Eleven Notes on the Cantankerous Credit Markets

1) Note to small investors seeking income: When someone friendly from Wall Street shows up with an income vehicle, keep your hand on your wallet. One of the oldest tricks in the game is to offer a high current yield, where the yield can get curtailed through early prepayment (typically in low interest rate environments), or some negative event that forces the security to change its form, such as when a stock price falls with reverse convertibles. Wall Street only gives you a high yield when they possess an option that you have sold them, that enables them to give you the short end of the stick when the markets get ugly.

2) When times get tough, the tough resort to legal action. Financial Guarantee Insurance contracts are complicated, and the guarantors will do anything they can to wriggle off the hook, particularly when the losses will be stiff.

3) The loss of confidence in financial guarantors has not changed the operations of many muni bond funds much. With less trustworthy AAA paper around, many muni managers have decided that holding AA and single-A rated muni bonds isn’t so bad after all. Less business for the surviving guarantors, it would seem.

4) Jefferson County, Alabama. Too smart for their own good. So long as auction rate securities continued to reprice at low rates, they maintained low “fixed” funding costs from their swapped auction rate securities. But when the auctions failed, the whole thing blew up. There will probably be a restructuring here, and not a bankruptcy, but this is just another argument for simplicity in investment matters. Complexity can hide significant problems.

5) Spreads were wide one week ago, even among European government bonds, and last week, as these two posts from Accrued Interest point out, we had a significant rally in spread terms last week. Now, credit can be whippy during times of stress, and there are often many false V-like bottoms, before the real bottom arrives. Be selective in where you lend, and if the sharp rally persists for another few weeks, I would lighten up. That said, an investor buying and holding would see spreads as attractive here. When spreads are so far above actuarial default rates, it is usually a good time to buy. I would not commit my full credit allocation here, but half of full at present.

6) I don’t fear ratings changes, if that is the only thing going on, and there is no incremental credit degradation, or increased capital requirements. But many investors don’t think that way, and have investment guidelines that can force sales off of downgrades that are severe enough. Personally, I think Fitch is best served being as accurate as possible here; they don’t have as large of a base to defend, as do S&P and Moody’s. So, if downgrades are warranted, do them, and then make the other rating agencies justify their views.

7) I have not been a fan of the ABX indices, and I thought it was good that an ABX index for auto ABS did not come into existence.

8) So what is an auction rate security worth if it is failing? Par? I guess it depends on how high the coupon can rise, and the debtor’s ability to pay. It was quite a statement when UBS began reducing the prices on some auction rate securities. Personally, I think they did the right thing, but I understand why many were angry. A complex pseudo-cash security is not the same thing as owning short-term high-quality debt.

9) Then again, there are difficulties for the issuers as well, particularly in student loans. Not only are costs increased, but it is hard to get new deals done.

10) GM just can’t seem to shake Delphi. In an environment like this, where liquidity is scarce, marginal deals blow apart with ease, and even good deals have a difficult time getting done.

11) Regular readers know that I am not a fan of most complex risk control models that rely on market prices as inputs. My view is that risk managers should examine the likely cash flows from an asset, together with the likelihood of the payoff happening. With respect to bank risk models, they were too credulous about benefits of diversification, as well as what happens when everyone uses the same model. Good businessmen of all stripes focus on not losing money on any transaction; every transaction should stand on its own, with diversification as an enhancer in the process.

Comments

[venividivici:]

Wall Street has decreed that this market is going up no matter what the news says. But then Wall Street has no credibility whatsoever. April Fool's Day must surely go down in the annal's of sharemarket history as its most idiotic. Diabolical news greeted as great news.
Nothing changes. After the dot com crash, these same people again and again encouraged tbe lemmings to test the height of the cliff.

2008 Apr 06 07:31 AM

[deaverb:]

Author covers important subjects and inspires us to think about them. Sunday is a particularly good day for this, so Alpha gets credit too. On the Delphi front, GM was smart enough to dump that overpriced union wages mess. Some investors underestimated how bad it was--which only indicates how smart GM was to dump it, even with the bite backs. Better than being responsible for the mess--in any way but financial. As the creaky bellows rattle, and Delphi grinds to a slow death through high costs and tough work rules, GM at least can concentrate on its own businesses--and only have to pay (much simpler than trying to save the mess or defend it in public). Kudos to GM mgt for dumping it.

2008 Apr 06 09:07 AM

[Deacon:]

My Letter to Editors at DailyReckoning.Com:

Pay attention, folks!

This is a conspiracy-driven dismantlement of the West's
financial underpinnings, for a certain purpose: TO EQUALIZE
GLOBAL ECONOMIES, for future installation of one-world
government.

I've provided all the details in my essay, "Planned
Destruction of America" (linked below), which is my report
on Lt. Col. Archibald Roberts' 1968 booklet: "The Anatomy
of a Revolution".

Study my essay, then write as if we're all being led down
a path to hell on Earth by secretive, elite movers and
shakers on the Left and Right (path to hell aka Third-Way
Global Economic Socialism. Read and learn and teach:

The EU and the coming North America Union are products of
the 1940s GATT formulations, and very few analysts are
aware of it ((GATT, NAFTA, and CAFTA are socialistic
attempts at equalizing global economies, in order to in-
stall one-world government under THIRD-WAY Global Economic
Socialism)).

My missive to Ron Paul’s staff, regarding my view that
this financial crisis is not by happenstance nor
mismanagement—but BY DESIGN!:

The Honorable Ron Paul is ignorant of an ongoing conspiracy
to topple, financially, the West, in order to equalize
the world’s economies; for building one-world government
under GLOBAL ECONOMIC SOCIALISM. // The conspiracy began
in the 1940s with the GATT formulations. // Ask why
Greenspan had violated his chairmanship duties by advising
prospective home buyers to take out an ARM. // Ask why
Greenspan had sent out fed regulators to warn banks that
they’d be charged with RACISM if they didn’t loosen home
loans for minority, HIGH RISK home buyers. // Ask why
Greenspan recently, TRAITOROUSLY, had advised OPEC oil
producers to de-link from the U.S. dollar. // Greenspan -
the FEDERAL RESERVE - has embarked on a purposeful set of
monetary policies designed to destroy the West’s financial
underpinnings. // Read about the WHO, the HOW, and the WHY
of it in my below article (first one):

Planned Destruction of America
planneddestructionofam.../

Corporate America: What Went Wrong?
corporateamericawhatwe.../

This one helps to confirm efforts to PURPOSELY trash
America’s financial underpinnings:

www.321gold.com/editor...

P.S.

Oil is payoff for the West's efforts at providing PROXY
COMBATANTS for Israel--for protecting Israel from expanding,
encircling Islamic Arabism; a Jewish nation-state having
supporters throughout the West willing to destroy the entirety
of Western civilization for Israel's sake.

That's the gut-wrenching truth of why Western democracies
are sacrificing blood and treasury in the Middle East; especially
the U.S., which has enough off-shore and on-land oil reserves
to last 300 years at her present rate of consumption, and
which reserves were PURPOSELY capped and/or not drilled
because Israel's supporters poured millions of dollars into
ENVIRONMENTAL MOVEMENT groups' coffers, to work at
keeping America from oil/energy independence and tied to
Israel's interests in the Middle East. That's the truth you'll
NEVER see nor hear reported in Western mainstream news
media, because Israel's supporters control what's fit to be
said or printed about why the West wars with Islamic
Arabism.

2008 Apr 06 09:45 AM

[Kunst:]

Deacon: It's getting boring (not) reading your missive over and over.

2008 Apr 06 03:57 PM