Colouring Hank

There's nothing really new in the WSJ's The Fannie & Freddie Question but it is a nice read and it gives some interesting colour on Paulson. I bet he really really wishes it was November.

Defusing Journalistic Hyperbole

Sometimes I wonder if the FT is sponsored by Euronext or the CBOT. Today there is an article by Aline van Duyn on derivatives and termination events. She points out, quite reasonably, that Fannie and Freddie are amongst the largest dollar interest rate derivatives counterparties - because they are hedging the prepayment risk of their mortgage books. Conservatorship is a termination event so any restructuring of the GSEs will need to be mindful of that.

Bizarrely, then, she uses this as the platform for an anti-derivatives screed. She moves seamlessly to credit derivatives - without any logical connection of course other than the D word - and starts talking about derivatives timebombs. Why does no one ever talk about bond market timebombs? Could it be that it is easy to pick on the derivatives markets? Perhaps journalists - like the government official van Duyn imagines in her article - need to spend more time learning about derivatives before blaming all the markets worries on them.

The biggest SIV in the world ponders its next move

The dumping-rubbish-ABS-into-the-ECB story is warming up nicely. The FT reports:

The European Central Bank faces an acute dilemma: on the one hand it needs to ensure that banks have access to adequate liquidity, but on the other it needs to prevent banks profiting unduly from central bank funding. Recent signs of banks undermining the ECB’s generous rules on collateral are worrying, and the ECB should address them promptly. What it cannot afford to do is cause a new storm in the markets. That is easier said than done...

Spanish banks are scaling up their use of mortgage-backed securities to obtain funding from the ECB – in place of investors willing to take them off their balance sheets.

So, ECB, what's it to be? Moral hazard and a subsidy to any bank that can brew up Euro ABS, or a Spanish banking crisis?

LEH

I am (1) above the waterline on Lehman and (2) starting to take it personally. This is usually a very bad sign for a position. There are doubtless hazards to navigate ahead but I think there may be more value there if Fuld can get something done soon. Despite Bloomberg's (reasonable) concerns about Lehman's mortgage assets and, according to FT alphaville, only three suitors remaining in the chase for the asset management unit I still there is the possibility of a surprise on the upside here.

Freddie with FED leverage

Dealbreaker points out a nice trade:

A bank that bought the six month notes from Freddie this morning could also bid to borrow from the Fed's Term Facility, which held an $75 billion auction today. As collateral for the borrowing, the bank could offer the newly purchased Freddie notes, for which the Fed would give them credit for 97% of their market value. Recently, the TAF pricing topped out at 2.35 percent for 28-day borrowing. So a bank buying $100 million of Freddie paper yielding 2.858% could flip it to the Fed, borrowing $97 million at around 2.4% (assuming the pricing will be slightly higher this time around).

At the end of the day, a credit desk could buy $100 million of Freddie debt for just $3 million down. On that $3 million, the desk would receive a 17.7% annualized return, or 8.8% over six months.

If you believe in the Treasury guarantee of the GSEs, and I think I do, that's not a bad return.

Stop cowering, start taxing

Polly Toynbee had an excellent OpEd piece in the Guardian yesterday on Labour's dismal cowering in the face of the anti-tax lobby. Why a nominally center left government refuses to impose the tax burden fairly is beyond me. They lack courage in tackling the super-rich, corporate tax planning, and the rest of the machinations of the tax 'optimisation' industry.

So, here are some proposals.

• Remove the possibility of non-resident status for UK citizens. If you want a UK passport, pay your tax. Americans pay tax on their worldwide income: why shouldn't Brits?
  
• Reduce period non-doms are allowed to work in the UK without paying tax to 30 days, and include travel time.
  
• Remove all of those trust loopholes that allow the rich to avoid inheritance tax. Use the savings to raise the threshold for paying it.
  
• Stop companies redomiciling to low tax countries by assessing tax on the value added by management in the UK. A brass plate and three directors in Dublin should not be enough to re-domicile profits if head office for all practical purposes is in London. And while you are at it, crack down on transfer pricing games.
  
• Remove the unlimited carry forward of losses, tapering it out over five years.
  
• To stop individuals hiding incomes, make overseas accounts illegal. That would provide a huge boost to the British financial system, and remove significant income from those places (like the Channel Islands or Bermuda) that have made a business out of defrauding the British taxpayer.
  

There's more, lots more, but that would be a good start.

Recapitalisation and the Debt/Equity Spectrum

Myron Scholes gave a good talk at the Lindau Nobel Prize winners meeting. The video is here.
Scholes has a number of points but one that is of immediate interest is his observation on debt holder pressure. Scholes notes that as banks get riskier and require more capital debt holders want the new capital to be more equity like than the instruments they hold - making their debt safer - while equity holders do not want to be diluted. Therefore recapitalisations tend to involve hybrid, subordinated instruments. Which indeed they have.

His other point in this area is that leveraged capital structure are naturally negatively convex in the sense that as asset prices fall, the issued debt gets riskier, and so to reduce this, institutions must delever in falling markets. This certainly happens -- it is just not clear to me that Scholes has established the need for institutions to hedge movements in the CDS spreads. After all, this (from FT alphaville) is a pretty good sign that any such hedging has not been entirely successful:

This does however throw an interesting theoretical light on Goldman and Morgan Stanley's decision to link the amount of leverage it will provide to their own debt spread.

Analytical Fiction

No, not a post on Kristeva (although you might call it one on American Pragmatism). Rather -- and this is a little cruel, so of course I am going to do it anyway -- a link to a series of embarrassing pictures showing Citi's research call on the broker/dealers and their actual performance. It's not pretty, but then trying to make short term calls on the markets rarely is. That's my excuse for Lehman being off 6% today, and I am sticking to it...

Where are the 'risk free' curves in dollars now?

It is a serious question: the Treasury curve is being moved by concerns about the cost of the GSE bailout, with some commentators saying that the US could lose its AAA.

And the Libor curve, according to a money manager quoted by Bloomberg,

aren't reflective of the entire banking system but of three or four major banks that continue to have pressure on liquidity

So where is the 'risk free' curve in dollars exactly?

Call of the week...

I have been wrong about this before and I may well be wrong about this again. But still, long Lehman. There, I've said it.

Keys not judgements

What were the ratings agencies doing really? Frank Portnoy writing in the FT, tells it like it is:

the rating business has shifted from providing information to selling “regulatory licences”, keys that unlock financial markets. Consider Constant Proportion Debt Obligations, the financial Frankensteins that the agencies’ flawed mathematical models said were low-risk. Does anyone believe parties paid for triple A ratings of such instruments because those ratings gave them valuable information? More likely, ratings were valuable because they permitted investors to buy something triple A-rated that paid 20 times the spread of other triple A-rated instruments.

In other words ratings can only really be objective when they are not used for anything. The SEC has already removed reliance on ratings from many of its rules, but I am not holding my breath waiting for Basel to do the same. However sensible an idea it might be, I doubt regulators are willing to admit how ill-conceived the Basel credit risk rules really are.

What's the biggest SIV in the world?

The ECB of course. Silly question. And they are even beginning to worry about it. The WSJ has details of an interview Nout Wellink gave yesterday. He is reported to have said:

“If we see that banks become very dependent on central banks, then we must stimulate them to tap other sources of funding,”

(It was in Dutch, however, so I can't read the original.) What that stimulus will be, however, is an interesting question. Or is it time for a Spanish banking crisis?

Fannie and Freddie lead spreads higher

From the FT:

Yield premiums across credit markets have jumped...

The CDX is near its highs and the iTraxx IG is near 100 again. The CMBX AAAs are nearly at 200 as this picture from Markit shows:

Much of the market action is GSE-motivated, with the market worried about the consequences of their problems. It seems unlikely that they will be able to do much about MBS spreads given they will be concentrating on how to refinance the $200B plus of their debt due this year. So:

[Short term] Treasuries are seeing some safe-haven buying, there are worries that greater government support for the GSEs will result in much more Treasury debt issuance as the taxpayer foots the clean-up bill for the mortgage malaise.

This explains why the yield curve.. has been steepening in recent days...

Both the two-year and five-year [swap] spreads are trading more than 1 per cent above Treasury debt...

With corporate credit and agency spreads wide and little fresh risk capital in the market, it is hard to see what will cause the markets to calm. Meanwhile Lone Star is doing some more fishing after the Merrill trade earlier in July, buying IKB. It is a good time to have cash...

Beware certainty

Wise words from Doug Kass, via Big Picture:

I continue to listen to and read a lot of convicted opinions for instance, the market has bottomed, financials have bottomed, oil has topped, stocks are enormously undervalued against historic measures...

I would put those convicted opinions in a locked closet

Quite right. The more convinced someone is that they are right about an unknowable future, the less weight I place on that forecast. Blessed be the doubters, for they shall inherit positive alpha.

Dismally bad

Larry Elliott in the Guardian has an article encouraging the Bank of England to cut rates. Larry is harsh with the Bank, accusing them of being asleep at the wheel, and he presents as evidence the Bank's 2007 CPI prediction:This shows a zero chance of inflation reaching 5% in 2008. If we now turn to the latest report, we find:In other words, current CPI over 5% and likely to stay there for six months. For me this is not proof of the Bank's guilt: this is just proof of how utterly unscientific economics is. After all, the Bank of England staff are neither ignorant nor lazy. They will have applied reasonable econometric tools in reasonable ways to get the first chart. The fact that reality turned out not just different from their prediction but completely outside the error bars simply shows that far too often when tested against reality, economics fails dismally.

Update. See here for a comprehensive account of the failure of economics. Or at least its failure to be funny.

The other guy's GSEs

Fannie and Freddie fell twenty something percent yesterday as the market digested a report by Barron's on the state of the Agencies. In practical terms the Barron's report seems to be pretty much correct: the Agencies will require recapitalisation, and it is unlikely this will be achieved without substantial help from the Treasury. However I do wonder about the timing. As the WSJ pointed out, it all depends on how big Paulson's balls are:

He can either continue to muddle along and inject a few billion dollars of preferred equity into Fannie and Freddie on an “as needed” basis until the end of the Bush administration in January.

Or he can go full steam ahead with a pre-emptive government takeover of Fannie and Freddie. Ironically, this radical step would make Fannie and Freddie an election issue. And perhaps only that would create momentum for true GSE reform.

The unfortunate reality is that politicians won’t embark voluntarily on a GSE overhaul a few months before an election. It isn’t a vote-winning issue. They would rather throw money at Fannie and Freddie and pray for a housing rebound.

The implication is that we will get piecemeal solutions to keep Fannie and Freddie afloat, just, until after the election rather than full scale reform. I think that's right. The agencies are going to be the next guy's problem.

Position review

Before the summer began I discussed a few positions, purely on a didactic basis (of course). Time for a reckoning.

• Seller of credit protection on LEH and MER and long a FTD basket on the subordinated prefs of national champion banks. Both ugly on a MTM basis, but both positive carry. I still wouldn't touch the financials' equity, but I do think too big to fail is a profitable position in the medium term. I am toying with adding CDS on Fannie and Freddie's senior debt based on the same philosophy.
  
• Short Gold. This has finally made a decent chunk of change. Time to take it off.
  
• Long prime jumbos. Good news: the conforming/jumbo spread has come in as more jumbos have become agency-eligible. Bad news: the agency/treasury spread has gone to the moon. I still like long liquidity/funding risk in the current markets. Hold on, but it may be a while.
  
• Long the iTraxx, short the component's equity. The short has done well, and the long is basically flat. This is a long term equity/credit dislocation play.

Additionally I would consider long dollar vs. EUR and GBP, and receive fixed in GBP for one year.

Market gaps

Classical economics, curse its worm-infested body, teaches us that the market will generate innovations which meet demand. Leaving aside for a moment the obvious problem with this - that there is no account of how fast such creativity will happen - my recent travels have convinced me that there is a massive opportunity at the moment for operating companies to make more money from transport. I, and I am sure many others, would pay more for a ticket in a guaranteed child free carriage on a train or cabin on a plane. After all, if I took a tuba with me on my journey, and attempted to learn how to play for the entire trip, I would quickly be silenced. But the same volume of noise can easily be created by one child. First class is no guaranteed of peace as I found out on one memorable trip to New York: the front of a 747 is not the best location for a creche. So, please Mr. Planeman, Mr. Trainman, can I please pay more for a child free trip? I rather suspect the answer will be no, not because the scheme wouldn't work, but because of the opprobrium some of the breeders would foist upon anyone who dared to suggest their dearest's screams were unwelcome: Adam Smith is no match for the pram wielding classes.

Quid pro CDO

No, I don't have anything to say. I just like FT Alphaville's coinage.

Oh all right there, I will say something relevant... Here's a nice article in the FT about Tranche Warfare. You will of course be astonished, especially if you have read this, but:

Some of the CDO and CDS documents leave a lot to be desired, and contain basic errors. The fear is that, as the courts get involved, we are going to have some unpleasant surprises.

What is the bond/CDS basis?

Accrued Interest has a fascinating data point on the troubles of the financials at the moment: Citi's latest five year was done at 337 over Treasuries or roughly 235 over Libor.

AI then suggests that there is an arb between CDS at 160 over and the bond at 239 over. In ordinary conditions that would be true because in ordinary conditions a trader would assume he or she could fund the bond at Libor flat, buy the CDS at 160, be risk flat, and make 79 running. But... firstly at the moment there aren't many Libor flat funders. The C deal discussed is evidence enough of that. And second you are only risk free if the CDS is guaranteed to pay - and which counterparty can be sure of that for in a situation where Citigroup is in default? The 160 over then does not reflect the real cost of being sure of protecting Citi debt, but rather the credit weighted average cost across typical CDS counterparties: buying protection on C from Berkshire Hathaway, say, would probably be more expensive (it certainly ought to be if Warren's folks are sharp).

A trade like long the debt long CDS protection only makes sense if (Bond spread over Libor - my funding cost over Libor to term) > (CDS spread + cost of complete credit protection on CDS counterparty for CDS receivable). The 2nd and 4th terms are typically small in an ordinary market. But this ain't no ordinary market.

California Foreclosures

Prompted by an article in the WSJ on foreclosures, I did a little research. The basic issue is to what extent banks are delaying selling foreclosed inventory, or delaying the foreclosure process, either because they do not want to realise the loss, they do not want to increase their volume of REO (real estate owned) or they do not physically have the capacity to process all the foreclosures they have. So, how long can a bank delay an auction once the property has been foreclosed? In CA at least, the answer is a year. The relevant portions of the CA state code are here, if you have tolerance for US law, and the key paragraph reads:

There may be a postponement or postponements of the sale proceedings, including a postponement upon instruction by the beneficiary to the trustee that the sale proceedings be postponed, at any time prior to the completion of the sale for any period of time not to exceed a total of 365 days from the date set forth in the notice of sale. The trustee shall postpone the sale in accordance with any of the following:

1. Upon the order of any court of competent jurisdiction.
   
2. If stayed by operation of law.
   
3. By mutual agreement, whether oral or in writing, of any
   trustor and any beneficiary or any mortgagor and any mortgagee.
   
4. At the discretion of the trustee.

So we are in a situation where property is dripping out of the bottom of the bucket through foreclosure sales, property is entering the bucket through delinquencies turning into foreclosures, and property cannot stay in the bucket for more than a year, ordinarily. This is clearly going to lengthen the duration of the real estate downturn, at least until the bucket starts to empty. Clearly it is in banks' economic interest to get this done, but I wonder whether they have the capacity to sell at a much faster rate than they are doing now, or whether the market in parts of California, Nevada, Florida and Illinois will support that volume of sales.

Update. Foreclosure volumes are rising fast in CA: 1,300 a day are now being executed according to the LA Times, or more than three times the rate of a year ago. I'd really like to see a detailed industry wide analysis of the levels and trends in delinquencies of various ages, foreclosures, and REO to get a sense of how full the bucket is. My sense is that the banks are effectively long rather more property than they would have us believe but pinning this down is difficult.

Another update. Further background is here (an LA Times update) and here (a discussion by Sacramento Real Estate Statistics of a Deutsche research report on Shadow Inventory).

Short Sweda

I find this article from Bronte Capital about Swedbank's woes reasonably convincing. Going big into the Baltics seemed like a great strategy when they were doing their Ireland impression, but now it seems some birds - quite a few birds actually - are coming home to roost.

Risk and climate change policy

Just before I went away Paul Krugman posted on the economics of catastrophe, and I have been meaning to follow up for a while. Krugman picks up on some research by Marty Weitzman looking at the distribution of outcomes of climate change. The basic idea is to look at the uncertainties and hence come up not just with a single prediction of the path of global average temperatures, but a path of distributions. There is a lot of model risk in this analysis - it is bad enough predicting financial distributions were we do at least have a lot of high frequency data - however the results are interesting. Krugman says:

Marty surveys the existing climate models, and suggests that they give about a 1% probability to truly catastrophic change, say a 20-degree centigrade rise in average temperature.

Twenty degrees would be game over. Even if it is only 0.01% chance, this is an outcome worth hedging. Clearly then it is not just the expected temperature change that we should be concerned with, it is the variance of that change, or more accurately the upside tail of the distribution. As Krugman says, mobilizing people to protect against low probability but catastrophic outcomes is crucial. Hedging far from the money is cheap, but you do actually have to buy those options.

BAA to be rent asunder?

The FT reports that UK Competition Commission is considering forcing BAA to give up at least one of its London airports. Given that this government will never agree to the right step - nationalising BAA - I suppose that is a start.

Update. So the competition commission is demanding that BAA sell not one but two London airports. Excellent. The Daily Mash puts it best:

SATAN, the Prince of Darkness, is to launch an appeal after he was ordered to sell Heathrow.

The Competition Commission ruling is a major setback to Beelzebub's plan to expand his kingdom of the damned via the world's third busiest airport. He said last night... "Our latest customer survey showed more than 90% would rather be roasted on a spit and have the flesh ripped from their bones by a horde of fire-breathing, shit-covered demons than endure another minute in one of Heathrow's check-in queues.

Tasting 100

I have been meaning for a while to blog about a post on VOX about wine pricing. To paraphrase heavily, Parker determines the en primeur price, but the price at maturity depends on how good the wine really is. Given that Parker isn't a really great judge of how a wine will mature, and weather charts are better than him, there is an arb. The most obvious example I remember is the 86s, which were clearly overpriced in their youth, and now have faded to over-oaked oblivion while the 85s are still going strong.

There's nothing like leverage

From a recent Hussman Funds post, Nervous Bunny:

if we include the fair value of preferred equity, we find that on a fair value basis, Fannie Mae is operating at a gross leverage multiple of 72.7 (total assets comprised primarily of mortgage loans, divided by shareholder equity). In other words, a slight 1.4% deterioration in the value of Fannie's book of assets will wipe out all of the remaining shareholder equity. This makes Long Term Capital Management look like a conservative strategy.

Obviously if we don't include the prefs, it's harder to compute the leverage as Fannie has negative equity on a fair value basis. So while Hank might have no plans to put more cash into Fannie and Freddie, it will only take a small fall in their assets before he has to.

Undercover equilibrium: Holiday reading 2

The other popular economics book I read on holiday was Tim Harford's Undercover Economist. It's an interesting if quick read, and I can entirely see how it stimulated admissions to undergraduate economics programmes. It strikes me, though, that Harford's examples work best when the notion of price is unproblematic. He is presenting classical economics, so he assumes that prices are known and that all agents have a view as to the correct price for a good or service. Things get a lot more interesting once prices are not observable or when agents don't know what the 'right' price is. As, umm, in the debt markets at the moment. The Big Picture has a related discussion concerning the failure of equilibrium economics.

I have several favorite examples of where markets simply get it wrong. When I spoke with the reporter on this, I used the credit crunch as exhibit A. It began in August 2007 (though some had been warning about it long before that). Despite all of the obvious problems that were forthcoming, after a minor wobble, stock markets raced ahead. By October 2007, both the Dow Industrials and the S&P500 had set all time highs. So much for that discounting mechanism.

We've seen that sort of extreme mispricing on a fairly regular basis. In March 2000, the market was essentially pricing stocks as if earnings didn't matter, growth could continue far above historical levels indefinitely, and value was irrelevant.

My own view is that finance is not an equilibrium discipline, mostly, so while classical economics might work well in explaining the price of coffee - one of Harford's examples - it does rather less well in asset allocation or explaining the return distribution of financial assets. Rather new news arrives faster than the market can restore equilibrium after the last perturbation, meaning that most of the time equilibrium is not a useful concept.

Soros and Equilibrium: Holiday Reading 1

While I was away, perhaps slightly masochistically*, I read the new Soros book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means. It is not a particularly good summary of what happened, nor a detailed analysis of why it happened, but it does make an interesting point. Soros claims, I think very plausibly, that finance is reflexive, that is that the very study of it changes the object being studied. I have written about this before, but it is interesting to see Soros making much of the role of reflexity in the formation of asset price bubbles.

Of course, this feature of finance renders the received wisdom of classical economics rather suspect. In particular, models in finance are not time-stable in the same way that a good piece of science is, simply because the way market practitioners behave changes. The S&P return distribution with over half of all trades done by machine (2008) is unlikely to be the as that when most of the market went via floor traders (1988).

* 'We read popular finance books so you don't have to dot com' has not, funnily enough, been registered as a domain name...

Investment strategies old and new

This is a very fine post on investment. I picked it up via Naked Capitalism, and I heartily recommend it.

Ball of steel or brains of lead?

In what is either a strong buy signal for the market or a strong sell signal on the stock, MBIA has announcing that it was not changing its projection of losses on its mortgage-related exposures. The FT story is here. Yes, they had some bizarre FAS 159 gains (CNN is here and my take on the rules is here): yes, they resumed a share buy-back programme. But ignoring all that, if their actuarial loss estimates for RMBS have not changed, either that is a very useful datapoint on where realised default losses actually will be, or their actuaries are fools and it is time to short the stock again. It will be interesting to see which.

Update. John Dizard has pointed out the possible value in the monolines as a vulture play on the eventual losses on RMBS. I can see the idea, but I'd like to know more about the implied residual value of the monolines given the current equity price. Are they really cheap yet?