Why I'm Underperforming in This Market

by: David Merkel, CFA

I’m worried. That doesn’t happen often. Over the years, I have trained myself to avoid both worry and euphoria. That has been tested on a number of occasions, most recently 2002, when I ran a lot of corporate bonds.

Ordinary risk control disciplines will solve most problems eventually, absent war on your home soil, rampant socialism, and depression. I like my methods, and so I like my stocks that come from my methods, even when the short term performance is bad. Could this be the first year in seven that I don’t beat the S&P 500? Sure could, though I am still ahead by a few percentage points.

Let’s start with the central banks. I don’t shift my views often, so my change on the Fed is meaningful. But how much impact have the temporary injections of liquidity had? Precious little so far. Yes, last I looked, Fed funds were trading below 5%; banks can get liquidity if they need it, but credit conditions are deteriorating outside of that. (more to come.) I don’t believe in the all-encompassing view of central banking espoused by this paper (I’d rather have a gold standard, at least it is neutral), but how much will full employment suffer if most non-bank lenders go away?

Why am I concerned? Short-term lending on relatively high quality collateral is getting gummed up. You can start with the summary from Liz Rappaport at RealMoney, and this summary at the Wall Street Journal’s blog. The problems are threefold. You have Sentinel Management Group, a company that manages short term cash for entities that trade futures saying their assets are illiquid enough that they can’t meet client demands for liquidity. Why? The repurchase (repo) market has dried up. The repurchase market is a part of the financial plumbing that you don’t typically think about, because it always operates, silently and quietly. Well, from what I have heard, the amount of capital to participate in the repo market for agency securities, and prime AAA whole loan MBS has doubled. 1.5% -> 3%, and 5% -> 10%, respectively. Half of the levered buying power goes away. No surprise that the market has been whacked.

Second, away from A1/P1 non-asset-backed commercial paper, conditions on the short end have deteriorated. As I have said before, complexity is being punished and simplicity rewarded. High-quality companies borrowing to meet short-term needs are fine, for now. But not lower-rated borrowers, and asset-backed borrowers. Third, our friends in Canada have their own problems with asset-backed CP. Interesting how Deutsche Bank did not comply with the demand for backup funding. Could that be a harbinger of things to come in the US?

On to Mortgage REITs. Thornburg gets whacked. Analyst downgrades. Ratings agency downgrades. Book value declines. Dividends postponed. It all boils down to the increase in margin and decrease in demand for mortgage securities (forced asset sales?).

It’s a mess. I’ve done the math for my holdings of Deerfield Capital, and they seem to have enough capital to meet the increased margin requirements. But who can tell? Truth is, a mortgage REIT is a lot less stable than a depositary institution. Repo funding is not as stable as depositary funding. There will come a point in the market where it will rationalize when companies with balance sheets find the mortgage securities so compelling, that the market clears. After that, the total mortgage market will rationalize, in order of increasing risk. Fannie and Freddie will help here. They support the agency repo market, but the AAA whole loan stuff is another matter. Everyone in the mortgage business except the agencies is cutting back their risk here.

By now, you’ve probably heard of mark-to-model, versus mark-to market. The problem is that mark-to-model is inescapable for illiquid securities. They trade by appointment at best, and so someone has to estimate value via a model of some sort. The alternative is that since there are no bids, you mark them at zero, but that will cause equity problems for those buying and selling hedge fund shares. This is a problem with no solution, unless you want to ban illiquid securities from hedge funds. (Then where do they go?)

There’s always a bull market somewhere, a friend of mine would say (perhaps it is in cash? that is, vanilla cash), but parties dealing with volatility are doing increasing volumes of business, which is straining the poor underpaid folks in the back office.

Why am I underperforming now? Value temporarily is doing badly because stocks with low price-to-cash-flow are getting whacked, because the private equity bid has dried up. That’s the stuff I traffic in, so, yeah, I’m guilty. That doesn’t dissuade me from the value of my methods in the long run.

Might there be further liquidity troubles in asset classes favored by hedge funds? Investors tend to be trend followers, so yes, as redemptions pile up at hedge funds, risky assets will get liquidated. Equilibrium will return when investors with balance sheets tuck the depreciated assets away.

Finally, to end on a positive note. Someone has to be doing well here, right? Yes, the Chinese. Given the inflation happening there, and the general boom that they are experiencing, perhaps it is not so much of a surprise.

With that, that’s all for the evening. I have more to say, but I am still not feeling well, and am a little depressed over the performance of my portfolio, and a few other things. I hope that things are going better for you; may God bless you.