what hope does that offer for the value of the rest of AIG?

TO BE NOTED: From The Aleph Blog:

"What to ask AIG May 12th, 2009

The Committee on Oversight and Government Reform has asked Ed Liddy and the AIG trustees to testify Wednesday. Here are the questions that I would ask, given my recent piece on AIG.

• Are you going to be able to use all of your deferred tax assets? What level of sustained profitability does that imply, and how are you going to get there?
• Are you going to destack your Life and P&C subsidiaries to avoid double counting of subsidiary capital on a statutory basis?
• If relatively clean and simple subsidiaries like Hartford Steam Boiler and 21^st Century got sold for bargain prices near where AIG bought them, and below book value, what hope does that offer for the value of the rest of AIG?
• You’ve lost a lot of money recently. What do you project to be your level of annual sustainable profitability to be over the next three years?
• There are rumors that AIG is slashing pricing to stay alive in the short run on a cash flow basis. Many competitors are alleging this. Is this true?
• What have happened to your efforts to sell AIA and your asset management arm?
• What has happened to your efforts to sell International Lease Finance?
• How is United Guaranty going to survive amid mounting residential mortgage losses?
• As you wind down AIG Financial Products are you finding “deadweight losses” where the subsidiary was fundamentally mishedged?
• How are you dealing with defections of key personnel, and bad employee morale?
• How are you dealing with increased surrender activity in your domestic life subsidiaries? Will you need more capital as a result?
• Are you going to try to sell Alico?
• Are you going to try to sell AIU?
• What are the core businesses that you are going to keep, and why are they worth keeping?
• How will AIG repay the US Government in full?
• How have you reduced risk in your asset portfolio?

That’s all, and I hope Mr. Liddy, who I have met and I think he is a bright guy, will do well. He is a bit of a bagholder in the AIG mess."

Bubbles are financing phenomena; depressions are financing phenomena. They are opposite sides of the same coin.

TO BE NOTED: From The Aleph Blog:

"Not All Bubbles Lead to Depressions

I enjoyed the opinion piece in yesterday’s WSJ, From Bubble to Depression? I want to clear up a few of their misconceptions. Key quote:

Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

They almost get it in their later paragraphs, but the answer is simple. In the first “crash,” the losses were mainly equity-based, so there were no knock-on effects on other entities. No additional dominoes fell. With housing in the late 2000s, a loss of $3 billion happened on assets that were usually levered with debt at 5x to 30x, probably averaging 10x. And, these mortgages were held by leveraged banks that had borrowed in many other places in the overall financial system, and sometimes by even more leveraged speculators using CDOs.

Let me say it again — Bubbles are financing phenomena; depressions are financing phenomena. They are opposite sides of the same coin. The severity of bubbles differs with the amount of debt employed and the pervasiveness of the sectors of the economy affected. The tech bubble did not have much debt, and it was contained. The real estate bubble was the opposite.

The thing is, the amount of debt we have racked up as a fraction of GDP exceeds that of the Great Depression. My view is that many debts will have to be liquidated before the US economy grows robustly again, whether through payoff, compromise or inflation.

Now, we had Michael Mayo today offering his opinions on the banks, (two, three) which are not all that much different than mine. In an era of debt deflation, coming off record debt-to-GDP ratios, it is next to impossible for the US Government to make any significant difference against the deflation. Better not to try at all. An action big enough for the US Government to absorb the necessary amount of bad debt will kill the Dollar.

This last bubble has led to a depression, because of the debts incurred. We must liquidate debts, but in the process, the economy will suffer. I’m sorry, I like prosperity too, but there is no way out of this period of debt liquidation. Just as the period of debt growth pushed asset prices up, so the period of debt deflation will push asset prices down.

My advice? Avoid almost all banks, and other financial companies sensitive to the stock market or real estate, in terms of both equity and bond investments.

1. David Merkel Says:
   April 7th, 200912:09 pm at

   Logan, I’m not ruling it out. I’m saying there would be a cost attached. Some problems with collateral values could be solved through inflation, passing the costs to those who cannot hedge fully, which is most of us, but especially the elderly and foreign creditors.

   I’ve been asked about the effect on gold and other hedges — I do think that inflation will be one of the tools that the government/Fed uses to get out of this crisis, and it will have a positive effect on all inflation hedges. In the short run, though, Ben Bernanke is determined not to let any the liquidity that he is monopolizing leak out into the broader economy; I think he is trying to fight a depression without creating any inflation, which I think is an unusual intellectual conceit. I’m just not sure how long the condition will last.

   Oh, and regarding bonds — since someone else asked: I like TIPS, foreign short-to-intermediate bonds, conforming RMBS, Short-to-intermediate corporates BBB and lower but not of financials (except a few stray insurers).

Eventually, there is a tipping point where the investor realizes that things are so bad, that it is better not to invest any more

TO BE NOTED: From The Aleph Blog:

"Replace the Car or Repair It?

It is a tough practical decision — when do you replace a car versus repairing it? There isn’t an easy answer, but the intelligent way to approach it is to estimate the present value of the cost of continually repairing the old car versus the cost of buying a new one, net of the sales proceeds of the old car.

It’s a tough decision, with many squishy variables. Nonetheless, it is the right way to frame the question. It is also the right paradigm for a number of other questions.

• When will the US give up on bailing out AIG (or any other firm)?
• When will the US Government default, or decide to inflate massively?
• When will China and the Arabs decide that “sunk costs are sunk” and abandon the US and the US Dollar?

After investing in an investment that proves to be bad, the question crops up, “Should I buy more? If I liked it at 25, don’t I love it at 15?” The same thing with govenment decisions, except that they are writ larger.

Eventually, there is a tipping point where the investor realizes that things are so bad, that it is better not to invest any more, because it would be throwing good money after bad. Replace the car, repairing it will cost too much.

In this uncertain environment, that is what we are facing now:

• What will the US do with marginal firms? AIG or Lehman treatment?…
• When would the US give up on issuing more debt?
• When will foreigners give up on buying US debt?

None of these are necessarily second quarter 2009 issues. Neither is a car replacement; I can just repair it for now.

My advice is to start thing ahead, and ask when parties that you rely on are likely abandon ship. Then change your investment processes to avoid the likely path of disaster. This is messy, but it is the best way to operate."

Some reward should come to those that did it well

TO BE NOTED: From The Aleph Blog:

"The Bonus Canard in Financials

It was 2000 when I received my first significant bonus check working for a financial company as part of an investment department. Now don’t get me wrong, as an investment actuary at prior firms, I took on complex projects that no one else could do, and I did them not for any bonus that I might receive, but just to do my best. My bonuses were maybe 3-5% of my pay, and I was happy with them. That the NPV I created for the company was 5,000x that did not bother me. I work to do my best. I have turned down higher paying jobs that would hurt my family, but I love intellectual challenges, whatever they pay. (I tell this story in greater detail to younger people in investments, in order to show them that we do our work to do our best, regardless of the compensation.)

Now, in 2000, when my boss gave me the check, I looked at it and thought there must be an error. He told me that he was very happy with my work, and that we had all hit the top of the scale in our bonus formulas. He told me to invest it wisely. (How I invested it is another story, and one worth telling later.) I thanked him, and then called my wife, telling her that I had a check for 105% of my salary. We were amazed.

I didn’t get it, so I went back to my boss several days later, and asked him why the bonus was so large. We had a good relationship, and at the time, I didn’t realize that I was slowly becoming his main assistant. He told me, “The St. Paul wants its investment managers to focus on safety, not short-term returns. But they compete for investment talent among other investment firm that do swing for the fences. They want smart people, but they don’t want them to take undue risks. That’s why they make the bonuses easy to get, unless we lose a lot of money.”

That made sense, but it made me think that my real pay was double what I signed up for. Wow. I did not realize what a good deal I had. Double my pay to make money for the company, but keep it safe. That’s a challenge I could love.

When we merged into another firm that had the opposite philosophy, my pay went up, but my bonus went down in percentage terms. I would make more money if I took more risk, but I maintained the same behavior, because I serve a higher power than money.

At my next firm, my bonus was not predictable. Whether I did well or badly, I could not figure out how I would receive a bonus.

My main point here is that there is no one correct bonus formula. We can bonus for performance and/or safety, over short and/or longer horizons. It is easy politically to criticize the bonuses at AIG, because why whould a losing firm give bonuses, but perhaps employees did the right thing in their area of the company, while other areas failed. Some reward should come to those that did it well."

We are dealing with something not normal over the last 70 years, and overall market values are reflecting that

TO BE NOTED: From The Aleph Blog:

"Of Course not at Par; That’s Par for the Course

There are several truths well-known to educated investors that have been glossed over in all of the discussions of mark-to-market accounting, or SFAS 157. (Really SFAS 133, but SFAS 157 clarified it.)

• Accounting rules have little impact on stock prices. Almost every academic study on accounting rules supports that idea. Why? Investors attempt to estimate the stream of free cash flows that an asset will throw off. Accounting rules can help or hinder that. Because SFAS 157 attempts to calculate a present value of cash flows for level 2 and 3 assets, it aids in that estimation.
• Parties involved confuse regulatory with financial accounting. Mainly due to the laziness of financial corporations in the boom phase of our markets, they looked to minimize effort, and make the accounting the same for regulatory and financial purposes. This was foolish, because there is no one accounting method that is ultimate. Every financial statement answers one main question. For GAAP, the balance sheet asks “What is the net worth?” Regulatory accounting would ask “Is net worth positive under conditions of moderate stress, including the possibility that markets go illiquid, and we have to rely on cash flows to pay off the liabilities?”
• There are always two ways to do accounting. You can do mark-to-market, or you can do book value accounting with impairment. Darkness encourages skepticism. In a period where there are few credit risks, book value accounting will be well-received. In an era where credit risks are significant, book value accounting will be no help, investors will distrust book value, and the effect might be less than where fair value estimates are provided. Regardless, the cash flows will still flow.
• Equity-like investments deserve equity-like accounting. They should be market to market, as equities are. With derivatives, this is the reason that we mark them to market, their values are so variable. So we should mark speculative mortgage investments: estimate the future cash flows, and discount them at a high, but not equity-like interest rate.
• But what of assets that are seemingly money good, but the few trades that have happened indicate a value at 60% of par, possibly because of The Bane of Broken Balance Sheets, or Time Horizon Compression. Here’s the problem: we have a lot of people alleging that those values can’t be right. Let them stand up and start buying to prove it all wrong. Part with precious liquidity to gain uncertain yield. It is quite possible that we are in a depression, and as such, there are too many assets relative to the ability to fund them — asset values must fall. Don’t immediately assume that the few trades in the market are ridiculous because they are lower than your current marks.
• Some argue that there is an inconsistency between loans and bonds. Bonds get marked to market, while loans are marked at book. There is no inconsistency. The loans are held to maturity, unless sold. The bonds could be held to maturity as well, in which case they are at book value, and only changed if there is a need for a writedown, the same as the loans. Most companies have not chosen that option, largely because they want the right to sell assets if they want to. But that locks in their accounting; if they want the ability to sell, they must accept balance sheet volatility.
• We have to differentiate SFAS 157 from misapplications of SFAS 157, which might be driven by the auditors. SFAS 157 does not mean last trade. In thin markets, companies are free to use discounted cash flow and other analyses to estimate fair value.
• Now all of this said, practically, SFAS 157 leads to overestimating the value of assets. In the consulting work I have done, companies are not willing to mark their volatile assets down to levels near their fair value, much less last trade, which is worse. They are hoping for some huge return of risk-taking to appear, and revalue their assets. What if present conditions persist for five to ten years, where there are too many debts relative to the wilingness to fund them, as in the Great Depression? In that situation, SFAS 157 would prove to be too flexible, with banks marking assets higher than warranted.

The anti-SFAS 157 arguments rely on an assumption that things aren’t so bad — that mean-reversion is right around the corner. We are in a situation where marginal cash flows to purchase dud assets aren’t there. Mean reversion is a long way off, and the valuations of financial assets reflect that consistently. Try selling a bunch of whole loans held at par. See what the offers are. Why aren’t banks doing that to raise liquidity? Because the prices don’t justify it.

You can’t fight cash flows. Accounting exists to partition cash flows into periods, so that analysis of businesses can be done, and debt financing can be secured. In the end, cash flows win out, regardless of the accounting methods.

Thus my opinion: SFAS 157 is a good standard, and I am no fan of the FASB generally. There are misapplications of SFAS 157, forced by auditors, I believe. SFAS 157 already offers decent flexibility to management teams — let them use that flexibility, but no more. After that, let the regulators set their own solvency rules.

-==-=-=–==–=-=-=-==–=-==-=-=-

PS — What foes of SFAS 157 are unwilling to admit, is that lenders lent money near the peak of an amazing bull market, and now the collateral values lent against are far less than imagined at the time of lending.

It’s like the FRAM oil filter ad — “you can pay me now or pay me later.” There is a great deal of hubris involved in arguing that the market as a whole is out-of-whack. (Much as I had hubris toward the end of the bull phase… let me stab myself.) In ordinary bear markets, there is some strength somewhere to support asset values. That is not true now. We are dealing with something not normal over the last 70 years, and overall market values are reflecting that. Eventually accounting values will get there, as they did in the thirties."

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.

The nature of a holding company is to be a financing vehicle.

TO BE NOTED: From The Aleph Blog:

"Holding and Operating Companies March 25th, 2009

Around 25 years ago (I feel old), I was a teaching assistant at UC-Davis. I was nominated for the best teaching assistant twice, but never won the prize. That was fine with me. I did my best, whether rewarded or not.

My love of teaching is what drives me to write this blog. I like to think that I am a good teacher, much as I know that I am not perfect at it.

A reader asked me to explain the difference between holding and operating companies. I will do that here, realizing that I am summarizing a complex subject.

The nature of a holding company is to be a financing vehicle. The holding company owns (holds) other operating companies, and receives dividends from them. The holding company pays interest on its debts, and dividends to shareholders, if any. A holding company is a means of controlling a number of operating companies with somewhat disparate goals. Certain common functions are centralized, like accounting, finance, human resources, etc.

Now the operating companies are typically at the lower level of the holding company structure, and there may be holding companies held by holding companies, before getting to the operating companies below.

Typically the owners of stocks and bonds own securities from holding companies. There are operating company bonds, and sometimes stocks trade where the holding company does not own 100%. Those are unusual.

Holding companies exist to organize operating businesses into a coherent whole. It may not always succeed, but that is the goal."

It will probably take some disaster to dislodge the US Dollar, and force the changeover

TO BE NOTED: From the Aleph Blog:

"Translation: We Really, REALLY, Hate You Guys!!

From an earlier post, point 4:

“We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.” [emphasis mine]

So said Mr. Luo, a director-general at the China Banking Regulatory Commission. I’ve been saying for a long time that China is stuck, and that we are their problem, and not vice-versa. There may come a point where they stop buying US Dollar-denominated debt, and let existing debt mature, but that will come after a shift in their own economy where they are no longer driven bythe promotion of their exports. There aren’t many large good alternatives to US debt for parking the proceeds from exporting aggressively.

So today, we get another volley from China as they realize that they are stuck holding US Dollar denominated assets that they are more certain than ever will depreciate. They see injustice in having bought too many dollars in exchange for the exports they paid to promote to the US. Excerpting from the article:

People’s Bank of China Governor Zhou Xiaochuan said he wants to replace the dollar, installed as the reserve currencyWorld War II, with a different standard run by the International Monetary Fund (IMF). after

China, the top holder of US Treasury bonds with 739.6 billion dollars as of January, according to American figures, earlier expressed concern over its investment as the world’s largest economy battles a deep recession.

“The outbreak of the crisis and its spillover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system,” Zhou wrote in an essay posted on the bank’s website Monday.

Zhou’s comments come ahead of the G20 summit from April 2 in London, where world leaders and international organisations including the IMF are to discuss reforming the financial system.

He suggested the IMF’s Special Drawing Rights, or SDR, could serve as a super-sovereign reserve currency as it would not be easily influenced by the policies of individual countries.

Russia has also proposed the summit discuss creating a supranational reserve currency. The IMF created the SDR as an international reserve asset in 1969, but it is only used by governments and international institutions.

“The reform should be guided by a grand vision and start with specific deliverables,” Zhou wrote. “It should be a gradual process that yields win-win results for all.”

However, China’s proposal was unlikely to lead anywhere because the SDR is not a currency system backed up by a government, independent Shanghai-based economist Andy Xie said.

Xie said the proposal was probably a protest aimed at Washington’s plan to buy one trillion dollars of its own debt, diluting the value of China’s dollar reserves and raising fears of inflation.

“It’s a sad situation: China is America’s banker. America owes so much to China, but it’s not afraid of China,” he said. “China is America’s hostage. It’s not the other way around.” [emphasis mine]

As the world’s main reserve currency, US dollars account for most governments’ foreign exchange reserves and are used to set international market prices for oil, gold and other currencies.

As the issuer of the reserve currency, the US pays less for products and borrows more easily.

Strategic Drawing Rights are a cute idea, but it would be too small to support global trade. Like the Euro, it is a political construct, but one with less dedicated political and economic support.

As I commented in my piece, It is Good to be the World’s Reserve Currency, there’s no good alternative to the US Dollar yet. Like the mercantilists of old, who bought gold dear, and sold it cheaply, so will it be for China — they bought US Dollar claims dear, but will sell them more cheaply. This is the price of forced industrialization.

There will come a time when the US Dollar is no longer the world’s reserve currency, but there needs to be a worthy competitor, or a willingness to do without a single clearing unit. This is an age of computers, so there does not need to be a single dominant unit of exchange, but habits die hard. It will probably take some disaster to dislodge the US Dollar, and force the changeover. Whether that comes through inflation, default, partial default, or war remains to be seen."

That is the Ponzi definition of solvency. So long as there is an unclaimed dollar in the till, the financial institution is solvent.

From the Aleph Blog:

"When is a Financial Company Insolvent?

Every now and then, I see a stupid post saying that a financial company is solvent if it is still making timely payments on its liabilities. That is the Ponzi definition of solvency. So long as there is an unclaimed dollar in the till, the financial institution is solvent.

To this I say “hooey.” Financial institutions don’t have all that much to them. They are just a bundle of promises. “Parties I have lent to will pay me more than parties I have borrowed from.” They are a bundle of longer-dated accruals. The value of assets and liabilities can’t be firmly fixed in the same way that those of an industrial company can. In that same sense, the current value of assets versus liabilities in a financial firm correlates highly with the trading value of its equity.

So when a financial company has a negative net worth on a fair market value basis, the odds of the common stock being wiped out is high. Could the market come back? Yes, but the odds are less than even.

This is my way of saying that regulators should take control of operating financial companies when the fair value of their net worth goes negative. Like a good technical trader, honor the stop-loss."

Me:

1. Don the libertarian Democrat Says:
   February 21st, 200911:21 am at

   “Every now and then, I see a stupid post saying that a financial company is solvent if it is still making timely payments on its liabilities. That is the Ponzi definition of solvency. So long as there is an unclaimed dollar in the till, the financial institution is solvent.”

   A very good point.This view might explain why Ponzi Schemes seem like an unsolvable puzzle. They mimic working investments for quite a long time, in the sense that they are making payments, which is what many investors mainly care about, not looking under the hood. My only question about Ponzi Schemes is: Where is the hood?

This blog post alleges that US money market funds faced a calamitous withdrawal on 9/18/08

From the Aleph Blog:

"The Story Not Told?

I’m tossing this out for comment. This blog post alleges that US money market funds faced a calamitous withdrawal on 9/18/08, and the US Treasury put a stop to it , and then announced the TARP, etc.

I viewed the recommended video, and indeed Paulson says little, but might hint at bigger things.

But we have better information from the Joint Economic Committee of Congress. Let me quote from this on page 9:

Breaking the Buck Causes Runs on Money Market Mutual Funds. On Monday September 15, 2008, the $62 billion Reserve Primary Fund, a money market mutual fund, “broke the buck” because of its investment in Lehman Brothers’ short-term debt securities. The Reserve Primary Fund suspended redemptions for one week.
On June 30, 2008, money market mutual funds had total assets of $3.3 trillion of assets. Among these assets, money market mutual funds held $701 billion of commercial paper, or about 40 percent of all commercial paper outstanding. “Breaking the buck” at the Reserve Primary Fund caused investors to question unnecessarily the soundness of other money market mutual funds.
Irrational runs on money market mutual funds began. For the week ending on Wednesday September 17, 2008, investors redeemed $145 billion from their money market mutual funds. On Thursday September 18, 2008, institutional money managers sought to redeem another $500 billion, but Secretary Paulson intervened directly with these managers to dissuade them from demanding redemptions. Nevertheless, investors still redeemed another $105 billion. If the federal government were not to act decisively to check this incipient panic, the results for the entire U.S. economy would be disastrous.
1. To satisfy redemptions, money market mutual funds slashed their holdings of commercial paper. Commercial paper outstanding fell by $52 billion during the week ending on Wednesday September 17, 2008 as money market funds refused to rollover commercial paper. If this trend continued, major non-financial firms would
a. Lose their primary source for short-term borrowing, and
b. Call upon their back-up lines of credit with commercial banks.
2. Given the extreme funding problems commercial banks were encountering during the week, commercial banks would either:
a. Slash credit to small- and medium-size non-financial firms and households to meet the line of credit commitments to large non-financial firms, or
b. Not be able to fulfill the line of credit commitments to large non-financial firms at all.
3. The result would be a disabling credit contraction that would trigger a severe and lengthy recession with large declines in production and employment, further erosion in household wealth, and a significant increase in the federal budget deficit as countercyclical outlays soared and tax receipts dwindled.
Birth of a Comprehensive Plan. This run forced Chairman Bernanke and Secretary Paulson to reassess the federal government’s previous ad hoc approach to the global financial crisis. Together Bernanke and Paulson concluded a comprehensive plan was necessary to (1) restore confidence and (2) kick start credit markets into functioning again.
To stop the runs on money market mutual funds and to revive the market for commercial paper, Chairman Bernanke and Secretary Paulson acted swiftly on Friday September 19, 2008.1. Secretary Paulson announced a temporary program through which the Treasury will use the $50 billion in the Exchange Stabilization Fund to protect investors in money market mutual funds from any losses should their fund “break the buck” during the next year. Money market mutual funds will pay an insurance premium to the Treasury for this guarantee.

2. The Federal Reserve established two loan facilities to help money market mutual funds meet any demand for redemptions.
a. The Federal Reserve will extend non-recourse loans of up to $230 billion to banks and other depository institutions to buy investment-grade asset-backed commercial paper from money market mutual funds.
b. The Federal Reserve will extend non-recourse loans to primary dealers of up to $69 billion to buy short-term debt securities of Fannie Mae, Freddie Mac, or FHLBs from money market mutual funds.

So is that why our government acted so precipitously? To rescue the money markets? That seems to be true, but after a shutdown of withdrawals, the government could have simply quietly bailed out a few funds, and the crisis would have passed. Instead, they panicked, and opted for an unwarranted wider solution, the TARP.

There would have been better ways to deal with runs on money market and other funds, but the government uses old models in their economic reasoning."

Me:

1. Don the libertarian Democrat Says:
   February 15th, 200911:43 am at

   I agree with Kurt, in the sense that the Money Market redemption threat was a way of finding out how far the government would go in financially intervening. From the prior Sunday, and the special trading session, many investors knew that, if Lehman went down, Merrill could follow quickly. In other words, a Calling Run ( Debt-Deflation ) was possible. When Lehman hit, the government aided AIG, the B of A bought Merrill, and the government essentially guaranteed Money Market Funds. All of these actions suggest to me that the government understood that we might be in a Calling Run. The mystery is why they have chosen such odd methods to stop it, other than generally admitting that the government is on the hook.

   For me, a Calling Run is different than just redemptions in one area. Since no one knew who or how much anyone was committed to mortgages or mortgage related securities, and they could see a huge fall in prices and a tsunami of defaults coming, people started calling in cash in all sorts of investments, some only tangentially connected to mortgages. This also showed in the flight from agencies to treasuries, from implicit to explicit guarantees.

   Once a Calling Run begins ( Fisher’s Debt-Deflation ) only the government can stop it, because only the government has the assets available to be believable in easing wipe-out concerns. The government has been trying to do this ever since, but poorly. The whole point of the total guarantee is to stop the run, and allow an orderly exchange of assets and losses, not keep it going, only in slow motion.

   I like your plan, and would be inclined to support it, but not here. Again, for me, since many smart people saw this as a possibility, including Bernanke, I simply can’t explain their poor choices.

   You know more than me, but that’s how I see it. By the way, paradoxically, even though I believe that we needed to honor these guarantees in this instance, I believe that these implicit guarantees are the main cause of this crisis. In this, I seem to be alone. For me, nothing else explains the risk taken by major banks and investment firms.

Depressions, and severe recessions, attract protectionism

From the Aleph Blog:

"Depressions Attract Protectionism

Depressions, and severe recessions, attract protectionism. It’s the nature of the beast. So long as political pressures are “to do whatever it takes to create prosperity” at home in the short-run, governments will target spending to domestic firms (an increasingly squishy concept in a global world). What politician would defend to local constituents a bailout package where foreign firms directly benefit from the expenditure of domestic tax dollars?

Though I did not vote for him, I appreciate the principled approach that President Obama is taking here. He is taking a longer view, and wants to avoid trade wars. Few politicians take the longer view; that is why they not statesmen.

By their nature, economic crises make people short-termers. They look to what will help themselves survive amid volatility. The long-term good of many would involve patience, and a willingness to not press for short-term advantage. Perhaps Kings could do that, though often they didn’t, but democratic officials are on a short leash from their electorates.

Even Authoritarian places like China tend toward protectionism, though. Their legitimacy is based on their ability to deliver continued prosperity. There is increasing unrest in China during this slowdown; expect the Chinese government to do what it can to appease its populace, including measures that protect local businesses.

That’s why I am not surprised at protectionist impulses at this time. They are short-term rational for politicians, while long-term irrational for economies. This is just another reason why we are foolish to trust in politicians to assure our economic well-being. Their short-term orientation is out of sync with what it takes to manage an economy.

We will be best off if after this crisis we realize that the government played a starring role in creating it, and mismanaging it. Were there businessmen to blame? Yes, but they took their cues from financial regulators that stopped regulating, and an accomodative monetary policy. The government did not do its job right, assuring the value of currency/credit.

=–=-=-==–=-=-=

Additional Notes:

1) Now Barney Frank wants to hand over oversight of systemic Risk to the Federal Reserve. As if they can do their current job well — the Peter Principle is in action here. I was joking about it last year, but why not create the Federal Office for Oversight of Leverage [FOOL]? After all, the tasks of monetary policy are considerably different from those of containing systemic risk, even though they are related.

2) Speed really benefitted us during the original passage of the TARP, right? No, it didn’t. So where does Timothy Geithner get off urging speed at this point? Speed does not eliminate bad debts. Speed does allow for many venal legislators to push their own pet projects, and use a crisis to disguise their efforts.

3) Read Yves Smith’s piece:The Bad Bank Assets Proposal: Even Worse Than You Imagined. Our government resists letting banks fail, and then letting the FDIC/RTC2 reconcile them. They would rather intervene to let marginal or defunct entities live."

Me:

Don the libertarian Democrat Says:
February 4th, 200910:48 am at

I have a slightly different reading on this. There is a major problem with the Saver/Export Country /Spender Country Symbiosis. One way to ease this would be for the Spender Countries to increase exports to Saver Countries. I see this proposal as a trial balloon to see how this policy might go. In other words, we can export more goods to you, or you can export less goods to us. Which would you prefer?

but if I fail to define something adequately, let me know in the comments, and I will add an entry to the new Jargon page.

If you read my blog ( Cate ), you know that I try and simplify things. In that spirit, two excellent posts. First, from The Big Picture, a good resource:

Killer glossary via the BBC:

click for full crisis glossary

>

Source:
The layman’s finance crisis glossary
BBC, 10:14 GMT, Thursday, 8 January 2009
http://news.bbc.co.uk/2/hi/uk_news/magazine/7642138.stm

PERMALINK"

Please keep this. And, from the Aleph Blog:

"Jargon

When I was an actuary interacting with the investment department inside a life insurance company, one of the things that I learned early was that there was an inpenetrable jargon on the part of the bond investors that neophytes had to learn. My boss, the best actuarial businessman that I have ever known, insisted that we have a weekly meeting with the investment department, and in their offices. Being on their own turf made them freer to talk their own lingo, and that helped us learn it.

When I went to work in an investment department years later, the shoe was on the other foot. I was still learning investment lingo, but when the actuaries showed up, I was there to translate. Not surprisingly, there is jargon on both sides, often with the same term having two different names, because it is used two different ways.

It was true until the day I left the firm, where I heard a bond term I had never heard before. We have a lot of jargon in investing, whether it is fixed income or equities. There is additional jargon in insurance.

Here’s my offer: I try to define what I write about, but if I fail to define something adequately, let me know in the comments, and I will add an entry to the new Jargon page. Let me know; I live to serve."

This is a great offer. More blogs should do this.

"This is not a costless exercise in fairness."

David Merkel on the Aleph Blog:

"Cramming Down on Whom?

I favor cramdowns for now, becauseLike the recently departed Tanta at Calculated Risk, I also favor the concept of cramdowns in mortgage foreclosure proceedings. It would bring balance to the negotiations, and discourage banks from making bad loans. If a bank could be forced to compromise during a foreclosure (odd because it is secured lending), the result could leave more homeowners in their homes, and with mortgages where the principal balances reflect current conditions.( THESE ARE GOOD ARGUMENTS, BUT I DO NOT FAVOR THIS. )

In order for loan modifications to work, there has to be forgiveness of principal owed( I AGREE ), though perhaps by granting the banks a part of the upside if the property is sold at a gain in later days( I AGREE ). Forgiveness of principal allows the LTV ratio to remain whole, while reducing the payment at the same time.

But what does that do to the banks? The cramdowns cram immediate losses onto the banks. What if the actions of judges lead to the insolvency of banks? What if the possibility of future cramdowns lead mortgage rates to rise, in order to account for the risk? This is not a costless exercise in fairness.( I DON'T WORRY SO MUCH ABOUT THIS, BECAUSE THE JUDGE CAN REVIEW ALL SUCH CONCERNS. I SIMPLY DO NOT ACCEPT THE COURTS OR GOVERNMENT FORCING LENDERS TO TAKE A LOSS. IF WE, AS TAXPAYERS, WANT TO SOLVE THIS CRISIS OF LOAN MODIFICATIONS, WE SHOULD ALL PITCH IN BY HAVING THE GOVERNMENT BUY THE MORTGAGES FROM THE LENDERS AT AN AGREED DISCOUNT. IT WOULD COST THE TAXPAYERS A LOT OF CASH, AND MORE OR LESS MAKE LENDERS WHOLE, BUT THAT'S FAIRER THAN FORCING LENDERS TO LOSE MONEY FOR THE SOCIAL GOOD. I SUPPOSE YOU EITHER SEE MY POINT OR YOU DON'T. )

Articles on the cramdown proposal:

• Lawmakers set new mortgage bankruptcy bill
• Stimulus Package to Include Cram-Downs: Report
• Banks to Lose a Security Blanket
• Plan to Cut Foreclosure Rate Clears Key Hurdle

I favor cramdowns for now, because it can be a win-win for the borrowers and banks( IF IT IS, IT SHOULD BE POSSIBLE TO NEGOTIATE THESE LOAN MODIFICATIONS WITHOUT FORCE. ). Leave the homeowner in place, who values the home, while making him pay something close to maximum sustainable monthly amount.

It makes the system more flexible, and at this point, that is a good thing."

I agree with ends, but not the means, although I grant that it is well intentioned.

"I will defend SFAS 157, and the other mark-to-market accounting standards, but I won’t defend an application of them that is too rigid. "

David Merkel on the Aleph Blog with a post that I agree with:

"Fair Value Accounting — It Is What It Is December 27th, 2008

I’ve written on mark-to-market accounting before. Searching my blog, I was surprised to find how many pieces I have written in 2008 on the topic.( A GOOD RESOURCE )

• Pandora and the Fair Value Accounting Rules
• Mark-to-Market Accounting Is not the Major Problem
• The Economics of SFAS 157
• Accounting Rules Do Not Affect Cash Flows
• Illiquid Assets Financed by Liquid Liabilities (Or, why were you playing near the cliff?)

So, it’s interesting to me to see the FASB interested in continuing with Fair Value accounting, despite all of the criticism. It’s not to say that MTM accounting is perfect — all accounting methods are approximations and are imperfect, but does it convey the best information needed for investors to make reasonable decisions, at an acceptable cost?

If MTM accounting were proposed in the ’80s it would never have been approved. The value of common financial instruments did not usually change much( GOOD POINT ); unless an equity had a public market, revaluations occurred only for reasons of impairment. But derivatives and structured security prices vary considerably, and their prices often vary in a way that approximate valuations can be calculated from the prices of other publicly traded securities( YES ).

Now, that many financial companies trade below their net worth is a proof in this environment that investors don’t trust the value of the assets, nor their earning power. Many assets have not been marked down to their fair value( I AGREE ).

I will defend SFAS 157, and the other mark-to-market accounting standards, but I won’t defend an application of them that is too rigid( I AGREE ). When trades are infrequent, and there are strong reasons why the security deserves a different value than last trade, then let the security be marked to model( A GOOD PROPOSAL. I HAS PROPOSED DOING BOTH, WITH MTM BEING NECESSARY, AND ALLOWING FMV IN CERTAIN CASES ). It is the best that can be done. But merely that a security is at an unrealized loss for several years should not in itself be a reason to mark the security down, if the management concluded that it was “money good.” (they get their principal back.)

The mark-to-market rules as stated have flexibility in them, aiming for a fair statement of the net worth of the firm. Given the nature of the investments and hedges employed, this is a good thing if done properly and fairly.

Can these rules be used to distort accounting? Of course, in the short run. In the intermediate-term, the errors catch up, and destroy the cheater. In the long run, cash flows determine the value of a business.

So, be wary in the present environment. Just because a financial institution trades below book value does not mean that it is cheap. Much of the cheapness stems from the opaqueness in pricing of unique risks( TRUE. I WOULD ADD FEAR. ).

The challenge is analyzing what an asset is truly worth, and when that value can be realized. That is the challenge with financials today."

His plan might be a better solution than mine.

"For a classic understanding of central banking, do not read Ben Bernanke. Instead, read Walter Bagehot."

David Merkel on the Aleph Blog with a review of one of my favorite books:

"This is a wonky book, and not for everyone. It details the actions of monetary policy in the United Kingdom for much of the 19th Century. In Great Britain, that was a century of incredible growth, and yet stability of the overall price level. The Gold Standard worked, and the UK Government di not try to cheat on it, as it did in the early 20th century before the Great Depression.

One of Bagehot’s main ideas was that during a crisis, central banks should lend at a penalty rate without limit, and that would re-liquefy the marginal banks in the system that just needed a little to get by. Bad banks would fail; good banks would not need to borrow. We can contrast that with present policy of the Fed to lend against marginal collateral at favorable rates. Ain’t no chance of us getting out of the problem that way. All we do is create a new class of arbitageurs to extract money from the taxpayers, or Treasury note buyers.

The mangement of a good central bank is very conservative, and keeps a reserve large enough to avoid all disasters. This again is the diametric opposite of the Federal Reserve, which was not in a conservative posture, and believes it can solve all of the credit problems through the wanton expansion of its balance sheet.

For a classic understanding of central banking, do not read Ben Bernanke. Instead, read Walter Bagehot. If you want to buy it, you can find it here: Lombard Street: a description of the money market. Or, you can get it for free here.

PS — Remember, I don’t have a tip jar, but I do do book reviews. If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don’t pay anything extra. I’m not out to sell things to you, so much as provide a service. Not all books are good, and not every book is right for everyone, and I try to make that clear, rather than only giving positive book reviews on new books. I review old books that have dropped of the radar as well, like this one, because they are often more valuable than what you can find on the shelves at your local bookstore.( IF YOU BUY THE BOOK, DO IT THROUGH HIS WEBSITE )

"But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed"

David Merkel on The Aleph Blog with a list:

"1) There are firsts for everything. Americans paid down debt for the first time, according to a Federal Reserve Study that started in 1952. America has always been a pro-debt and pro-debtor nation( SPENDER NATION ). It goes all the way back to the Pilgrims, who paid back the merchant adventurers who funded them at a rate of nearly 40%/yr over a 15-20 year period. But, the Pilgrims did extinguish the debt. Us, well, I’m amazed at the decrease, but we need more of that to restore normalcy to financial institutions.

2) Dropping to 45%, though, is the amount of aggregate home value funded by equity. With the decline in housing values, the fall in the ratio was inevitable. The low ratio puts downward pressure on home prices, because it means that more homes are underwater ( IT STILL HAS A GOOD SIDE ). Perverse, huh?

3) It’s a long interview, but Eric Hovde (my former boss) has a lot of important things to say regarding the financial sector. Few hedge funds focused on financials remained bearish on the sector, but Hovde’s funds survived to 2007-2008 where his bets paid off.

4) Is there a Treasury bubble? Yes, but it may persist for a while because of panic, central bank buying, buying from pension funds and endowments, mortgage hedging, and more( TRUE ).

5) Now these same low yields whack Treasury money funds. How many will close? How many will cut fees? How many will break the buck, and credit negative interest? An unintended consequence of monetary policy. Another unintended consequence reduces liquidity in the repo markets. Yet another unintended consequence is the reduction in investment from Japan and other nations that don’t want to hold dollars at low rates( WHO KNOWS? ).

6) Brave Ben Bernanke is fighting the Depression. If his theories are right( I AGREE WITH BERNANKE ) (and mine wrong), if he succeeds, he will face a difficult challenge in collapsing the Fed’s balance sheet as inflation re-emerges, without taking the wind out of the economy ( TRUE ). But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed and the US Government to handle( TRUE ).

7) Inflation is the lesser evil at this point.( I AGREE ) It would raise the value of collateral over the value of the loans, dealing purchasing power losses to those that made the bad loans, but not nominal losses.

8 ) I have said before that the Fed and Treasury are making it up as they go( TOO MUCH ), and Elizabeth Warren now confirms it for the Treasury. My Dad (turned 79 yesterday) used to say, “The hurrier I go, the behinder I get.” So it is for the TARP bailout( A HYBRID ). Policy made hastily rarely works. Spend more time, get it right. The market won’t die as you work it out.

9) But will AIG die, or the automakers?

• Sales are slow for assets at AIG. ( THEY WILL BE. BUYERS CAN TAKE THEIR TIME ) (no surprise valuations are crushed, and all likely buyers face lower P/Es and higher debt costs.)
• And who knows where the writeoffs end? As I said long before the failure of AIG, don’t trust the financial statements ( TRUE ). The palce was too complex, and the culture of fear inhibited objective financial reporting.
• GM’s suppliers are seeking cash. Just one of the costs of financial stress.( WOULDN'T YOU )
  
• Suppliers worry over a lack of demand if the automakers fail. They should retool for Japanese and European automakers. ( MAYBE )
  
• From Credit Slips, the important idea is that without a good business plan the automakers are toast anyway. I predict they will be back hat in hand in half a year even with a bailout( THEN WE CAN LET THEM FAIL ).
• A GM bankruptcy would take a long time, and a prepack would not get done before the cash runs out. Maybe, but I would still take it through bankruptcy, with the US Government as the DIP lender. ( THE BAILOUT NEEDS TO BE SEEN AS JUST THAT, BOTH FOR SOCIAL REASONS DEALING WITH PERCEPTIONS OF FINANCIAL TYPES BEING THE ONLY ONES SAVED, AND THE GOVERNMENT GUARANTEES ARE ESSENTIAL TO GETTING OUT OF THIS . THAT'S WHY INVESTORS ARE FLEEING AGENCIES FOR TRASURIES )
  

10) Even VCs are looking at the survivability of their portfolio holdings. Who can survive and become cash-flow positive in a tough environment. Who needs little additional funds?

11) Leveraged loans are attractive, but it is a situation of too many loans with too few native buyers. Watch the loan covenants, so that you can get good recoveries in a default. If you are an institutional investor, this is a place to play now that will deliver reliable returns net of defaults. For retail investors, the closed end funds typically employ too much leverage — it is possible that one could collapse before this crisis is over.

12) Residential mortgages continue to weaken along with property prices. Two examples: Alt-A loans and second mortgages.

13) I have a lot of respect for Dan Fuss. This is a tough time for anyone taking credit risk. That said, it could be a good time to take on credit risk now, if you have fresh money to deploy.

14) Two views of the crisis: one that focuses on structured finance, particularly CDOs, and one that focuses on macroeconomics. I favor the latter, but both have good things to say.

15) Michael Pettis is one of my favorite bloggers. He notes the weakness in China, and notes that the current economic situation is ripe for trade disputes. ( I'VE BLOGGED ABOUT THIS POST )

16) You can give the banks funds, but you can’t make them lend. Would you lend if you didn’t have a lot of creditworthy borrowers? ( YOU CAN MAKE THEM LEND )

17) The export boom is dead, for now. Fortunately, imports are falling faster, so the current account deficit is falling.

18) I blinked when I saw this Wall Street Journal Op-Ed. Sorry, but the secret to changing the residential real estate market is not lowering interest rates( IT'S A WAY THAT THEY CAN BE SEEN AS HELPING HOME OWNERS ), but writing-off portions of loan balances. Most delinquents can’t make even reduced payments, half re-default, and can’t refinance because the property is underwater. Yes, I know that the government is pressing to have Fannie and Freddie suck down more losses by letting underwater loans refinance, but if you’re going to do that, why not be more explicit and let the losses be realized today by resetting the loan’s principal balance to 80% of the property value, and giving the GSE a property appreciation right on any growth in the home value on sale, of say 150% of the amount written down?( THAT'S A POSSIBLE SOLUTION )

19) On commercial property, when do you extend on a loan vs foreclosing? In CMBS, if the special servicer has no bias, or if a healthy insurer/bank holds the loan on balance sheet, you extend when you are optimistic that this is just a short-term difficulty with the property, and you think that the property owner just needs a little more time in order to refinance the loan. More cynically, extensions can occur in CMBS because the juniormost surviving class directs the special servicer to extend because it maximizes the value that they will get out of their investment, because a foreclosure will wipe out a portion of their interests, since they are in the first loss position. With a less than healthy bank or insurer, the same procedure can happen if they feel they can’t take the loss now. (I know that in a extension/modification there should be some sort of writedown, but some financial entities find ways to avoid that.)

20) Time to go bungee jumping with the US Dollar? As Bespoke pointed out, the Dollar Index has just come off its biggest 6-day loss ever. Should we expect more as the US heads into a ZIRP [zero interest rate policy], with aggressive expansion of the Fed’s balance sheet, much of which might be eventually monetized? The best thing that can be said for the US Dollar is that it is already in ZIRP-land, and much of the rest of the rest of the world is being dragged there kicking and screaming ( TRUE ). As the interest rate differentials narrow in real terms, the US Dollar should improve.( TRUE )

But, there are complicating factors. Future growth or shrinkage of the demand for capital will have an impact, as will future inflation rates. Even if the whole world is in a global ZIRP, there will still be differences in the degree of easing, and how much easing the central bank allows to leak into the money supply ( TRUE ).

This is a mess, and over the next few years, expect to see a whole new set of metrics develop in order to evaluate monetary policies and currencies ( TRUE ). For now, put your macroeconomics books on the shelf, because they won’t be useful for some time ( TRUE ).

A good post.

"In the recent past most anomalies have been saturated."

I read the Aleph blog anyway, but the use of the phrase "Nonlinear Dynamics" pulled me right in:

"There have been a lot of articles recently about the poor performance of hedge fund of funds, and hedge funds generally ( I'M FOR THEM ). I’ve written before on this topic, so if you have a subscription to RealMoney ( I DON'T HAVE ANY REAL MONEY FOR "REAL MONEY" ), and want to peruse my earlier pieces on market structure, here they are (with their odd titles, I wanted something more consistent):

• Managing Liability Affects Stocks, Pt. 1
• Separating Weak Holders From the Strong
• Get to Know the Holders’ Hands, Part 1
• Get to Know the Holders’ Hands, Part 2

Many investment managers seem to not think globally about their businesses. It becomes: “Follow my process. Buy and sell securities that my process reveals. Succeed. Rake in more money to invest, if my marketing guy is competent.” ( THE MARKETING GUY. YOU NAILED IT. )

Market environments like this reveal the weaknesses inherent in balance sheets of all sorts. Every investment enterprise, every company, and even you have a balance sheet. During times of stress, those balance sheets get tested. Many of them are found wanting, if one can read the writing on the wall.

An investment manager thinking globally, using logic from a source like Co-opetition, or Michael Porter’s Five Forces considers not only his actions, and the actions of securities that he has bought or sold short, but considers in broad the actions of other managers, and companies that he does not own. He also considers the affairs of his investors, and the stresses they are under. What if they are under stress, and need to redeem funds at an inopportune time? What if they pour in money in a frenzy during good times?

It is important, then, to think about how a manager should structure the cash flows of his fund. How liquid/fungible are the assets? As with a money market or stable value fund, how much can the book value (what investors can withdraw) differ from the market value (best estimate of what the securities are worth)?

With some open-end real estate funds, they limit redemptions to the amount of cash that can be realized at each withdrawal date, and investors stand in line for the portion of their money that they will receive. Or, consider hedge funds with illiquid positions. Many funds, including the famed Citadel, are restricting withdrawals in order to avoid fire sales (or forced buy-ins) of assets.

But there is more to the Co-opetition framework here. Shouldn’t managers try to estimate if there are too many other managers following their strategies? With all of the adulation over managing the endowments at Harvard and Yale, isn’t it possible that too many endowment managers got Swensen-envy, and decided to allocate to “alternative assets” at the worst possible time? That ’s a reason to be cautious on illiquid alternative asset classes. You can’t undo the decision without significant costs. Also, there is greater freedom to mess up, as happened with Calpers on real estate.

Another way to think about it, is that when too many managers pursue the same strategy, in absolute terms, it does not matter if you are the best manager of the strategy ( GOOD POINT ). If too much money is being thrown at the strategy, it will underperform, and the best manager will be carried down with the wors ( GOOD POINT )t. The relative performance will be better, but there will still be a likely loss of assets in the “bust phase” of that market. ( ALL GOOD POINTS )

But in the present environment, we have had the challenge of many managers seeking returns off of every market anomaly that we collectively can imagine. When a market anomaly gets saturated with enough assets, returns become market-like. Risk becomes market-like as well, because the investors are subject to needs/fears for cash flow. In the recent past most anomalies have been saturated. ( I'M MORE FAMILIAR WITH TEMPORAL ANOMALIES, BUT A GOOD POINT AND A GREAT SENTENCE )

That is one great reason why so many seemingly unrelated asset classes have become so correlated. The investor base as a whole diversified, and all of the asset classes are subject to their greed and fear. ( AGAIN, GOOD POINT )

Now, there will always be new entrants with novel and profitable theories, but their success will attract imitators, and their returns will decline. Aleph will give way to Beth, oops, Alpha will decline, and the new methods will correlate with the market as a whole (Beta).

As for hedge fund-of-funds, they suffer from the conceit I described yesterday. They look at past uncorrelatedness, and presume that past is prologue. Thus someone with a positive alpha, and uncorrelated returns can get a big allocation, like Mr. Madoff. ( THE PAST ISN'T ALWAYS PROLOGUE )

As investors, we need to think about the markets as a whole. We can’t afford the luxury of ignoring the broader picture, as some stock pickers might. Instead, we need to consider the macro and the micro factors, and when we can find them with any accuracy, the technical factors. ( SOUND ADVICE )

This is not easy to do, and I often fail. But I would rather be approximately right than precisely wrong. May it be so for you as well."

An excellent post. But always remember:

The Keeper: She has an illusion, and you have reality. May your way be as pleasant.

"Let real estate prices find their levels where ordinary people con afford ordinary homes without incurring a boatload of debt."

David Merkel on the Aleph Blog joins the no on GSEs crowd, but for different reasons, I believe. Let's see:

"1) Regarding taxation, my view is that all income should be taxed equally and regularly. I’m not generally in favor of deferring or exempting taxes on asset classes of any sort."

This is my basic position.

"2) The Federal Reserve is buying up mortgage assets. Now the Treasury is thinking of subsidizing mortgage rates. Don’t we do enough in the US to overinvest in housing?"

In my opinion we do, but getting rid of the mortgage deduction is going to take some political creativity I've yet to come across. Theory won't do it.

"Call me a skeptic here. In credit crunches, the value of the collateral is far more important than the rate charged. I care more as a lender about the return of my money, than the return on my money. Lending to entities where the loan-to-value is high is fraught with peril. Losses occur with little regard for the interest rates charged. Life events matter more: death, disaster, disability, divorce, and dismissal from employment. Negative life events cause borrowers to choke on interest payments when refinancing is impossible.

Lowering the mortgage rate to 4.5% will subsidize borrowers who can refinance through conventional mortgages, but will do little good elsewhere. The subsidy will also add to the financing needs of the US Treasury, which is getting stretched."

Okay. Everyone agrees that:

1) It helps refinancing mortgages

2) It doesn't really help that many people buy new houses, or, if it does, Roubini says it will be because standards are still being ignored

"The efforts of the Fed and Treasury may lower mortgage rates for a time, but as the government borrows more, there will be pressure for rates to rise. For now, it may seemingly work, but it will eventually fail, and the outcome will be worse than if they hadn’t acted."

That's basically my point. It's too little for the price.

"So I’m not crazy about government action here. Why should we risk the credit of the Republic over homeowners? Let real estate prices find their levels where ordinary people con afford ordinary homes without incurring a boatload of debt."

Well, there is no real disagreement. I simply understand why the Fed is trying to do something on this issue politically. I don't feel nearly as qualified or certain as Roubini or Merkel about what the price of a home should be. That, to me, depends upon the needs, desires, and finances, of particular individuals, who are under no compulsion to act or value homes as their parents did, one way or another.

"I have another idea that I think is more powerful: Issue 40-, 50-, 75-, and 100-year bonds. Issue TIPS versions as well. Hey, issue a perpetual "

Thank Heaven for David Merkel on The Aleph Blog:

"My Idea

Lest I merely seem to be a critic, I have another idea that I think is more powerful: Issue 40-, 50-, 75-, and 100-year bonds. Issue TIPS versions as well. Hey, issue a perpetual — Consols! As I have said earlier:

		David Merkel
		Now Let’s Have a Treasury Century Bond!
		8/3/2005 9:30 AM EDT

George, I’m really glad to see that the Treasury has finally gotten a lick of sense, and is re-issuing the 30-year, which they should be able to at yields lower then the current long bond maturing in 2031 (probably 10 basis points lower).

Timing is anyone’s guess, but I would suspect two auctions — in November 2005 and February 2006 — in order to give the new benchmark bond sufficient liquidity. Given the absence of long issuance, demand for this bond will be very strong in the hedging community.

Now, the Treasury won’t do this, but my guess is that there is even more demand for a 50-year, or even a century bond (100 years). It would help pension funds and structured settlement writers match their liabilities. Those bonds could sell at yields less than the 10-year. Won’t happen, but I can dream.

Final note, this removes one of my reasons for lower long rates, but I am still biased toward lower long rates. The other reasons still hold.

none mentioned, though I own Treasury Securities of various sorts, both directly and indirectly (don’t we all?)

There is a decent amount of demand for safe long-dated debt from pension plans, life insurance companies, and other long-term fixed income investors. These bonds would likely have lower yields than the 30-year bond, because of buyers that like long fixed income because of its reliability in a crisis. (And, for bond geeks — high positive convexity.)

Personally, I think the market would happily digest a lot of really long debt from a seemingly strong entity like the US Government. What, are we going to let the Europeans have a monopoly on long sovereign debt here? ;) US Treasury, be innovative — show the world how confident we are in the future of the US by issuing debt as long as we think this republic will last. Surely that is longer than 30 years."

He's prescient. Period.

One thing about that Aleph. It's not originally Hebrew. It's a stylized version of the Aramaic Aleph. The Original Hebrew Alphabet is now only used by Samaritans.