The paradox of high inflation is that it can make stocks, claims on productive assets very cheap

TO BE NOTED: From ducati998:

"Liquidity, velocity and stocks

Posted by ducati998 under economic theory
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The function of money is to facilitate exchange, and eliminate barter, thus speeding up, and expanding trade. The demand for money is increased by the following two conditions:

*Increase in productivity
*Increase in prices

The demand for money falls when the opposite conditions are operant:

*Fall in productivity
*Fall in prices

The Federal Reserve and Treasury have been increasing the volume of money within the system. Productivity has been falling, curtailed by falling demand for products & services that have excess capacity. The money supply has continued to grow.

Who are the recipients of the increased money supply? One of the rules of inflation is that the early recipients of new money, are allowed to buy assets with the new money thus essentially buying at a discount. The later you enter the chain, the greater the expropriation of your wealth that you will suffer.

The banks, auto-makers, and any other lame ducks that you can think of. Essentially anyone who was profilgate and stupid in combination.

What will they do with the new money? Hoarding will take place in some instances, but, many will buy assets with the money, to take advantage of a small window of opportunity of increased buying power that the new money affords.

Stocks have been rising, but the common concensus would seem to indicate that it is not Mutual Fund Managers, Pension Fund Managers etc who are driving the market. However, the banks have on aggregate, have been simply hoarding, rebuilding their capital ratios via Federal Reserve interest payments on said reserves.

Surplus money, or liquidity, needs to find a home. Rising asset prices, provide such a home. Rising prices remove liquidity, and by definition drive an increase in the demand for money.

The surplus money or liquidity, in pushing prices higher therefore eliminates the surplus supply of money, creating in time a deficit. A money deficit can be corrected through selling products/services.

What happens though when money is continuously pumped into the system? Prices will continue to rise. The Federal Reserve and other Central Banks, have not yet considered slowing the creation of new money, as, the economy, and particularly unemployment remain critical issues to their re-election, albeit, for Obama, 2.5yrs away.

Time will play a factor within the advent of an increase in liquidity and rising prices, as it takes time for the increased liquidity to leak out. Banks, as previously alluded, are not buying, rather, they are hoarding, rebuilding Balance Sheets.

Treasury paper, for psychological reasons, has been a recipient of much liquidity, although, with a failed auction last week, this asset class may well start leaking liquidity back into alternate assets. Banks, Pension Funds and Sovereign holders constitute major players.

China, is not happy. China has already made noises with regard to replacing the US dollar as the Reserve Currency. China will not be blind to the threat of increased liquidity within the Banks and what it must eventually mean. As a country in surplus, as opposed to a US deficit, China can withdraw liquidity, at no discount, due to US liquidity provision via Quantitative Easing, and reallocate this liquidity, [this holds true for Petro-dollars etc]

Where would this liquidity flow to?

The paradox of high inflation is that it can make stocks, claims on productive assets very cheap. Asia and South American inflations of recent times bear this out.

Although the official inflation rate is negligible, the creation of so much new money has created the potential of a serious inflation should it be released, highly possible."

The trouble is that liquidity is hard to define and can be impossible to measure

TO BE NOTED: From the FT:

"With no measure, is liquidity half-full or half-empty?

By Tony Jackson

Published: May 10 2009 17:23 | Last updated: May 10 2009 17:23

One of the more intractable problems to have emerged from the financial crisis is that of liquidity. In normal times, we assume an asset can be sold at its market price. Take that away, and the effects are literally incalculable.

How regulators and practitioners address that is plainly crucial. The trouble is that liquidity is hard to define and can be impossible to measure. There is even disagreement over how far it is a good thing.

For our purposes, liquidity can be taken as the extent to which a security can be traded, promptly and in size, without disturbing the price. Whether that is measurable depends on the type of security in question.

The liquidity of an equity can usually be measured pretty accurately, since the size and price of deals are displayed in real time on the stock exchange screen. Prices of corporate bonds, on the other hand, are mostly not displayed even daily. As for volume, figures are only available months in arrears.

If that is true of basic bonds, it is true in spades of those structured securities which – under the title of toxic assets – lie at the heart of the crisis. So far, there seems little prospect of changing that.

As one simple indicator, take the fact that whereas investment banks have devised hedges against all sorts of other risks, from inflation to longevity, they have yet to come up with a liquidity hedge. That would be a very profitable product. But it would require a common definition and measurement of liquidity itself.

Ditto for the ratings agencies, which have been roundly abused for assessing securities only for default risk and thus, by implication, looking at the wrong thing. But I am assured that they spent a lot of time and effort in the 1990s trying to devise a liquidity measure, only to give it up as a bad job.

It might be thought that regulators, in tackling the liquidity question, would have come up with definitions of their own. Apparently not.

The UK’s Financial Services Authority said last December that it would require banks to give “far more information” on liquidity risk. They should detail their holdings by asset class, maturity, currency, whether they were eligible for central bank monetary operations, and “any other characteristics considered relevant”.

But how is liquidity to be defined? None of our business, the FSA says. The liquidity of individual instruments tends to be “situation-specific”.

Given which, it is striking that the FSA’s list of criteria bears scant resemblance to those applied by UK bond traders themselves, as set out in a pilot study from two former practitioners, David Clark and Chris Golden.

The maturity of an issue, for instance, was placed 32nd by traders in a list of 47 liquidity criteria. Right at the top came whether the bond could be borrowed in the market, and whether it could be easily hedged through derivatives.

It is therefore striking that authorities in general are so exercised about the evils of shorting and credit derivatives, both of which are regarded as essential to liquidity by practitioners. But this brings us to the next point: whether liquidity is seen as desirable at all.

Keynes wrote in 1936 that the “fetish of liquidity” was profoundly anti-social. Individuals could be liquid, but not communities, which were collectively stuck with the underlying asset – the steel mill, shipyard or whatever.

The existence of a liquid market, he conceded, might lower the cost of capital. But it meant the purpose of investment became merely “to pass the bad half-crown to the other fellow”.

Something of the same distaste seems to be emerging today. Lord Turner, chairman of the FSA and author of the authoritative Turner Review on the world banking crisis, remarks in it that tightening liquidity is justified “in order to reduce risks to future financial stability”.

This is in spite of the fact that, like Keynes, he accepts the usefulness of liquidity. For the banks, he says, regulatory restraints on liquidity also mean constraints on “aggregate system-wide maturity transformation” – in effect, the supply of credit. But the price is worth paying.

It might seem we are talking here of a different kind of liquidity – the quantity of liquid assets held in reserve by the banks. The link, though, lies in the definition of what constitutes liquidity in an asset.

If the banks can only hold Treasuries rather than private securities, the less the demand for the latter. The less the scope, too, for securitisation – the vital form of lending which has yet to recover in this crisis, in spite of the best efforts of the authorities.

There are no easy answers to all that – just a lot of questions which seem not so much unanswered as unaddressed. If you wonder why the crisis is dragging on, this is part of the reason.

tony.jackson@ft.com"

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."

credit investors soon seemed to realise that ‘less bad’ news was not yet ‘good news’

TO BE NOTED: From Alphaville:

"Liquidising the credit rally Posted by Tracy Alloway on Apr 16 13:00.

The recent stabilisation in the Institute for Supply Management Index (ISM) has been hailed by some as justification for a rally in corporate credit.

Indeed, there’s historical precedence for that. Over the past 40 years, when ISM stabilises, credit spreads have tended to tighten. But, it’s important to note, that such rallies have usually been very temporary and quickly reversed. Credit markets have usually waited for manufacturing to actually expand — not just slow its slide — before pricing in a more sustainable, longer-term rally.

You can see the tendency in the charts below, from Dresdner Commerzbank. The red dots are the low points in the ISM Index and the green ones are what the bank deems sustained rallies in credit spreads.

Here’s what Dresdner analyst Willem Sels has to say on the subject:

Every time ISM found a bottom, spreads started to come in. But in each case, credit investors soon seemed to realise that ‘less bad’ news was not yet ‘good news’, and the spread path reversed. The real sustainable spread compression started only later… It is remarkable that these ‘true’ rallies all occurred only when ISM was back above 50 again (52 in most cases – as shown on the ISM graph), i.e. when manufacturing was expanding again.

So, historically, it’s taken nine to 15 months after the troughing of the ISM for a “true rally” in credit to take hold. If history repeats itself (past performance is not necessarily indicative of future results and all that), we’re looking at September/October for a meaningful tightening in spreads — and that’s assuming that the ISM has really troughed — a rather risky premise.

Of course, you could argue that the above analysis ignores the possibility that spreads may have overshot fair value. Savvy investors could jump in now and make a short-term killing, maybe even a longer-term one. But, there’s one thing that should be giving them pause for thought and that’s liquidity.

Here’s Sels again:

One of the reasons why investors do not want to anticipate a rally too far ahead is the cost of getting it wrong. As we suggested before, even if there were scope for further spread compression, we think spreads would widen out again before starting a sustainable rally. In the current market environment, it is very difficult to get in and out at an acceptable cost (even if one were able to time it perfectly).

You can see that lack of liquidity in this chart, with trading volumes of corporate bonds still very thin.

In otherwords - if you want to chase a quick credit rally - make sure you can get out swiftly.

Related links:
Any angels left in heaven? - FT Alphaville
Chief of NYSE cautious over rally in March - FT
The incredibly shrinking market liquidity, or the upcoming black swan of black swan - Zero Hedge
Merrill let loose on the quant scent - Zero Hedge

This entry was posted by Tracy Alloway on Thursday, April 16th, 2009 at 13:00 and is filed under Capital markets. Tagged with corporate credit, credit, Ism index, liquidity."

doubted his own theory on the sensible ground that people were not so rational and long-termist

TO BE NOTED: From the FT:

"Insight: Public sector replaces private as engine of borrowing

By John Plender

Published: April 14 2009 16:28 | Last updated: April 14 2009 16:28

With so many countries running big current account surpluses during the credit bubble, the resulting excess savings ensured that bond market vigilantes – investors who go on strike in government bond markets – were well and truly anaesthetised. Government budget deficits, however great, could always be financed without difficulty while markets were awash with petro-funds and surplus Asian and continental European savings.

Not so today. In both the US and the UK, recent bond market auctions have met with poor receptions. Last week’s fiscal stimulus package in Japan caused government bond yields to rise initially. The inevitability of huge increases in bond issuance to address the economic and financial crisis has prompted alarmist talk about dwindling investor demand, collapsing bond prices and a return of inflation.

Meantime, Ricardian equivalence, one of the fine old chestnuts of economic theory, has been making a comeback. This is the notion that where governments finance expenditure by borrowing rather than taxing, rational folk will save more to offset the impact of taxation further down the line. In other words, fear of government deficits turns them into squirrels, thereby offsetting the stimulus that the fiscal largesse is supposed to achieve. So what, in the face of these potentially conflicting arguments, is in store for the bond markets?

There is no disputing the reality of a huge potential supply of bonds, but the demand side of the equation is more complicated.

To start with, Ricardian squirrels can firmly be discounted. David Ricardo, the 19th century economist, doubted his own theory on the sensible ground that people were not so rational and long-termist.

The recent experience of rising budget deficits in Japan likewise casts doubt on the theory, since household savings rates there have declined.

That said, what is now happening in the Anglophone economies is that over-indebted households are rebuilding their balance sheets. The private sector’s desired savings rate is increasing, while debt is being paid down. In effect, the public sector has replaced the household sector as the engine of borrowing.

At the same time, the protracted decline in commercial bank holdings of government paper is set to reverse. In the period following the second world war, banks on both sides of the Atlantic held as much as 30 to 40 per cent of their assets in government paper. By 2007, when the credit crunch began, that had fallen to next to nothing, leaving the banks unusually vulnerable to liquidity problems.

Revisions to the Basle capital regime in response to the financial crisis will put greater emphasis on liquidity. The percentage is thus set to rise again.

On top of that we now have central banks engaging in quantitative easing, whereby they purchase assets – chiefly government debt – in exchange for money.

These demand side influences are together very powerful. That is not to say that investors will have no concerns about inflation. When governments are obliged, in the attempt to stave off deflation, to expand budgets and increase public sector debt rapidly, the risk is obvious. The key to addressing concerns about inflation – and also default – is for governments to articulate credible medium-term strategies to exit from fiscal and monetary largesse.

In the meantime, a world that is suffering from deficient demand and large output gaps is not the kind of place where inflation poses an immediate threat. Yet the scale of potential debt issuance is such that there is bound to be periodic indigestion in the market, with pressure appearing at different points on the yield spectrum.

The likelihood is that we are back to the kind of courtship rituals seen in the UK in the 1970s, with investors becoming increasingly coy in the face of a relentless barrage of IOUs. Government debt managers will have to re-acquire marketing skills, which at that time included offering partly-paid gilts and other devices, to add speculative spice to the surfeit of bonds on offer. Stand by for the focus of financial engineering to shift from private to public sector paper.

John Plender is an FT columnist and chairman of Quintain"

lend support to government measures aimed at taking troubled assets off banks’ balance sheets—such as the US Troubled Asset Relief Program (TARP)

TO BE NOTED: From Shopyield:

"The pricing of subprime mortgage risk in good times and bad: evidence from the ABX.HE indices

The pricing of subprime mortgage risk

Ingo Fender (BIS)* and Martin Scheicher (ECB)**

Abstract

This paper investigates the market pricing of subprime mortgage risk on the basis of data for the ABX.HE family of indices, which have become a key barometer of mortgage market conditions during the recent financial crisis. After an introduction into ABX index mechanics and a discussion of historical pricing patterns, we use regression analysis to establish the relationship between observed index returns and macroeconomic news as well as market-based proxies of default risk, interest rates, liquidity and risk appetite. The results imply that declining risk appetite and heightened concerns about market illiquidity—likely due in part to significant short positioning activity—have provided a sizeable contribution to the observed collapse in ABX prices since the summer of 2007. In particular, while fundamental factors, such as indicators of housing market activity, have continued to exert an important influence on the subordinated ABX indices, those backed by AA and AAA exposures have tended to react more to the general deterioration of the financial market environment. This provides further support for the inappropriateness of pricing models that do not sufficiently account for factors such as risk appetite and liquidity risk, particularly in periods of heightened market pressure. In addition, as related risk premia can be captured by unconstrained investors, ABX pricing patterns appear to lend support to government measures aimed at taking troubled assets off banks’ balance sheets—such as the US Troubled Asset Relief Program (TARP). ( NB DON )

Keywords: ABX index, mortgage-backed securities, pricing, risk premia.
JEL classification numbers: E43, G12, G13, G14.
*

BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The views expressed in them are those of their authors and not necessarily the views of the BIS.

Copies of publications are available from:

Bank for International Settlements

Press & Communications

CH-4002 Basel, Switzerland

E-mail: publications@bis.org

Fax: +41 61 280 9100 and +41 61 280 8100

This publication is available on the BIS website (www.bis.org).

This was written by cate. Posted on Saturday, April 4, 2009, at 2:14 pm. Filed under Open engines, Pricing, Trading, Transparency. Tagged Liquidity, risk, subprime. Bookmark the permalink. Follow comments here with the RSS feed. Post a comment or leave a trackback."

Note to Treasury Secretary Geithner and his team… you could encourage the TARP banks to use this platform to list mortgage securities…

TO BE NOTED: From Shopyield:

"Trading platform transparency

There are many alternative trading systems (ATS) in the fixed income markets… they have slightly different price discovery, quotation and trade reporting structures… think of them as “liquidity pools”…

I’ve always thought the important thing for market transparency and fairness is that all investors have access to all bids and offers on an ATS (think of eBay’s structure)… this is also how exchanges work… (instead of this structure most fixed income platforms are “request for quote” (RFQ) where a buyside firm puts out a request for bids or offers from dealers… generally other investors don’t see the RFQs… so the ATS are most often dealer controlled markets… I wonder what academic studies are available on this topic?)

Broadridge, which spun off from ADP, announced a new alliance to create access to less liquid mortgage and other bonds… the platform allows equel access to all users (sellside and buyside)…

Note to Treasury Secretary Geithner and his team… you could encourage the TARP banks to use this platform to list mortgage securities… here is what the platform can handle (article follows from Wall Street and Tech):

Trade Discovery ™

• Agency Pools
• Agency CMOs
• Trust IOs / POs

~~~~ Broadridge, Beacon To Help Clients Find Fixed-Income Liquidity

Trading clients allowed to pore over daily fixed-income securities transaction records.
By Penny Crosman
March 31, 2009

Broadridge, a provider of technology-based outsourcing solutions to the financial services industry, and Beacon Capital Strategies, which operates a marketplace dedicated to providing liquidity and electronic trading in the less-liquid fixed-income market, today announced a multi-year strategic alliance. The alliance is meant to help the firms serve their clients who actively trade less-liquid fixed-income securities including agency mortgage-backed securities, asset-backed securities, and collateralized mortgage obligations.

Broadridge is a fixed-income securities processing provider that currently handles on average more than $3 trillion in notional value of U.S. fixed-income securities transactions daily. Beacon established the first trading platform tailored to he less-liquid fixed-income market, which is open to all participants on an anonymous and equal basis. This alliance will help the firms’ clients locate difficult-to-find securities in the less-liquid fixed-income segment, thereby enhancing liquidity and efficiency to the overall marketplace.

By using Broadridge’s impact and MBS Expert products and Beacon’s Trade Discovery platform, clients will be able to search through less-liquid fixed-income securities, find the other side of the trade for instruments that meet specific investment criteria, and transact on liquidity that otherwise would not be publicly advertised in current trading channels.”~~~~

This was written by cate. Posted on Tuesday, March 31, 2009, at 2:19 pm. Filed under Launching..., Liquidity, Open engines, Pricing, Trading, Transparency. Tagged ATS, dealers, MBS, OTC, Treasury, Wall Street. Bookmark the permalink. Follow comments here with the RSS feed. Post a comment or leave a trackback."

Here is a simple way to create public price reporting of OTC CDS

TO BE NOTED: From Shopyield:

Derivative trade reporting

Here is a simple way to create public price reporting of OTC CDS… it would be very simple to turn the DTCC Warehouse into a public trade reporting system like TRACE is for corporate bonds… the winds seem to be blowing towards keeping this a dark market though… too bad… from Wall Street and Tech …

~~~~ New Automated Data Feed Between Omgeo’s Crosscheck and DTCC

The link is designed to reduce operational risks in the over-the-counter (OTC) credit derivatives market by enabling market participants to align their portfolios with contract records maintained by the DTCC Warehouse.
By Melanie Rodier
March 30, 2009
Omgeo announced the availability of an automated data feed between Omgeo CrossCheck and DTCC’s Trade Information Warehouse.The link is designed to reduce operational risks in the over-the-counter (OTC) credit derivatives market by enabling market participants to align their portfolios with contract records maintained by the Warehouse, a service offering of DTCC’s Deriv/SERV unit.

According to a release, Warehouse is the market’s first trade database and centralized electronic infrastructure for post-trade processing of OTC derivatives contracts over their lifecycles, from confirmation through to final settlement.

Omgeo CrossCheck is a centrally hosted, exception management solution that automates the comparison of portfolios of derivatives between counterparties.

It helps minimize the risks and consequences of unaligned portfolios in advance of payments, collateral calls, credit events and other situations, according to Omgeo.

As such, firms are better able to scale their business as volumes expand, while effectively managing risk in times of market stress, allowing for high levels of transparency and efficiency, the company said in the release.

The new link enables Omgeo clients that are also customers of DTCC’s Deriv/SERV and the Trade Information Warehouse to receive an automatic feed of relevant credit derivative trade data from the Warehouse to CrossCheck. With this feed in place, clients can compare their portfolio records against the Warehouse to ensure agreement with the “golden copy” of trade details for positions with all counterparties who use Deriv/SERV.

“Since the debut of Omgeo’s counterparty risk management offerings, and specifically our portfolio reconciliation service Omgeo CrossCheck, we’ve been dedicated to ensuring that the data involved is of the utmost quality,” said Steve Matthews, managing director, product at Omgeo. “By linking CrossCheck to the global standard for centralized and secure data for OTC derivatives at DTCC’s Trade Information Warehouse, our clients can be assured that their risks are further mitigated throughout the length of their derivatives contracts.” ~~~~

This was written by cate. Posted on Monday, March 30, 2009, at 3:24 pm. Filed under Creativity, Launching..., Liquidity, Transparency. Tagged CDS, DTCC, OTC, Wall Street. Bookmark the permalink. Follow comments here with the RSS feed. Post a comment or leave a trackback.

But this has some chance of success in my opinion, and so is worth a try

TO BE NOTED: From The Aleph Blog:

"Liquidity and the Current Proposal by the US Treasury

One of the earliest pieces at this blog was What is Liquidity?, followed by What is Liquidity? (Part II). I’ve written a bunch of pieces on liquidity (after doing a Google search and being surprised at the result), largely because people, even sophisticated investors and unsophisticated politicians and regulators misunderstand it. Let’s start with one very simple premise:

Many markets are not supposed to be liquid.

Why?

• Small markets are illiquid because they are small. Big sophisticated players can’t play there without overwhelming the market, making volatility high.
• Securitization takes illiquid small loans and transforms them into a bigger security(if it were left as a passthrough), which then gets tranched into smaller illiquid securities which are more difficult to analyze. Any analysis begins with analyzing the underlying loan collateral, and then the risks of cashflow timing and default. There is an investment of time and effort that must go into each analysis of each unique security, and is it worth it when the available amount to invest in is small?
• Buy-and-hold investors dominate some markets, so the amount available for sale is a small portion of the total outstanding.
• Some assets are opaque, where the entity is private, and does not publish regular financial statements. An example would be lending to a subsidiary of a corporation without a guarantee from the parent company. They would never let and important subsidiary go under, right?
• The value of other assets can be contingent on lawsuits or other exogenous events such as natural disasters and credit defaults. As the degree of uncertainty about the present value of free cash flows rises, the liquidity of the security falls.

When is a securitization most liquid? On day one. Big firms do their due diligence, and put in orders for the various tranches, and then they receive their security allocations. For most of the small tranches, that’s the last time they trade. They are buy-and-hold securities by design, meant to be held by institutions that have the balance sheet capacity to buy-and-hold.

When are most securitizations issued? During the boom phase of the market. During that time, liquidity is ample, and many financial firms believe that the ability to buy-and-hold is large. Thus thin slices of a securitization get gobbled down during boom times.

As an aside, I remember talking to a lady at a CMBS conference in 2000 who was the CMBS manager for Principal Financial. She commented that they always bought as much of the AA, single-A and BBB tranches that they could when they liked the deals, because the yield over the AAA tranches was “free yield.” Losses would never be that great. Privately, I asked her how the securitizations would fare if we had another era like 1989-92 in the commercial property markets. She said that the market was too rational to have that happen again. I kept buying AAA securities; I could not see the reason for giving up liquidity and safety for 10, 20, or 40 basis points, respectively.

Typically, only the big AAA tranches have any liquidity. Small slices of securitizations (whether credit-sensitive or not) trade by appointment even in the boom times. In the bust times, they are not only not liquid, they are permafrost. In boom times, who wants to waste analytical time on an old deal when there are a lot of new deals coming to market with a lot more information and transparency?

So, how do managers keep track of these securities as they age? Typically, they don’t track them individually. There are pricing grids or formulas constructed by the investment banks, and other third-party pricing services. During the boom phase, tight spread relationships show good prices, and an illusion of liquidity. Liquidity follows quality in the long run, but in the short run, the willingness of investors to take additional credit risk supports the prices calculated by the formulas. The formulas price the market as a whole.

But what of the bust phase, where time horizons are trimmed, balance sheets are mismatched, and there is considerable uncertainty over the timing and likelihood of cash flows? All of a sudden those pricing grids and formulas seem wrong. They have to be based on transactional data. There are few new deals, and few trades in the secondary market. Those trades dominate pricing, and are they too high, too low, or just right? Most people think the trades are too low, because they are driven by parties needing liquidity or tax losses.

Then the assets get marked too low? Well, not necessarily. SFAS 157 is more flexible than most give it credit for, if the auditors don’t become “last trade” Nazis, or if managements don’t give into them. More often than not, financial firms with a bunch of illiquid level 3 assets act as if they eating elephants. How do you eat an elephant? One bite at a time. They write it down to 80, because that’s what they can afford to do. The model provides the backing and filling. Next year they plan on writing it down to 60, and hopefully it doesn’t become an obvious default before then. Of course, this is all subject to limits on income, and needed writedowns on other assets. I have seen this firsthand with a number of banks.

So, relative to where the banks or other financials have them marked, the market clearing price may be significantly below where they are currently marked, even though that market clearing price might be above what the pricing formulas suggest.

The US Treasury Proposal

The basics of the recent US Treasury proposal is this:

• Banks and other financial institutions gather up loans and bonds that they want to sell.
• Qualified bidders receive information on and bid for these assets.
• High bid wins, subject to the price being high enough for the seller.
• The government lends anywhere from 50-84% of the purchase price, depending on the quality and class of assets purchased. (I am assuming that 1:1 leverage is the minimum. 6:1 leverage is definitely the maximum.) The assets collateralize the debt.
• The FDIC backs the debt issued to acquire the assets, there is a maximum 10 year term, extendable at the option of the Treasury.
• The US Treasury and the winning private investor put in equal amounts, 7-25% each, to complete the funding through equity.
• The assets are managed by the buyers, who can sell as they wish.
• If the deal goes well, the winning private investors receive cash flows in excess of their financing costs, and/or sell the asset for a higher price. The government wins along with the private investor, and maybe a bit more, if the warrants (ill-defined at present) kick in.
• If the deal goes badly, the winning private investors receive cash flows in lower than their financing costs, and/or sell the asset for a lower price. The government may lose more than the private investor if the assets are not adequate to pay off the debt.

I suspect that once we get a TLGP [Treasury Liquidity Guaranty Program] yield curve extending past 3 years, that spreads on the TLGP debt will exceed 1% over Treasuries on the long end. Why? The spreads are in the 50-150 basis point region now for TLGP borrowers at 3 years, and if it were regarded to be as solid as the US Treasury, the spread would just be a small one for illiquidity. (Note: the guarantee is “full faith and credit” of the US Government, but it is not widely trusted. Personally, I would hold TLGP debt in lieu of short Treasuries and Agencies — if one doesn’t trust the TLGP guarantee, one shouldn’t trust a Treasury note — the guarantees are the same.)

One thing I am unclear on with respect to the financing on asset disposition: does the TLGP bondholder get his money back then and there when an asset is sold? If so, the cashflow uncertainty will push the TLGP spread over Treasuries higher.

Thinking About it as an Asset Manager

There are a number of things to consider:

• Sweet financing rates — 1-2% over Treasuries. Maybe a little higher with the TLGP fees to pay. Not bad.
• Auction? Does the winner suffer the winner’s curse? Some might not play if there are too many bidders — the odds of being wrong go up with the number of bidders.
• What sorts of assets will be auctioned? [Originally rated AAA Residential and Commercial MBS] How good are the models there versus competitors? Where have the models failed in the past?
• There will certainly be positive carry (interest margins) on these transactions initially, but what will eventual losses be?

The asset managers would have to consider that they are a new buyer in what is a thin market. The leverage that the FDIC will provide will have a tendency to make some of the bidders overpay, because they will factor some of the positive carry into the bid price.

I personally have seen this in other thin market situations. Thin markets take patience and delicate handling; I stick to my levels and wait for the market to see it my way. I give one broker the trade, and let him beat the bushes. If nothing comes, nothing comes.

But when a new buyer comes into a thin market waving money, pricing terms change dramatically after a few trades get done. He can only pick off a few ignorant owners initially, and then the rest raise their prices, because the new buyer is there. He then becomes a part of the market ecosystem, with a position that is hard to liquidate in any short order.

Thinking About it as a Bank

More to consider:

• What to sell?
• What is marked lower than what the bank thinks the market is, or at least not much higher?
• Where does the bank know more about a given set of assets than any bidder, but looks innocuous enough to be presumed to be a generic risk?
• Loss tolerances — where to set reservation prices?
• Does participating in the program amount to an admission of weakness? What happens to the stock price?

Management might conclude that they are better off holding on, and just keep eating tasty elephant. Price discovery from the auctions might force them to write up or down securities, subject to the defense that prices from the auctions are one-off, and not realistic relative to the long term value. Also, there is option value in holding on to the assets; the bank management might as well play for time, realizing that the worst they can be is insolvent. Better to delay and keep the paychecks coming in.

Thinking about it as the Government and as Taxpayers

Still more to consider:

• Will the action process lead to overpriced assets, and we take losses? Still, the banks will be better off.
• Will any significant amount of assets be offered, or will this be another dud program? Quite possibly a dud.
• Will the program expand to take down rasty crud like CDOs, or lower rated RMBSand CMBS? Possibly, and the banks might look more kindly on that idea.
• Will the taxpayers be happy if some asset managers make a lot of money? Probably, because then the government and taxpayers win.

Summary

This program is not a magic bullet. There is no guarantee that assets will be offered, or that bids for illiquid assets will be good guides to price discovery. There is no guarantee that investors and the government might not get hosed. Personally, I don’t think the banks will offer many assets, so the program could be a dud. But this has some chance of success in my opinion, and so is worth a try. If they follow my advice from my article Conducting Reverse Auctions for the US Treasury, I think the odds of success would go up, but this is one murky situation where anything could happen. Just don’t the markets to magically reliquefy because a new well-heeled buyer shows up."

1. David Merkel Says:
   March 25th, 20091:19 pm at

   RB — since writing, I have had more time to think.

   Because of the auction process, subsidized funding, and the free put option, this will tend to get the buyers to overpay, which might induce the banks to part with more dud assets. Then the pricing grids will reflect those overstated prices, making the banks look better than they should. The banks get time, but the underlying problems in the eventual cash flows don’t disappear.

   Losses will get taken later by the asset managers, but mostly, by the government. Maybe things will be better then — some suggest that the economics team for Obama is merely playing for time and hoping.

Me:

1. Don the libertarian Democrat Says:
   March 27th, 20098:04 am at

   An excellent post. One of the few commentaries on this plan that I can understand, and relates well to what I actually read in the government White Paper and further comments.

   The holding company post was very good as well.