25 Facets of the Current Economic Scene

1) So many managers lose confidence near turning points, like Bruce Bent in this article. Still others maintain their discipline to their detriment, not realizing that they have a deficiency in their management style. Alas for Bill Miller. A bright guy who did not get financials, or commodity cyclicals.

2) We will see rising junk bond defaults in 2009. Some defaults will be delayed because covenants are weaker than in the past. But defaults primarily occur because cash flow is insufficient to finance the interest payments on debts. That can’t be avoided. After Lehman, what can you expect?

3) As housing prices fall, which they should because housing is in oversupply, more homeowners find themselves in trouble. Remember, defaults occur because a property is underwater, and one of the five Ds hits:

• Divorce
• Disability
• Death
• Disaster
• Dismissed from employment

As it stands now, the jumbo loan market is looking at more trouble — there was a lot of bad underwriting there during the boom.

4) I am not a fan of workouts on residential mortgage loans. Most of them don’t work out. Loans typically default because of one of the 5 Ds, and modifying terms is adequate to help a small number of the borrowers.

5) I’ve talked about this for a while, but Defined Benefit pensions (what few remain) have been damaged in the recent bear market. What should we expect? When companies offer a fixed benefit, and rely on the markets to fund it, they rely on the kindness of strangers, who they expect to buy equities when they need to make cash payments on net.

6) There are two credit markets. Those that the government stands behind, and those that it does not. That is the main distinction in this credit market, with Agency securities falling into a grey zone.

7) If we were dealing with your father’s financial instruments, we would use his financial rules. As it is, more complex financial instruments that are more variable in their intrinsic value must be valued to market, or, the best estimate of market. There are problems here, but remember that market does not equal last trade for illiquid, complex securities. Also, there should be caution over level 3 modelled results. From my own work, those results are squishy.

8 ) During a crisis, many relationships boil down to liquidity. Who has it? Who needs it, and at what tradeoff? The same is true of venture capital today. Who will fund their commitments? Beyond the issue of dilution looms the issue of survival. VC backed companies lacking cash will have a hard time of it in the same way their brother public companies do.

9) The Fed ain’t what it used to be. Today it has all manner of targeted lending programs, and a disdain for stimulus through ordinary lending.

10) General Growth Properties relied on continual prosperity, and look where it led them. Better, consider the Rouses who sold to them near the peak. Good sale.

11) How can SunTrust be in this much trouble, needing a second does of TARP funds so soon? I don’t get it, but it is endemic of our banking sector. The TARP Oversight Panel is supposedly going to ask a bunch of questions to the Administration regarding past use of TARP funds, but the questions are vague and easy to answer in generalities.

12) There were warnings of trouble inside both Fannie and Freddie, as well as a few recalcitrant analysts outside as well (including me). Now they recognize the trouble they are in, maybe. (Also: here.) Congress does what it can now, not to identify what went wrong, but to divert attention and blame away from themselves. No one supported the expansion of Fannie and Freddie more than Congressional Democrats. Political critics were marginalized.

Now, it is possible that Congress could double down on its stupidity, and cause Fannie and Freddie to not require appraisals on refinanced loans. They have enough credit risk as it is; should they do loans that are not adequately secured by the property?

13) The euro makes it to its ten-year anniversary, and we are told… see, as sound as a Deutschmark. Well, maybe. Having a strong currency might be fine for Germany, but what of Greece, where the credit default swap market is pricing in a 12%+ probability of default over the next five years? They might like a weaker euro.

14) Is Britain a greater default risk than McDonalds (MCD)? Is the US a greater default risk than Campbell Soup (CPB)? Sovereign default is a different beast than corporate default. Corporations don’t control their own currency (hmm… does that make Greece more like a corporation of the Eurozone? or more like California in the US?), and so bad debt decisions compound over longer periods of time, until we end up with inflation, a forced debt exchange, or an outright default. It is possible for the US to default without Campbell Soup defaulting, but the life of any US corporation would be made so much more difficult by an outright default of the US government, that I would expect an outright default to cause most US companies, states, and other nations to fail as well, because of implicit reliance on the creditworthiness of the Treasury.

15) What is stronger now, fear or greed? Let’s take up greed. I got a large-ish amount of responses to my pieces Does Not Pass the Japan Test, A Reason to Sell Stocks Amid the Rally, and my more bullish piece Momentum in the S&P 500. There are a lot of bulls here:

• Admit It: You’re Worried You Missed The Bottom
• Equity Risk Premiums
• Market bottom by year-end

Bottom-callers are out in droves, with many sophisticated arguments. They all hinge on one idea: that we can return to normalcy soon with a compromised financial system, and debt levels that are record percentages of GDP.

16) On the fear front, we have:

• Regression to the Mean
• Q Ratio Signals ‘Horrific’ Market Bottom, CLSA Says

Here’s the main graph from the second piece:

The basic idea behind the two pieces is this: sure, we’re at average valuation levels now, but in a real bear market values can get cut in half from here. My view is this: we’re not at table-pounding valuation levels yet, but someone with a value and quality bent will make money over the next ten years.

17) Less helpful are pieces like this one: Five Sparks for a Stock Market Comeback. His five sparks are:

1. No More Downward Revisions to GDP Growth
2. An Enormous Government Stimulus Package
3. An End to Redemption-Related Selling by Hedge and Mutual Funds
4. Increased Lending
5. Tax Cuts

I fear this confuses the symptoms with the disease. Yes, it would be nice if many of these happened, but with the deficit hitting record levels, 2 and 5 are problematic. In an over-indebted economy 1and 4 are tough as well. As for point 3, you may as well argue with the sunrise, because most investors are trend-followers, whether they know it or not. Redemptions typically end after the market has turned significantly. It’s not a leading indicator, nor is it necessarily an “all clear.”

18 ) There are other reasons for concern, among them low t-bill yields. There is significant fear, such that short term investors will take zero, rather than put principal at risk. Maybe we should call t-bills the biggest mattress in the world to hide money under.

19) From the “read your bond prospectus with care department,” Catastrophe bonds are only as good as the collateral backing the deal or creditworthiness of the obligor. Though it may have seemed a good idea at the time, allowing for lower quality collateral has caused the creditworthiness of several catastrophe bonds to suffer as Lehman defaulted, and as losses on subprime mortgages rose. My take is this: analyze all the risks on a bond, even the obscure ones. A lot of exchange traded note [ETN] investors probably wish they had paid more attention to who they were lending the money to, rather than the index attached to the notes.

20) The “read your bond prospectus with care department” does have a humorous side, as Paul Kedrosky points out on this amendment to some new Illinois GO bonds. They don’t sound too worried, but maybe the lawyers have to be more pro-active, and put the following new risk factor into the prospectus:

Endemic Political Corruption

Your investment in the state of Illinois is subject to risks involving political corruption, which is a normal fact of life in Illinois. In lending to the State the lender bears the risk that the corruption level gets so great that it affects the trading value of these securities, and that interest and principal repayment could be impaired.

21) Even if you don’t have 5 of your last 9 Governors removed due to scandal, like Illinois, it’s tough to be a state nowdays. Now you have the credit default swap [CDS] market spooking investors in your bonds.

22) So what would it mean for the Fed to issue debt? Is it just an alternative to Treasuries and the Fed’s present relationship with the US Treasury? A way to pay interest to those that participate in the Fed funds market, but can’t leave excess reserves at the Fed? Or, a way to have a sovereign default without a sovereign default?

I’m not sure, but I would be careful here. What can be used for a single limited pupose today can be put to unimaginable uses tomorrow. The Fed’s balance sheet is already at much higher levels of leverage than it was three months ago. Does it really want to take on more? Granted, seniorage gains/losses go back to the Treasury, which then can borrow less or more in response, but as the Fed’s balance sheet gets more complex, it makes it more difficult to gauge their policy responses, and I think it will lead to a lack of trust in the Fed and the US Dollar.

23) With conditions like these, should we be surprised that volatility is high in the equity markets? By some measures, it is higher than that in the Great Depression. I’m not sure I would call it a “bubble” though. Extreme Value Theory tells us (among other things) that when a probability distribution is ill-defined, don’t assume that the highest value that you have seen is as high as it can get. Records beg to be broken.

24) It’s not as if I am the only one thinking about issuing longer US Treasury debt. Now the Treasury is thinking about it as well. It will fill a void in our debt markets that life insurers, endowments, and DB pension plans will want to invest in (and create a bunch of new leveraged fixed income investments for speculators).

25) Three articles to close with:

• A good summary of how we got into this mess from Charles McCreevy, the European Commissioner for Internal Market and Services.
• A semi-liquidationist view of how to get out of the crisis, by Harvey Golub, a former chairman and CEO of American Express.
• What would the price of gold be if used it to back our currency? Over 10x what it is now.

Comments

[jrs87sch:]

I agree, as much as homeowners want workouts for their mortgage, the reality is that there is a reason that they are in default: They Can't Pay! It may sound mean, but you're right the workouts usually don't end up working.

Also, it's hard to restructure the loans when they've been diced up and packaged. Some mortgages are untraceable.

2008 Dec 12 01:25 PM

[Jackson Cash:]

Thanks for all the piss and vinegar (and effort)!

I'm reminded of the old shipwreck example -- one piece of floating wood with enough buoyancy to support two people, with thirty people trying to climb aboard... all will perish, some by violence, the rest by drowning as the wood is clawed into splinters.

2008 Dec 12 01:53 PM

[briacal:]

my mind is spinning while looking at so many arrows pointing at so many different directions

2008 Dec 12 04:24 PM

[Socialism c...:]

WOW. Most lucid insights on here in a long time!! A few comments:

5) How are those private defined-benefit pensions any different from entitlement government? Social Security & Medicare (and who knows what else coming soon...) are ALL pyramid schemes that are financed on the backs of younger generations. We MUST end this stuff. The ONLY way to pay for things is to pay for them yourselves, in order to have a solvent government and economy.

12) Yep. And all those who keep saying "now is not the time for blame, we must first save the economy" fail to see that not recognizing blame NOW impairs our ability to fix things -- because we are in fact REPEATING our mistakes!!

14) Downright sobering -- coincides with folks like Jim Rogers being not only a dollar bear, but an "America bear". Should note that he says he loves his country, but just happens to be worried sick about its financial future.

2008 Dec 12 05:03 PM

[Socialism c...:]

Really? You read that as pointing in different directions? Almost all look to be pointing downward to me!!


On Dec 12 04:24 PM briacal wrote:

> my mind is spinning while looking at so many arrows pointing at so
> many different directions

2008 Dec 12 05:04 PM

[carey_jim:]

The 10 Reasons for the Credit Crunch article lists 10 problems that can, apparently, be solved by more and better government regulations.

Government regulation of business was tried during World War I and II and worked wonders but in peacetime, no one should want to live like that, hopefully.

Government spending was 2% of GDP at the start of World War I and rose to 22% of GDP by 1919 which was the same percentage it was in the 1990s. After the war if fell back to about 8% of GDP and not 2%. World War I was the beginning of our problem of big government and NOT socialism which was brutally suppressed during that same period.

I think you should change your name to Fascism hates competition because socialism is virtually non-existent in America and where it exists, it competes quite well with its private counterparts.

When a government controls most of our lives, financial, business and social, we are living under totalitarian fascism and not socialism which would simply be the people owning businesses and receiving the profits from these socialist businesses.

The only people owned "businesses" I see in America are the post office, the public schools, the police and army and the fire departments, almost all of which have healthy competition from the private sector: UPS, private schools, and private security firms. The fire department seems to be the only secure socialist business without private competition. And all of these government owned businesses compete quite well with the private sector, thank you.

Social security and Medicare are not socialist either. They are simply government ordered insurance programs which don't meet your management requirements, apparently.

It sounds like you would be happy if every citizen was forced to save money for his own PERSONAL social security and medicare account and only be allowed by the government to withdraw a certain percentage of money from his own account at retirement age. Then he wouldn't be dependent on "younger generations." If his medical costs were higher than the amount he had saved, well too bad. If inflation wiped out his buying power, ditto.

If you aren't happy with laws that force you and others to do things they don't want to do, I don't blame you. I feel the same way. But don't complain about socialism when your real complaint is about the government telling you what to do.

When and if socialism comes to America we can complain about that too, but for now, our problem is Big Brother and the extent of his control over our personal lives not the existence of government run businesses such as the U.S. Post Office or the public school system.


On Dec 12 05:03 PM Socialism cannot compete! wrote:

> WOW. Most lucid insights on here in a long time!! A few comments:
>
>
> 5) How are those private defined-benefit pensions any different from
> entitlement government? Social Security & Medicare (and who
> knows what else coming soon...) are ALL pyramid schemes that are
> financed on the backs of younger generations. We MUST end this stuff.
> The ONLY way to pay for things is to pay for them yourselves, in
> order to have a solvent government and economy.
>
> 12) Yep. And all those who keep saying "now is not the time for
> blame, we must first save the economy" fail to see that not recognizing
> blame NOW impairs our ability to fix things -- because we are in
> fact REPEATING our mistakes!!
>
> 14) Downright sobering -- coincides with folks like Jim Rogers being
> not only a dollar bear, but an "America bear". Should note that
> he says he loves his country, but just happens to be worried sick
> about its financial future.

2008 Dec 13 01:14 PM

[John Lounsbury:]

Mortgage workouts? jrs87sch has a good comment - how can a mortgage be linked to the securities in which it actually resides? Without that link, workouts can not be effective because the financial system just becomes more tangled instead of sorted out.

Another thought on workouts - They can not be effective unless future monthly payments are matched by ability to pay. This can be done (for some mortgages) if:

1. Interest rates are lower. A proposal is under consideration to have government underwritten reduction to 4.5%.

OR

2. Acceptance of a reduced principal balance by the lendor. As pointed out above, for many mortgages, definition of the mortgage owners is very difficult. How can a multiheaded, difficult to identify owner, negotiate?

OR

3. Reduction of principal held by the mortgagor in return for shared future appreciation with the mortgagee. This has the same problem of complex mortgagor definition in 2. above.

4. Extended term of payment (30 years to 40 or 50 years, for example). Again this has to be agreed to with an ill-defined mortgagee.

If any or all of the 4. situations described above could be implemented, there would still be defaults, because of David Merkel's 5 D's and because there are some debtors who can not support any appropriate level of debt for the home they have "bought".

There is no way to get to the bottom without further mortgage defaults, as David clearly implies in the article.

David - congratulations on packing so much information and analysis into a short article.

2008 Dec 13 01:24 PM

[Jimmy Lathrop:]

David, your points are valid, as usual. But there is one point that I have to take issue with, and that is with point three. First, that blog post conveniently leaves out that these are modifications made by the loan servicer. These are modifications only in name. These loan modifications, written in a take it or leave it format merely extend the terms of the loan from 30 years to 40 years. The payment amount is lowered, but often times that does not result in a mortgage payment where the borrower is paying 38 percent of their income, the payment is still up around 60 percent. There is no wiggle room at all. NONE OF THESE LOAN MODIFICATIONS INVOLVE THE REDUCTION OF PRINCIPAL WHICH IS THE KEY TO PROVIDING HOMEOWNERS RELIEF. Sorry to shout, but it seems to be such a fundamental point. These mortgage originators used inflated values on homes, used CRA requirements as the basis for granting loans, or often just threw out ordinary lending due diligence over a prefunctory reading of a credit score. You haven't been late with a payment for your Sears Card in six months? Well all we need is an appraiser who says your house is worth 500k and we'll give you a loan for 400k, even though we are not going to check your income, assets or anything else. In New York City, we are not playing around with these investment bank mortgage backed trusts. They may think that by putting the unpaid principal back onto the loan as negative amortization would constitute a mortgage modification. When I am in the courtrooms and I see attorneys for lenders throwing up roadblocks and giving smoke screens I see the judges get upset. That why New York State has mandatory settlement conferences so that the judges can give the lender's counsel fair warning that any modification must be meaningful and not a band aid.

2008 Dec 13 01:28 PM

[carey_jim:]

A propos my comment on Socialism cannot work's post, I don't believe America is suffering from fascism, which is control of business by government, but contemporary America suffers from the opposite which is control of government, more or less, by business.

It is, of course, true that government controlled business quite spectacularly during World War I and II but it is just as true that government brutally suppressed socialism/communism during and after both World War I and World War II.

If we DO suffer a complete financial meltdown in the future however, I believe fascism is a much more likely to be offered as a solution than socialism. Our economy would then look more like it looked during World War I and II than it would look like the former Russian economy. What fascism would be CALLED by the advertising world is far beyond my imaginative capacity, however, but certainly not fascism..

2008 Dec 13 02:16 PM

[John Lounsbury:]

Anyone who has scanned down this far, go back and read (reread) what Socialism can not compete, carey_jim and Jimmy Lathrop have had to say. They have covered signifciant aspects of the debate about our future with pertinent references to current activiies and the fine list of 25 facets from David Merkel.

2008 Dec 13 03:56 PM

[Hmm?!:]

Bottom Line

From "Mortgage Liquidity du jour" by Credit Suisse. In 2006 48% of mortgages were low/no doc. An audit of 100 low/no docs revealed 60% of low\no doc applicants overstated their income by more than 50%!!!

Simple math tells me that at LEAST 30% of mortgage borrowers in 2006 never could pay in the first place.. It is probably much more than that!!!

TaxFoundation.org has Barney Franks on video, in congress, claiming Fannie and Freddie will never go bankrupt and taxpayers will never have to bail them out. Stopping oversight!!! Congressional democrats are without question to blame for driving this debacle home. This could have been stopped, albeit late in the game.

2008 Dec 14 01:29 AM