near term, based entirely on technicals, I've made a small short play in Treasuries. But I'm really just looking for a new entry on the long-side.

Almost exactly 2-years ago, I made my now famous (in my own mind) analogy of inflation to a Monopoly game. Basically my point was inflation wasn't about the price of any given property (or good) but the price of all the properties. Allowing any given good (at the time it was energy) to rise isn't, in and of itself, inflation.


Now there is fear that the Fed and Treasury's activities, especially the Fed's recent panache for "crediting bank reserves" (which means printing money). Here is the chart for M1 and M2 up 14% and 9% respectively in the last year.

Back to my Monopoly analogy. We might think of the M's as the actual multi-colored cash that each player has. As I demonstrated two years ago, an increase in cash available should cause the price level to rise, but only if you hold the savings rate constant.


Speaking more technically, you could say that an increase monetary base would have some multiplied impact on transactable money. In your textbook from college, this only involved banks and their willingness to lend. Actually, most often text books assume banks want to lend as much as they are legally allowed, which isn't the case right now. But I digress.


The securitization market makes this all much more complicated. The supply of loanable funds isn't just a function of cash in the banking system, but also cash invested in the shadow banking system. Right now net new issuance in ABS (meaning new issuance less principal being returned in old issues) is negative, meaning supply of funds from the shadow banking system is contracting.

This contraction of funds doesn't show up anywhere in the Ms, at least not directly, but obviously it matters in terms of consumers ability to buy goods. And it isn't just about availability of credit, which had everything to do with liquidity. Its about demand for credit also. Consumers want to save, they don't want to borrow right now. The following chart of household liabilities shows consumers actually decreased their total liabilities in 2008, the first year-over-year outright decline since the Federal Reserve began keeping the data in 1952.

Consumers are like a Monopoly player who has mortgaged all his properties. Passing GO doesn't cause him to buy more houses, it causes him to unmortgage his properties! That isn't inflation!


Getting back to consumers, it isn't clear to me that consumers are actually running out of money. Check this chart of the Household Financial Obligation Ratio, basically a debt service coverage ratio for consumers.

So consumers might not have to repay debt all at once, which is nice. It means a second-half recovery of sorts remains in play. But the large losses in assets coupled with out-sized debt ratios are going to cause consumers to keep saving at an elevated level. Check out liabilities as a percentage of disposable income.

This isn't a perfect ratio, since liabilities is a stock and income is a flow. But with declining asset values (both homes and financial assets), means that consumers are actually going to have to rely on incomes to pay debt service. Or for that matter to qualify for loans. So I'd think this ratio moves back toward 100%. That implies $3.6 trillion. TRILLION. It will be repaid over time to be sure, but it will remain a continual drag on consumer spending levels.

So keep this in mind when you think about the size of Fed/Treasury programs. $3.6 trillion. Are we worried about $800 billion for the "Stimulus Package" or the $1 trillion revised TALF? Not in terms of inflation.

I'm looking forward to the day when I'm worried about inflation. It isn't today."

Fed just disavowed the market of the notion that they would defend the 10-year at 3%

TO BE NOTED: From Accrued Interest:

"Fed to Treasury Market: It is you who are mistaken

Its flying a little under the radar this morning, but the Fed just disavowed the market of the notion that they would defend the 10-year at 3%. Today's Permanent Open Market action was to buy a paltry $3 billion in 10-year and longer notes.

Here are the last several POMOs of Treasury bonds (excluding TIPs)

I color coded it by the portion of the yield curve which the Fed was buying at each action. Notice that its very clear that the Fed isn't doesn't have a soft target of 3% on the 10-year. Moreover, the Fed isn't focused on the 10-year portion of the curve at all. Most of the buyer has occurred in the 4-7 year area, which I'm assuming the Fed thinks will be most influential on consumer borrowing rates.

This leaves me tactically short the 10 and longer part of the curve, looking to re-enter (I'm still a deflation believer) at a higher yield level. Technically, I don't see any stop points between 3.07% and 3.80%, so I'll probably we waiting a bit before re-entering the long-term Treasury market."

Even when the housing situation stops getting worse, statistically, prices will keep falling

TO BE NOTED: From Accrued Interest:

"Monday, April 27, 2009

Home Prices: A little higher! A little higher!

I'm getting tired of hearing that home prices still need to fall further. You can be the most bullish guy in the whole world on housing and you'd still have to admit that statistically home prices have to keep falling.

Consider how the major home price indices, both the FHFA and Case-Shiller, use repeat sales to calculate home price changes. Basically they look for homes that have sold twice, and measure the price change between the two sales periods. So if a home sells to the Skywalker family in 2004 for $100,000 and then to the Organa-Solo family in 2007 for $115,000, we'd call that one data point indicating that homes rose by 15% over those three years. (Do we think that Amidala's house was foreclosed on after she died? Or was there family money there?) Combine this with millions of other data points, and you can get some pretty solid estimates.


Now, I don't know of any better way to measure home price changes. Certainly I don't like using appraised values, especially in a market like this one. But the paired sales method is bound to lag reality in a market like this one.


Consider what we have in housing. Too many houses were built, and too many borrowers got funding that shouldn't. The former means there is too large a supply of homes, and the later means that foreclosures are creating even more supply of homes!


We in the financial business are used to things moving fast, but the housing market doesn't work like that. The foreclosure process is slow, and given the ever-changing world of government programs, I think many banks have been especially slow to initiate foreclosures. On top of that you have loan mods, a large percentage of which will re-default. For these reasons and others, I'm sure we will still be dealing with large numbers of foreclosures a year from now.

And remember that foreclosures aren't going to be evenly distributed across the country. They will be focused in areas where the bubble was worst. In other words, areas where there was already too much supply from builders! Areas where the gap between supply and demand is widest.

Demand for housing is also quite inelastic. I already have a home. Lower prices in and of itself doesn't incent me to buy another house, because I'd have to sell the one I have anyway. It isn't like when the Gap needs to clear out excess sweater inventory. They can make everything half off and unload it all. America needs to do a half-off homes sale, but can't actually get anyone to come to the mall to buy.

So it is inevitable that as actual transactions start to pick up, those transactions will show lower and lower prices, especially where foreclosures are high. Even when the housing situation stops getting worse, statistically, prices will keep falling. But we can't get to a bottom unless transactions pick up (which they have), and inventories are cleared out. The fact that increased transactions largely represent increased foreclosures is neither here nor there. We know foreclosures are coming. Let's get them out of the way.

Put all this together, and I'm watching stats like Existing Home Sales and NAHB confidence survey much more closely than today's Case-Shiller Index. On that basis, its reasonable to see the decline in housing finally abating. But only a fool would say that prices are about to bottom."

Instead of holding the unsold inventory, the dealers were exercising their rights to push bonds they couldn't remarket back to the LOC bank

TO BE NOTED: From Accrued Interest:

"Muni Swaps: Let's hope we don't have a burnout

Regular reader and sometimes commenter Gingcorp asked me to comment on this article in the New York Times about some, shall we say, questionable practices at Morgan Keegan's muni department.

I happen to know a fair amount about the problem of swapped muni VRDB's as I had a two clients threatened by similar circumstances. Unfortunately, the NYT article makes it sound like the municipalities were betting on interest rates which simply isn't the case. So I feel compelled to tell the world what's really going on here. Bear in mind that I can't speak to the situation in Tennessee specifically, because every situation can be a little different, but this should give you the general picture.

First, let's say its five years ago and you are one of these poor unsuspecting municipal authorities. Let's assume you are the authority who manages the local airport, the Bumpkin Airport Authority. You'd like to issue debt, and like any responsible financial steward, you want to minimize your interest cost.

Your banker suggests that a variable rate bond would lower your expected interest cost, because demand for short-term bonds is extremely strong. In 2004, the typical rate on variable rate muni debt (either auction rate or VRDN) was around 1.5%. (There are some additional fees involved, which we'll get to in a minute.)

First, a quick lesson on muni variable rate bonds. In a VRDN, the investor has the option to "put" the bond back to the municipality on any interest rate reset date, usually every 7 days, at par value. With an auction rate, investors can choose to "sell" at any auction, assuming the auction doesn't fail. Remember that until 2007, auctions almost never failed, so this wasn't seen as a big risk.

In both cases, the interest rate isn't based on some reference index, like LIBOR, but whatever interest rate clears the market.

But you, as the municipal airport authority, aren't interested in taking variable interest rate risk, as you don't have any natural variable rate assets. You'd rather lock in a certain interest rate today and have a known cost for whatever you are selling the debt to construct.

Your friendly banker has a solution. Sell the debt variable rate, and at the same time enter into a pay fixed, received floating swap. On its face, this can hardly be called creative finance. Its really finance 101. You have a floating liability, you want a fixed liability, just enter into a swap. Simple.

The Sith Lord was in the details. First of all, in order to do a VRDN, you needed to get a letter of credit from a bank. See, investors needed to know that the municipality had the cash to fund that put option I described above. The bank LOC allowed for that. So let's say the bank was charging 0.25% for the LOC. In the case of an airport authority, the bank would probably require that the municipality also buy a monoline insurance (e.g. Ambac) policy to protect the bank in the event the municipality defaults and the bank gets hit with a wave of puts. Let's say that costs about 0.10%.

But even in the face of those extra fees, the issue floating/swap to fixed still saves you a lot of money, because the fixed side of the swap is actually below where you could sell fixed rate debt. Everything is peachy.

The only remaining hitch is that, as I said above, muni VRDNs don't reset based on a specific index, but on whatever rate clears the market. This left the possibility that issuer A might pay a slightly higher rater than issuer B one week, but then issuer B would be higher the next week. Not because of anything about the issuers themselves, but just because of random variations in supply and demand at any point in time.

Unfortunately, the floating side of the swap had to be based on some predetermined index. Bankers usually picked one of two options. Either the SIFMA index, which is a published index of muni VRDN rates. Or they used 67% of LIBOR. E.g., if 1-week LIBOR was 3%, the the swap rate would be 2%. The 67% number was intended to reflect the typical gap between taxable and tax-exempt money market instruments. I believe the LIBOR version was more popular than the SIFMA version, and I have also heard swaps struck at 80% of LIBOR.

Right there was the red flag. What happens if the VRDN rate set by market forces isn't equal to the 67% of LIBOR level? This is known as basis risk, and it did happen under normal times. But it was always short lived. For example VRDN rates always rose during times when retail investors were pulling money out of muni money market funds, such as tax time. But those periods of elevated rates was always short-lived. The huge savings from the synthetic fixed rate structure overwhelmed these short-term costs.

Let's go back to the bank providing the LOC. Remember they required you to have a monoline insurance policy from Ambac to protect themselves. The actual legal language probably says something to the effect of...

"ABC Bank requires that Bumpkin Airport Authority acquire an insurance policy from a monoline insurer rated in the top ratings category from Standard & Poors and Moody's Investor Service. Should the authority be unable to acquire such a policy or should the monoline insurer be downgraded below Baa3/BBB- ABC Bank may withdraw the letter of credit."

Of course, don't need to worry about Ambac being downgraded right? Er... From the investor's perspective, you didn't wait around for Ambac to actually be downgraded. You were allowed to put these bonds back to the issuer at par! You hit that bid as hard as you could as fast as you could.

So now what happens? Remember that the interest rate that the Bumpkin Airport Authority actually pays is set by supply and demand. Now that the LOC is threatened, there is no demand, all supply. In order to actually entice some buyers, they had to set the rate at 7%, 8%, 9%, etc. Note that these weren't the failing auction rate bonds we heard so much about, although a similar story would apply have Bumpkin decided to go ARS.

Now Bumpkin is paying 9% on their VRDN, while the floating end of the swap is only paying you 67% of LIBOR, currently a glorious 0.25%. On top of the 9% you are paying investors, you are also paying your swap provider whatever the fixed leg of the swap is, probably something in the 4% area. Ugly.

But wait... it get worse. The interest rates are actually set by some dealer, called the remarketing agent. In normal times, the dealers would set the rate at something reasonable, and if they couldn't sell all their bonds right away, they'd just inventory them. So if it happened to be that a big holder of the Bumpkin Airport bonds wanted to put their bonds back on a given day, it was no big deal. The investment bank was willing to just hold the bonds waiting for the right investor to come along. It was considered a good use of balance sheet because it justified the remarketing fees the bank was collecting.

Once dealer balance sheets became crunched, nicities like this went right out the window. Instead of holding the unsold inventory, the dealers were exercising their rights to push bonds they couldn't remarket back to the LOC bank. These then because so-called bank bonds, and Bumpkin was charged some pre-determined rate on these, I think it was set off Prime.

But wait... it gets worse. Remember that the swap was intended to be a hedge against rising interest rates. It is therefore effectively a short position on long-term fixed rate bonds. In fact, long-term bonds have skyrocketed in value. Thus your swap is getting crushed. A 30-year swap struck on January 1, 2008 for $10 million notional value would currently be down $3 million in market value. Put another way, if you want out of this swap, you need to pay the investment bank $3 million.

Had the swap remained an effective hedge, this wouldn't be a problem, because Bumpkin Airport would be saving an equivalent amount of money on plummeting short-term rates. But in fact, Bumpkin is paying a usurious 9%.

So the VRDN itself is killing you. The swap is killing you. Basically, you're dead unless something changes.

What most municipalities did was refinance the Ambac-backed deal with a new VRDN without that stipulation. Except for a brief period in September and October 2008, the VRDN market has been pretty healthy. So once you refinance the VRDN, then the swap goes back to being a decent hedge. Everything works out just fine.

But even if you do a new VRDN deal, you still need a LOC from a bank. Guess what? Banks aren't so keen on tieing up their capital to make 25bps on muni LOCs. Instead, they've been picking carefully who they deal with, and charging a lot more to do it.

Even if the municipality can restructure, it isn't out of the woods entirely. If the swap is deeply underwater in nominal market value, the municipality probably has to post additional collateral. Think of it similar to margin posting on a futures contract. In some cases, this is no big deal, because the municipality has a decent sized general fund and simply must set aside certain securities as collateral. But in other cases, the municipality has little safety net. In fact, its more likely an issuer like Bumpkin Airport Authority has a sizeable investment portfolio compared with some county or school district which collects taxes directly. A lot of times, issuers with full taxing authority keep less in general funds. Politically, if the voters see that their county has a big investment balance they start wondering why tax rates aren't being lowered and/or why the money isn't being spent on new projects. An issuer with more volatile revenue, like a airport, toll road, hospital, etc., is more likely to build a reserve. It tends to be less politically sensitive if there aren't any direct taxes involved.

If you are an investor in munis, the best thing to do is hunt down how much VRDN exposure your bond issuers have, whether they have any monoline contracts attached, and what their plan for dealing with both is. You will probably find that you have nothing to worry about, but if you are sloppy, you could wind up with the next Jefferson County."

The thing that really worries me long-term is that we fall into a deflationary spiral

TO BE NOTED: From Accrued Interest:

"TALF: Anoat system?

This is the second time I've made an Anoat allusion in a week. That has to be a record of some kind.

Anyway, how worried should we be about the lack-lustre start to the TALF? The thing that really worries me long-term is that we fall into a deflationary spiral, which really would result in Great Depression: Episode II. As you can see in this graph...


... bank reserves have sky-rocketed. Meaning that while the Fed has been busy "crediting bank reserves (i.e. printing money) to pay for their programs, banks have been shoving that money under the proverbial mattress.

The so-called shadow banking system is even worse. The ABS market has completely collapsed (at least until the TALF, more on that coming). Thus all spigots to consumer credit have slowed to a trickle. That has serious implications for the de facto money supply, which by my estimation is sharply negative.

TALF aims to reverse that. We might not be able to force banks to lend, and maybe we really want them to rebuild capital anyway. And we do want consumers to save and rebuild their own balance sheets. But we also don't want them to over-save. That's how we become Japan. But if we get a decent new issue ABS market doing, then at least consumers who can afford credit can access credit.

The TALF was supposed to work by basically giving a tax-payer subsidized free lunch. A nearly guaranteed arbitrage. But in fact, no one is showing up at the Fed to take out TALF loans.

Its worrisome, but we shouldn't panic yet. First, we don't really care how much the Fed lends under the TALF program. We actually only care that the ABS market gets back on its feet. So far, we've only had very high quality ABS deals get done since the TALF: a couple auto loan deals, a couple credit card deals, and a student loan deal back by the Department of Education.

ABS traders I've talked to say there is plenty of demand for those deals, but for whatever reason it isn't TALF demand. Its possible that buyers have other funding options away from the TALF. Amidst worries about Congressional interference in compensation and other BS, I'd sure as hell take some other funding option even if it were at a higher cost. The ability to bring back my girlfriend from the dead just isn't worth making a deal with Darth Pelosi.

There is also supposedly strong secondary demand for ABS, which is stuff that wouldn't be TALF eligible anyway. Its almost like a market that's properly functioning! People are looking for good bonds at decent spreads!

Anyway, its possible that the TALF actually revives the market without being used heavily. This is basically what happened with the Fed's commercial paper program. It revived that market at least to the point where the top issuers can access the market.

So the thing to watch is not TALF loans, which I'm sure is what the media will focus on. Watch ABS issuance. "

Substitute any number for the equity, and the structure still doesn't work, because the underlying collateral is crap.

TO BE NOTED: From Accrued Interest:

"Leverage doesn't kill investors. Bad investments do.

Every one wants to blame the financial crisis on leverage. There was a glib comment on the blog the other day which reflects a common view:

"Sad to see the "cure" for overleveraged, undercollateralized balance sheets to be... more leveraged finance."

No offense to Jonathan intended, as his view probably reflects the majority of opinions among those who follow finance. But I find blaming leverage per se to be a weak argument. Thus I don't see bringing some degree of leverage back into the market as a negative. Furthermore, I don't think that simply blaming leverage will be constructive as we try to construct a regulatory structure to prevent similar meltdowns in the future.

Let's consider the case of a CDO of ABS. To make life simple, we'll assume CDO was constructed from mezzanine bonds from HEL deals. This would be securities similar to the ABX 2007-1 A index, basically the segment of major home equity deals from early 2007 which were originally rated "A."

The HEL deals were structured something like the following (although I'm presenting a simplistic version, the point stands.) I'm assuming $100 million original face, with the underlying mortgages having a 6.75% rate.

Senior: 5.75% coupon, $80 million

Mezzanine: 6.50% coupon, $15 million

Subordinate: 8.00% coupon, $5 million

All principal cash flows to the Senior until it is entirely repaid, then to the Mezz, then to the Subs. Interest payments are only made to the mezz and subs if the senior interest obligations have been met. (Don't get hung up on the math right now, it won't be important to my point. If you have questions about ABS and/or CDOs, e-mail me. Accruedint AT gmail.com).

In a CDO of ABS transaction, the CDO would buy a series of mezz bonds, then repackage them into a similar senior/sub structure. So now let's say we have a $100 million CDO which buys the mezz of 50 different HEL deals, all structured similarly to above.

The CDO builds its own senior/sub structure as follows:

Senior: 5.45% coupon, $80 million

Mezz: 6.00% coupon, $12 million

Sub: 8.00% coupon, $4 million

Equity: $4 million

Same deal as above, where the senior gets all principal and interest due before the other pieces. Only once all other classes get their principal and interest does any cash flow accrue to the Equity. One might think of the sub/mezz/senior pieces of the CDO as providing leverage to the Equity. Since the total assets in this deal is $100 million, with equity of $4 million, we have 25x leverage.

Its easy to see why the CDO of ABS world came crashing down. The ABX 2007-1 A is now trading at $2.5, or a 97.5% loss vs. the original face. So the CDO built on securities similar to ABX would have almost all principal in the deal wiped out entirely. Even the senior most piece of the CDO, which would have been rated AAA originally, would have suffered huge losses.

But was it the 25x leverage that was the problem? Not at all. Substitute any number for the equity, and the structure still doesn't work, because the underlying collateral is crap. If you are going to try to tell me that leverage caused the meltdown, then you'd need to show me how a different leverage figure would have prevented the problem. Here is an example of a leveraged vehicle that fails at any haircut.

Now one might say that if the ratings agencies would have required more overcollateralization, these CDOs never would have been created. Perhaps. But again, if leverage isn't the problem with the security, then allowing too much leverage wasn't the ratings agencies' primary mistake. The real problem is that the ratings agencies never considered the binary nature of these structures. If you build a CDO based on all mezz consumer loan ABS, and consumer loans perform poorly, then the whole deal is threatened. We didn't need catastrophic losses on consumer loans to impair the senior-most pieces of these CDOs. Had sub-prime consumer loans suffered a mere 10% loss rate, the CDO would have suffered a 50% loss rate! That would have resulted in the "AAA" rated Senior piece suffering a 30% loss. That isn't acceptable for a AAA-rated asset.

It isn't like the ratings agencies should have rated these types of CDOs AAA at some lower leverage level. They shouldn't have rated these types of CDOs at all. We talk about toxic legacy assets. These CDOs were toxic from the word go.

Now consider this. Why didn't the ratings agencies figure that consumer loans could go all go sour at once. Why did they assume that a 10% loss rate was nearly impossible? Or if you want to damn the ratings agencies as mere minions of the investment banks, why were people buying these CDOs? Those investors must also have assumed that the 10% loss rate was nearly impossible. Else they wouldn't have bought the bonds at all. So why was every one so confident?

We all want to blame some nefarious party, because that would feel better. It is more satisfying to think we were all duped by the evil geniuses on Wall Street. But what if it was as simple as the Fed having succeeded in dampening the business cycle that people started to assume volatility would remain permanently low? What if the fact that previous disturbances that could have had greater contagion (1987 crash, Asian Currency crisis, Russian Debt crisis, LTCM, Y2K, Dot Com bubble, 9/11, etc), didn't. People began to assume the age of crashes was over.

Now I'd be a fool to say that leverage played no part in the crisis. Clearly financials got over-leveraged. Part of the problem is that with so much leverage, some financials (AIG, Lehman, Bear) didn't have enough time to see if their asset bets would play out. But why they got over-levered was a response to contracting yield spreads. Or put another way, ROA was dropping so in order to get the same ROE you needed more leverage. Spreads were contracting (and thus ROA falling) because there was greater confidence in a more stable economic horizon. As ROA fell, too many fell into a trap of buying poorly constructed securities to get a relatively small amount of extra yield. And before you try to say that no one saw ABS CDOs as riskier, consider that the senior-most ABS deals always yielded 20-30bps more than the senior-most commercial loan-backed CDOs. Every one knew that consumer ABS-backed CDOs were more risky! ( NB DON )

So ultimately, leveraged investing comes down to picking good assets first, then getting the leverage right. The crisis has been brought on by poor asset decisions more so than too much leverage."

I've written on mark-to-market many times. I've always felt it was a good concept but has been applied incorrectly.

TO BE NOTED: From Accrued Interest:

"FASB: The Dark Side clouds every thing

The new FASB ruling is getting more play than it deserves.

I've written on mark-to-market many times. I've always felt it was a good concept but has been applied incorrectly. When the rules were written, it was never assumed that generalized risk aversion would ever rise to the extent that it has. Thus the rules assumed that a $30 decline in a bond price would always and every where indicate a security-specific problem. The rules (and/or the auditors) also assumed that securities that seemed similar at a glance could be used to value each other. They never assumed that various securities would ever become as granular as they eventually became. For example, a whole-loan RMBS with 15% California exposure suddenly was valued drastically differently than one with 25% CA exposure. But both were valued off the ABX as if they were the same, because the ABX was the only thing trading.

Anyway, the key thing that changes with this FASB guidance is the assumption of distress. Now any trade that occurs in an inactive market is presumed to be a distressed trade unless proven otherwise. I'd expect this means that most Level 3 asset prices will become more PV model-based and less trade based.

BUT...

I'd argue that this won't result in banks writing up their asset valuations. Think about it. Say XYZ Bank announces some huge quarterly EPS figure, but when the analysts look deeper into the number, it turns out it was all paper gains on Level 3 assets. Investors would universally pan the earnings figure, claiming it was all phantom profits on marks to make-believe valuations.

Conversely, let's say the same bank reports break-even earnings with no change in Level 3 and a healthy increase in loan loss reserves. Now what does the market think? Analysts would say that the bank has potential latent gains in their Level 3 portfolio that haven't been recognized.

This market is all about imagination. If you are a bank (or any financial), the market isn't going to just accept your balance sheet as reported. The market is going to try to imagine what your balance sheet is really. Since no one knows what it is really worth, investors are going to imagine. I argue that a bank is better off convincing the market that it is being too conservative, thus guiding the imagination to better times.

Otherwise the bank will only stimulate the imaginations of the "its all worthless" crowd, which I realize is the majority of the blogosphere. I don't get this point of view, and I think its all rooted in some sort of visceral desire to see the banking system crash and burn. I think Jim Cramer said it well on TheStreet.Com today:

"The first side is the "it doesn't matter and it is bad" camp. This is the camp that says it [the FASB ruling] is a mistake because it will give the banks too much latitude, and they don't deserve it. "Deserves," as they say in Unforgiven, "got nothing to do with it." This is a completely worthless position that makes you no money. Who the heck cares whether they "deserve" it? What is this, some sort of civics lesson? We are now going to invest on whether someone should be punished? This is about money. I could care less about "deserves". "

Its similar to my position on politics. As an investor you need to forget about what "ought" to happen and worry about what will happen. That's how you make money."

"Longer Treasury bonds are the better bubble candidates. "

From Accrued Interest:

"2009 Forecast Episode II: Deflation Strikes Back

This is Part II of a indeterminate series on the Accrued Interest 2009 Forecast. Here I'll focus on general interest rates and Treasury Bonds.


The question on many lips is are Treasury bonds a bubble? I've already said that fighting deflation will be the major theme of 2009. Deflation will remain the primary concern of the Fed until housing prices start to recover. I don't see that happening until 2010( I DISAGREE ). Until housing prices start to rise, we'll see persistently poor final consumer demand( I DISAGREE ). This in turn keeps the velocity of money low and thus the money supply contracting.


I have a very simplistic mental model for Treasury rates. Real interest rates should reflect the opportunity cost of money. Thus a short-term Treasury rate should be the opportunity cost plus an inflation premium. Longer-term rates should reflect both opportunity cost, inflation, and a term premium. When economic growth is weak, opportunities are less, and thus interest rates should fall.


If we have negative inflation, then short-term Treasury rates should be extremely low. Near zero makes sense for T-Bills (although negative yields is questionable at best). Less than 1% makes sense for the 2-year. So I see no bubble on the front end of the Treasury curve. Not that there is a ton of upside on the 2-year at 0.75%, but could it go to 0.50%? Sure.


Longer Treasury bonds are the better bubble candidates. One might be able to argue that in the short term, both growth and inflation will be negative, thus the equilibrium nominal short-term rate should probably be negative. But longer term, we'll eventually have both growth and inflation, and thus long-term Treasuries should not be approaching Japanese-like levels( I AGREE ).

So when the 10-year was pushing 2%, it felt bubbly. But still I resist the bubble label. To me, Treasury rates are clearly below "fair value" but given the extreme liquidity and economic circumstances, I doubt the 10-year can move above 3% until at least 4Q 2009. I think long-term Treasuries remain over-valued until its obvious that inflation is going to eventually become a problem.( A FAIR POINT. I BELIEVE PEOPLE WILL PULL OUT BEFORE THAT. )

What about Treasury supply you ask? Won't the massive debt load eventually push rates much higher? While acknowledging that supply is an obvious negative for prices always and everywhere, as it is, Treasury supply is clearly not overwhelming demand. The 3-year and 10-year auctions from last week went quite well.

Besides the theory that government debt crowds out private investment doesn't hold water right now. Private lending ain't happening in areas where the government isn't subsidizing. In essence, the Treasury is leveraging because the private sector can't.( TRUE. MULLIGAN DOESN'T SEE IT. )

Eventually, the Fed's programs will result in much higher inflation, and thus Treasury rates will rise substantially( I AGREE ). But I think this is a year or more away, too far away to recommend a short.

The problem for real money investors is that Treasury yields are so low, that you pretty much have to own something else. The yield advantage on short-term Agencies versus short-term Treasuries is so large that there isn't any logical scenario where the Treasury outperforms. Therefore I'm playing this by remaining underweight Treasury bonds, but owning stuff that can appreciate if Treasury rates fall. This includes bullet agencies, and some very high quality corporates( THESE MAKE SENSE. )."

He could well be right. I don't want to see another bubble burst, even in my bathtub.

"is it true that Americans are fundamentally spenders? "

Accrued Interest with some good points:

"2009 Forecast: That bad huh?

For most of my career, with an exception here and there, there have been two persistent trends. One is that in the debt markets, the fundamental outlook has generally been good. You had persistently low inflation, mostly low volatility, and a growing economy. Sure, some bonds went bad, but for the most part, the fundamental picture was good. The problem was always valuation. You'd look at a corporate bond and see a whopping 100bps spread or something and it would seem like all downside, no upside risk. But of course, you had to buy something, so you'd hold your nose and buy it.


Now its just the opposite. The fundamental outlook is piss poor, but the valuations look extremely cheap across all risk sectors.( I AGREE )


Risk assets are pricing in Armageddon( I AGREE ). As long as no one spies any horsemen running around, those risk assets ought to pay off well for investors in the very long term. But that's the real trick isn't it? When to jump in?


I think the key to bond investing in 2009 is two fold.


1) Protect your liquidity. Professional investors, whether leveraged or not, never know when their clients will need cash. And the cost of turning bonds into cash has never been higher than now. Non-pros tend to underestimate the probability of needing cash, and frankly, non-pros don't have as many resources for producing liquidity in bonds. No offense, but its true.


I believe that liquidity has probably bottomed( I AGREE ), or put another way, that liquidity won't get any worse than it is now. But when I say probably I mean like 65%. There is still a decent chance of another blow-up causing another spate of deep illiquidity.( PLEASE NO )


That being said, bid/ask levels are going to remain very wide, probably for the next several years. We've seen improved liquidity in high-quality sectors, like agencies and munis, but even there, I expect liquidity to wax and wane with buyer demand. Remember that dealers used to be the guardians of liquidity. That's gone and it ain't coming back.


2) Buy what you can hold. This isn't to say you can't put money into a bond as a trade, but given how wide bid/ask is, and given that you don't know when bids are going to suddenly disappear, you can't assume you can flip a position. So when buying a bond, ask yourself: would I hold this bond for the next year? Two years? To maturity? Is this credit strong enough that, if I had to, I'd hold this bond indefinitely?


I argue that you shouldn't buy anything in 2009 where you can't answer that question with a confident yes.


So with all that being said, here is my basic economic forecast for 2009. I'll follow this post up with thoughts on some of the major bond sectors. As always, I'll discuss a most likely scenario along with a less likely but possible scenario.


Growth
Most Likely: Sharply negative real growth in 4Q 2008, continuing (at a less severe pace) at least through 1H 2009. 2H 2009 likely near zero. Meaningful recovery doesn't start until 2Q 2010.

Less Likely: Government fumbles stimulus, and growth is negative through 2010 and possibly into 2011, with a deeper trough.

I think the immediate period after the Lehman/AIG/GSE/WaMu/Wachovia failures resulted in a massive pull back in economic activity( YES ). We saw it in Existing Home Sales in October/November, in auto sales activity, bank lending, everything.

That took what was already going to be a recession and turned it into something much worse( I AGREE ). I had thought that mortgage foreclosures could bottom in mid-2009, because that seemed like long enough for the bad loans to burn out. But the sharp contraction in 4Q 2008 will result in much higher unemployment, I suspect around 10% by the end of 2009, and thus the foreclosure party will continue on.

And it will take a slowdown in foreclosures for housing prices to bottom. I suspect it will be government intervention( NECESSARY ) that is the catalyst for this. We've already seen the government move to lower mortgage rates, which really should give us pretty good affordability. And while part of the initial problem with housing was over-building, but that ship has sailed. Housing starts have plummeted, and now all starts are pretty much multi-family or made to order.

Anyway, you need demand to outstrip supply in order for prices to start rising. As long as foreclosures are rising, that means supply is rising. Demand is going to be tepid until the employment picture improves. Rising supply and unchanged demand equals falling prices.

So I see home prices falling throughout 2009, absent direct government intervention either buying foreclosed properties or subsidizing banks to prevent foreclosures. Obama & Co. may actually take these steps, but I'd say it'll take several months for such a thing to pass Congress, then several more months to actually be implemented. So we're still looking at late 2009 at best.

GDP growth will probably be worst in 4Q 2008, then more modestly negative in 1Q and 2Q 2009. Beyond that is difficult to say. My base case is for 2H 2009 to be about zero real GDP growth, with a meaningful but tepid recovery in beginning in 2Q 2010.

The risk to this forecast is that the government bungles the bailout attempts, most likely by letting another financial institution fail( GOD NO ). It currently doesn't look like that's their strategy, but then again, after Bear Stearns it didn't seem like they wanted to let another institution fail. But then came Lehman.( YEP )

Another risk to this forecast is...

Inflation
Most Likely: Inflation? What inflation? The Fed will spend most of 2009 fighting deflation, although by 3Q or 4Q it will be apparent that the Fed will indeed win the battle. Headline CPI will print negative multiple times in 1H 2009, predominantly on falling food and energy prices.

Less Likely: We fall deeper into deflation, most likely because the less likely growth scenario comes to pass.

I've written a few times on deflation, which is truly the primary concern of the Fed right now. The Fed has plenty of tools to fight it, and Ben Bernanke is the right man for the job, having spent his academic life studying how the Fed blew it in the 1930's.

I don't see Japanese-style deflation taking hold, at least not for the same reasons as it took hold in Japan. The Bank of Japan maintained a ZIRP policy for many years to no avail. They still suffered from deflation. Why? Because you can't get consumer inflation without consumer spending. I argued this multiple times when energy prices were rapidly rising. Energy doesn't "create" inflation, rising money supply does.( I AGREE )

But even in the face of rapidly rising money can't create inflation unless consumers are spending. Right now, money is contracting and consumers are pulling back. In fact, those two things are usually correlated. But in the case of Japan in the 1990's, consumers refused to spend despite massive fiscal and monetary stimulus.

But here is where I think the U.S. differs from Japan. The Japanese are fundamentally savers. Americans are fundamentally spenders.( I AGREE )

Unemployment is going to be bad in 2009, heading toward 10%. But the other 90% of Americans will keep spending their income. Now they won't be able to spend their home equity, as in the past, but basically we're a nation of spenders( I AGREE ). Once the American stimuli take hold, consumer spending will advance anew. That's not to mention the fact that the U.S. Fed has been far more aggressive far earlier than the BoJ ever was.

Eventually this leads to some inflation problems( TRUE ), probably not till 2H 2010. To suggest that the Fed will provide just enough stimulus to avoid deflation but not create a significant inflation problem down the road is ridiculous( SO ARE MY FORECASTS ).

Key to the Fed's success is the progress on quantitative easing. The TALF is the quintessential example of QE, where the Fed targets interest rates away from overnight bank lending rates. There will be no limit as to how far the Fed goes to fight deflation. They could buy corporate bonds, municipal bonds, commercial mortgages, anything( TRUE ). Beware what you short!

However, if we get another big leg downward in economic growth, resulting in even tighter consumer lending conditions, then the deflation fight becomes more difficult. I'd still see the Fed eventually winning, but such an outcome would result in a much longer period of ZIRP and eventually much bigger inflation spike.

In the next couple days, I'll be discussing my investment strategy around this forecast."

Now Paul Kedrosky:

"Interesting contention over at Accrued Interest:

The Japanese are fundamentally savers. Americans are fundamentally spenders.

Is it always and forever true that Americans are spenders? I’ll concede upfront that the Japanese are savers, and that Americans have for more than fifteen years been crummy savers, but is it true that Americans are fundamentally spenders? Is it not possible that we could see a state change here given what has happened in stock markets and housing, etc.?( IT IS POSSIBLE, BUT I WOULD SAY ONLY AS A RESULT OF A REALLY BAD RECESSION OR DEPRESSION. OTHERWISE, WE ARE A NATION OF SPENDERS. )

I’m unconvinced that it can’t change. I could cite the recent uptick in spending in the U.S., post stimulus, with BLS showing U.S. savings rates up to 2.8% or so, which is a big increase in a short amount of time. I’m on record as saying the U.S. personal savings rates hits 7% in short order, and stays there, at least for a while.( I SEE MORE LIKE 3-5 %. BUT SHORT TERM MEANS A REVERSION TO OUR NATURAL STATE AS SPENDERS. )

Feel free( THAT'S WHY NOTHING IS WRITTEN ) to take the other side."

"But somewhere in there is a legitimate, rational debate."

Accrued Interest addresses Mark-To-Market:

"Mark-to-market accounting has got to be one of the most controversial topics of the year. Unfortunately, its also rife with bias and downright zealotry. You have on one side apologists for financial companies and/or people looking for a one-trick excuse for the whole financial meltdown. On the other hand, you have people who believe all of Wall Street is just lying and everything they own is worthless.


But somewhere in there is a legitimate, rational debate. ( TRUE )


First let's consider what accounting is supposed to achieve. Broadly speaking, accounting should have a few simple goals:


1) Accurately reflect the current economic situation of a firm.

2) Allow for comparison of a firm's results and position over time.

3) Allow for comparison of one firm to another.

4) Be as objective as possible.

( IT'S A GOOD LIST, BUT I WOULD INCLUDE THE NOTION OF SOCIAL CONFIDENCE. IN OTHER WORDS, A SYSTEM OF ACCOUNTING THAT THE PUBLIC CAN TRUST AND BELIEVE IN, EVEN IF NOT INVOLVED IN THIS ISSUE PERSONALLY IN ANY WAY. IT COULD BE THAT MARK-TO- MARKET INSTILLS MORE CONFIDENCE IN THE SYSTEM )

Now let's consider how mark-to-market as a concept fits in with these goals. I call mark-to-market a "Liquidation Theory of Accounting." In other words, by marking all assets to where they could be sold, one is valuing a firm based on what it might be worth in liquidation( SELLING ).


This is clearly appropriate with any pool of assets intended to be traded in the open market( THAT NEED TO BE CONTINUALLY PRICED ). But in other assets, it isn't obvious that mark-to-market serves the 4 basic goals above. Take a life insurance company which bought the longest available Treasury Strip (5/15/2038) on August 8, when it was first trading. The position is an offset to their long-term liabilities, say the life insurance policy of a young person. For the sake of argument (and brevity) let's assume that the actuarial life of the policy holder is exactly 30-years, and the accrued interest on the strip will exactly cover the life policy with a small profit.


The strip was trading at $25.6 on 8/8, but is now about $42.5, an handsome 66% return( DUE TO CHANGES IN INTEREST RATES ).


But has the life company's economic situation changed? Is that firm 66% better off? We'd all agree that no, it isn't( THEY AREN'T GOING TO SELL IT. THEY MERELY KEEP GETTING THE SAME INTEREST AS BEFORE ). The basic economics of the firm haven't changed at all. They have the same liabilities and same cash flow stream. If we followed strict mark-to-market theory, we'd mark both the asset and the liability higher( BECAUSE THE STRIP IS WORTH MORE ), leaving the firm's balance sheet unchanged( SAME REVENUES ).


Or would we? Under current market conditions, "selling" the life insurance policy liability to another firm might be possible, but it would be highly unlikely to have the same gain as the Treasury position( IT WILL SELL FOR LESS ).


That example is very black and white, and of course, the real world is much more grey. Its easy to use a Treasury bond as an example, where we know the change in market value isn't reflective of a change in asset quality. But where there has been a real change in asset quality, the situation becomes more grey.


But still, mark-to-market still doesn't fully satisfy. Let's say that we have two firms, both have made loans to XYZ Retailer. But one is a bank which has made a traditional loan, and the other is a brokerage which holds a private placement bond. The broker almost certainly has to mark that loan to market, but the bank may not.


And in both cases, the rapid changing liquidity premium in the market place alters the "mark" for this asset. By this I mean, say the retailer is performing reasonably well, and thus the risk of non-payment remains remote. Given the weak economy, its obvious that the risk has increased by some degree, but given the extremely weak liquidity across fixed income products, the larger portion of the assets price decline would reflect liquidity( IT'S BECOME HARDER TO SELL, SO WORTH LESS. BUT THIS POINT CAN ALSO BE USED FOR FAIR VALUE, SINCE, IF THE BUSINESSES ARE HOLDING THESE ASSETS FOR THE LONG TERM, THERE IS A GOOD CHANCE THAT THEY WILL GO UP IN VALUE OVER TIME, AND SO VALUING THEM BASED UPON TODAY'S MARKET PRICE ISN'T FAIR, ESPECIALLY IF IT LEADS TO HIGHER CAPITAL REQUIREMENTS THAT FORCE THE BUSINESS TO SELL SOME OF ITS ASSETS AT A DISCOUNTED PRICE ). If the firms don't intend to trade the loan, is the changing liquidity premium relevant( NOT REALLY )?


There are other problems. Say you are a bank that has a private loan to a company with traded CDS contracts. Your best mark-to-market estimate would be to price the loan based on the cost of hedging out the credit risk. But in many cases, the CDS and cash bond markets have decoupled. Many bonds are trading a drastically wider levels than the CDS market, owing in part to easier funding of CDS. Take Amgen, where cash bonds are trading at a LIBOR spread of nearly 300bps, but the CDS are around 90bps. On a 10-year loan, that implies a valuation differential of about 15 points!( GOOD POINT )

So here again, we have a situation where two firms can use "market" prices to price non-marketable assets, and come up with wildly different valuations. We hear mark-to-market and assume that the "market" is some kind of observable thing. But that is just not the case( TRUE. IT DEPENDS ON WHAT THE METHOD IS USED FOR ).

I argue that when the current fair value accounting standards were cooked up, a rapid change in liquidity premia was never envisioned( THE MARKET WOULDN'T MOVE MUCH ). It was assumed that the market would deliver an efficient price which was primarily reflective of the real economic risks of a security. Thus a change in price would reflect a change in risks. It makes perfect sense in theory, but clearly does not reflect economic reality for some firms, nor does is it creating balance sheets which are comparable across firms( THE LAST FACT IS IMPORTANT ).


But what's the alternative? Those that are calling for an end to mark-to-market are out of their mind. First of all, there is no clear alternative. Second, we have enough trouble trusting firms' balance sheets as it is. Imagine if mark-to-market were suddenly suspended! ( IT WON'T PASS MUSTER, ESPECIALLY IN A CLIMATE OF DISTRUST )

And it doesn't help that so many critics of mark-to-market in the recent past have been managers of firms who were, in fact, fudging the real economic position of their firm( THAT'S THE BOTTOM LINE ).

So I don't know what the answer is. And I don't blame accounting for the financial crisis that we're going through. But I'd like to see some better ideas."

My idea is to have both accounting procedures done, if warranted, with Mark-To-Market the necessary one. In a financial crisis of any kind, a business could apply for an exemption from Mark-To-Market for a time based upon Fair Value Standards. However, the Mark-To-Market must be available as well in order to feel satisfied that everything looks in order. I don't know how this could be done, but the problem doesn't seem unsolvable.

"they would move out of Treasuries and into better yielding, high quality bonds. But that will be a slow process"

Accrued Interest doesn't see a Treasury Bubble:

"Yields on U.S. Treasuries have fallen to levels once thought impossible, and we are now hearing the "B" word (bubble) used to describe these formerly staid securities. Just a few days ago I was resisting the bubble label, but with the 10-year dropping below 2.10%, its getting very hard to argue. But more important than assigning labels like "bubble" is to discern what could cause the Treasury market to move in the other direction. In other words, if its a bubble, when can you short it? ( Good question )

First, consider who is driving the Treasury market to these levels. It isn't relative value investors, like money managers and mutual funds. Sure they might hold some amount in Treasury bonds for liquidity and duration management. But these kinds of managers are generally assuming that Fannie Mae and Freddie Mac debt has equivalent credit quality as Treasuries with substantially better yield ( I AGREE WITH THIS ASSUMPTION ). So investors who are willing to consider relative value have already reduced Treasury holdings as much as they are likely to any time soon. So selling pressure isn't likely to come from relative value buyers.

Foreign buyers have dominated the demand side of things, buying up just over half of net Treasury issuance in October. Why are they willing to buy at historic low levels? Classically foreign buying of U.S. bonds has been due to recycling of trade dollars. In other words, foreign money will keep flowing into the U.S. so long as U.S. consumers are buying foreign goods. Foreign buying of Treasuries has been especially robust among private accounts (not central banks), which suggests that foreign financial institutions are driving demand ( TRUE ).

A slowdown of foreign buying would clearly push rates higher, but in the near term, what would be the catalyst? Note that foreigners have been paying for their Treasury bonds by selling government Agency debt, $50 billion worth in October. This is reflective of a lack of confidence in any security not directly backed by the U.S. Government ( EXACTLY ). The Treasury could make the backing of Fannie Mae and Freddie Mac explicit( IT ACTUALLY IS ), but even this won't instantly reverse selling of Agency securities. Foreign trading is notoriously slow-moving, often waiting for bond maturities to reinvest rather than trading their portfolios. ( OK )

Many of those calling the Treasury market a bubble are ignoring the threat of deflation ( NOT IGNORING. PRAYING WE DON'T HAVE IT ). Under deflation, normal perceptions of interest rates as well as relationships among interest-bearing instruments break down. ( TRUE. THESE INVESTORS COULD BE CORRECT )

Of course, we don't need investors to sell to create selling pressure. The Treasury is doing plenty of selling of its own. If investors, both foreign and domestic, gained more confidence in financial institution generally, they would move out of Treasuries and into better yielding, high quality bonds. But that will be a slow process ( SO FAR, BUT IT MIGHT PICK UP ). But until this happens, demand for ultra-safe investments will continue unabated, keeping a lid on Treasury rates. But until this happens, demand for ultra-safe investments will continue unabated, keeping a lid on Treasury rates. ( TRUE )

I still see a real possibility, but nothing is written.

"You can't possibly be willing to lend money to anyone and lock in a loss on the trade. It doesn't make sense. "

Accrued Interest on the Treasury Bond Paradox:

"I'm on record as saying that I think Treasury bonds have no logical lower limit in yield. While its conceptually hard to be bullish on the 10-year at 2.60%, the threat of deflation completely changes the game.

However, there should be one logical limit on any bond, and that's zero. You can't possibly be willing to lend money to anyone and lock in a loss on the trade. It doesn't make sense.

So when I heard that there were T-Bill trades occurring above par, I was more stunned that Princess Leia aboard the Tantive IV. Who bought T-bills above par? Why would you enter into that trade with a certain loss when you can simply hold currency at no loss?

And don't tell me the dollar is worthless bullshit, because you aren't better off buying dollar denominated T-Bills if the dollar is worthless. Hell, if the dollar was a problem, Treasuries would be cheap, not insanely rich.

Now normally I'd assume that someone got trapped in a short, but who is shorting T-Bills? Seems like an odd trade.

Anyway, if you know how the hell this could have happened, post a comment."

In the comments, people try to give a number of reasons. Of course, people think that they're going to make or save money with this buying, so that's not a reason that distinguishes this buying from any other. What are the presuppositions of this buying? It can only be deflation, and rather decent sized deflation at that. After all, why not wait and see what happens holding cash for now otherwise? One idea is that it's a sort of insurance because it's the safest thing around, but that is the definition of the flight to safety.

"First, an increase in demand, ceteris paribus": with other things equal: "with" supplied by case, Ablative

Accrued Interest likes the whole 4.5 % Mortgage deal:

"Calculated Risk is one of the best financial blogs going. Accrued Interest should only hope to get 1/10th of their hits. And the blogging world will certainly miss Tanta. She and I had several e-mail conversations over the years and I learned a lot of very useful info about real-life mortgage servicing from her.

However, I really think CR is lawyering in this post from 12/3. In it, CR claims that lower mortgage rates will not improve home prices, only improve home demand. The crux of the argument is...

But the current buyer wouldn't pay much more, because the rational buyer would realize interest rates will probably not be artificially low when they try to sell, and their future buyer would have a higher interest rate and a lower price."

Forget anyone called the "Rational Buyer".

Here's the entire comment:

"But why would this push up prices as suggested by the Global Insight analysis? Prices would increase because of higher demand - not directly because of lower interest rates. A rational buyer wouldn't pay more just because the interest rate is lower - although they might have to pay more because the demand is greater. But the current buyer wouldn't pay much more, because the rational buyer would realize interest rates will probably not be artificially low when they try to sell, and their future buyer would have a higher interest rate and a lower price."

I sort of agree, but it would depend upon what a buyer believes. A lower interest rate is very important. So let's push on for a bit.

"To me, this argument has a few holes. First, an increase in demand, ceteris paribus, will always increase the price of a good. I suppose one could make some kind of non-linear demand curve argument, claiming that demand is higher at the current price point but does not support higher price points. CR doesn't say that, but it sounds like that's what is being advanced."

I agree with this. It will have some influence on housing prices.

"To follow his logic, however, is to say that buyers are indifferent to interest rates. If rates are high now, they are likely to fall in the future and vice versa. The data doesn't support this at all. Housing prices tend to rise when rates are low and lending standards are easy. That's exactly why we had the boom we just had!'

Yes. I've already agreed with this.

"Now maybe CR is saying that the 4.5% would be obviously artificial since its the product of Fed manipulation. Perhaps. But I will say that within the fixed income community, its is widely thought that mortgage rates are fundamentally too high. With the 10-year Treasury at 2.55%, mortgage rates shouldn't be 6%. At least not for conforming (i.e., GSE) loans. Based on more typical ratios, the rate should be 4.5-5%. If they Fed were to manipulate the loan rate back to its long-term norms, why would we expect the rate to rise precipitously in the future? Maybe because Treasury rates would rise if the economy returned to normal, but then we're back to claiming that buyers ignore rates, which they don't."

The 4.5 % is artificial. Period. It's just as you say about the "Fixed Income Community", only, I suppose, these are the government equivalent. I'm sure you're bright people, but not that bright. I'd rather not take anyone's word on this, even yours, which I respect.

"Put another way, when the Fed pushed short-term rates to 1% in 2003, did buyers abstain from those low-low-low teaser rates loans? Did they rationally assume rates would soon rise in the future? You and I both know the answer."

Interest rates matter. I'll tell you how perverse I am. I'm going to miss the phrase "Teaser Rates". Perhaps we can apply it to me now. I'm quite a teaser. Almost non-stop, in fact.

"Another way to think about it is if a home buyer plans on living in the home for an extended period, why not take advantage of the combination of low fixed rate mortgages and low prices currently available? Even if you assume rates may be higher in the future, wouldn't we also assume that over an extended period, say 5-7 years, housing would also recover?"

It makes sense. Move on.

"Now remember that new housing construction is well below normal household creation. So ignoring foreclosures, net supply of housing is negative. Thus, even if 4.5% mortgages can't stimulate enough demand to cause home prices to rise, could it create enough demand to soak up foreclosures? If so, that would certainly be a major step in the right direction, no?"

Yes. Agreed. It will do some good. Move on.

"The $10 trillion question is whether the Fed can succeed in pushing mortgage rates much lower. The Fed has plenty of money to do it. Remember that although the entire mortgage market is very large, the Fed only needs to manipulate new loans to change the clearing rate. Comparing the Fed's balance sheet to the entire mortgage market is the wrong comparison. Its like saying they can't manipulate Fed Funds by measuring the entire intra-bank lending market.

All they need to do is announce a target and pledge their full resources toward that target. Mortgage rates will drop down to 4.5% very quickly."

I don't like this target.

"Perhaps CR is thinking in terms of 4.5% mortgages "working" in that it "solves" the housing crisis. As I wrote here, there are no magic solutions that will immediately reverse the home price decline or avoid a deep recession. But there are appropriate measures which can help either diminish the downturn or shorten its length. This is one of them."

That's the argument for this, other than people wanting to see some government help going to stabilizing the housing market, and not just banks.

I can take the Fed Fannie/Freddie bit, but no more. Even then, I have a big problem:

Wouldn't it be better to let housing prices drop another 5 % or so and use that to spur demand rather than interest rates? I believe so. Of course, we'd need, all things being equal, for mortgage rates to stay the same or even slightly decline.

Also, I don't see that there are going to be that many people buying these homes now, given the lending conditions. That's why I don't credit that this will result in more shoddy lending. It might, but, right now, it's hard to see it occurring.

My main difference, however, with these proposals is that I don't know, or think that anyone really knows, where this housing bottom might be. Therefore, if the bottom is a lot further down, this might be a terrible mistake that will necessitate another drop in the near future. On the other hand, if we're closer to a bottom, then this could be a good deal for helping thaw a bit some of the more stringent lending requirements, that might be effecting even people who can afford buying a house.

In sum, I'd wait, and see where the market goes for a few months. If you want to fiddle, then leave it at the Fed Fannie/Freddie infusion, with no goals or targets. Let's see where this move takes us. The final option, adding the Treasury in and fixing a goal, I don't like, simply because I want the market to determine this and not experts, at least on this point.

I'm going to give Accrued Interest the final word with a few comments:

Accrued Interest said...

Oregon:

Lower mortgage rates would only result in a normal counter-cyclical impact. Not a return to above-trend price returns.

So I don't understand your moral hazard argument, when what you are talking about is punishing people who made good housing decisions. The 4.5% mortgages will only go to people who can put up down payments and afford the fixed payment.

By doing nothing, you are risking a downward spiral in home prices that hurts everyone. Where is the moral hazard?

Jesse:

I said prices would likely be higher, at least nominally, in 5-7 years. Inflation benefits borrowers, don't forget. You are better off in real assets given inflation!

12/7/08 6:09 PM