One of the fundamental tenets of effective central banking is independence from meddling politicians. While in most countries, a nominated head of the central bank must be given confirmed by the national legislature, it is generally regarded as detrimental for the government to be meddling in the decision making process of the central bank. That being said, high-level political oversight of central bank operations is a necessity.
After yesterday's shock and awe announcement from Europe's leadership which includes: 60B euros in government bond purchases by the ECB; 440B euros in loans or guarantees; as well as potentially 250B euros from the IMF (read America), I have yet to read any reaction to the apparent loss of ECB independence from Europe's politicians. Just last Thursday, Trichet stated unequivocally in a Q&A period that ECB purchases of government bonds had not been discussed at the most recent rate decision. Then in a complete 180 on the issue, on Sunday evening the ECB announced that they will be buying government bonds (along with the reintroduction of a number of liquidity facilities).
Admittedly, market volatility was very high Thursday and Friday, and the liquidity facilities existed during the earlier financial crisis. That being said, I am having an awfully hard time believing that the ECB did a complete 180 on the topic of QE over the course of one and a half trading days without enormous pressure from Euro zone politicians. If my convictions turn out to be rooted in fact, such overt political meddling does not bode well for the future of effective central banking.
Monday, May 10, 2010
Saturday, May 8, 2010
Thursday's Sell Off
I don't think I have ever felt my heart sink into my stomach the way it did when I was watching the chaotic sell off at 2:45 on Thursday afternoon. I literally thought that there had been another major terrorist attack, or a natural disaster orders of magnitude more severe than the oil spill in the Gulf (I do not mean to make light of the Gulf situation, but it's market impact thusfar has been relatively limited). Many market commentators and participants have blamed a "fat finger" putting in a sell order for 6 billion shares of P&G instead of 6 million. This may or may not be true, but it is ignoring the much more important issue. Once P&G started tanking, the rest of the market waterfalled with it, with the Dow down nearly 1000 points in literally minutes. The culprit is clearly algorithmic trade machines.
For those unfamiliar with the basics of how such programs work, they effectively trade securities based on the historical correlations between them. So if asset X drops historically in tandem with asset Y, and on a given day asset Y drops, algorithmic trading will exploit the 'mispricing' of asset X and short it based on the historical relationship between the prices of the assets. Then assuming a third asset (Z) historically falls when asset X swoons, another (or perhaps the same) algorithmic trading program will sell asset Z. These trading programs, combined with an erroneously large sell order which caused P&G to drop enormously (providing the spark), resulted in a positive feedback loop with enormous impacts on asset markets across the board. In this particular case, cooler heads prevailed and markets closed within spitting distance of where they were before this unprecedented sell off, but with trading trending in an increasingly automated direction, the next situation may not end so happily. In my opinion, the powers that be in financial markets want to distract attention away from the potentially enormous adverse impact of algorithmic trading, which provide very little economic value added to markets. This is why we are hearing more about a fat fingered trader in P&G than about algorithmic trading when this sell off, which is unprecedented in combination scope and speed, is discussed.
I don't want this rant against algorithmic trading to be understood as opposition to the high-frequency trading we were hearing about last summer where programmers equipped with the most sophisticated computers were supposedly front running the orders of, and thereby ripping off, institutional investors. These allegations are a complete misrepresentation of the reality of how such traders operate.
For those unfamiliar with the basics of how such programs work, they effectively trade securities based on the historical correlations between them. So if asset X drops historically in tandem with asset Y, and on a given day asset Y drops, algorithmic trading will exploit the 'mispricing' of asset X and short it based on the historical relationship between the prices of the assets. Then assuming a third asset (Z) historically falls when asset X swoons, another (or perhaps the same) algorithmic trading program will sell asset Z. These trading programs, combined with an erroneously large sell order which caused P&G to drop enormously (providing the spark), resulted in a positive feedback loop with enormous impacts on asset markets across the board. In this particular case, cooler heads prevailed and markets closed within spitting distance of where they were before this unprecedented sell off, but with trading trending in an increasingly automated direction, the next situation may not end so happily. In my opinion, the powers that be in financial markets want to distract attention away from the potentially enormous adverse impact of algorithmic trading, which provide very little economic value added to markets. This is why we are hearing more about a fat fingered trader in P&G than about algorithmic trading when this sell off, which is unprecedented in combination scope and speed, is discussed.
I don't want this rant against algorithmic trading to be understood as opposition to the high-frequency trading we were hearing about last summer where programmers equipped with the most sophisticated computers were supposedly front running the orders of, and thereby ripping off, institutional investors. These allegations are a complete misrepresentation of the reality of how such traders operate.
This Week in Europe
Okay, so a lot of things have happened since I last checked in with the situation in Greece. Where do we start? The upsized EU-IMF bailout is a good place. For those who have been under a rock for the last week, Sunday the EU and the IMF issued a statement detailing a 110 billion euro package of loans (at around 5% interest) for Greece, effectively removing them from private funding markets for the next two and a half years. The loan schedule was contingent on Greece implementing a strict set of austerity measures. Also included in the plan were much more realistic economic forecasts, in which the debt to GDP ratio peaks at 149% in 2013, falling from that point. Other bloggers/sites have told the story of last week better than I could here, so I will only comment on the broader issues behind this package.
It strikes me that the package announced by the EU/IMF will only serve to stave off a default by Greece (which would occur when their next bond matures on May 19th without the package). Why is default still inevitable? To answer this question, we must revisit our math on sustainable soveriegn debt loads. Assuming that Greece achieves trend growth of 2%, and that their average cost of debt is 5% (resulting in interest payments of 7.5% of GDP), it would be necessary for Greece to achieve a primary surplus of 5.5% in order to stabilize the debt/GDP ratio. Greece has never achieved this. So why lend them money at all? Well it appears to me that the idea was to prevent contagion until the other peripherals (who’s debt/deficit statistics aren’t as ugly as those of Greece) got their collective acts together and stabilized their fiscal situations – essentially to buy time for the other peripherals. I hope nobody at the EU-IMF summit was kidding themselves about Greece’s ability to achieve the fiscal consolidation necessary to avoid a debt spiral. The calculus appears to have been that the loss which will results from the restructuring of Greek sovereign debt (more on this later) will be outweighed by the ‘cost savings’ of preventing similar crises in Spain, Italy, Ireland and Portugal. This struck me as a relatively reasonable approach to mitigating the impacts of the crisis, despite the enormous agency problems it introduced for the peripherals. Too bad the Greeks ruined it all by rioting and shaking the market’s confidence in Greece’s ability to implement the austerity program and thereby putting enormous market pressure back on the remaining peripherals, with the chaotic results we witnessed in markets this week.
It strikes me that the package announced by the EU/IMF will only serve to stave off a default by Greece (which would occur when their next bond matures on May 19th without the package). Why is default still inevitable? To answer this question, we must revisit our math on sustainable soveriegn debt loads. Assuming that Greece achieves trend growth of 2%, and that their average cost of debt is 5% (resulting in interest payments of 7.5% of GDP), it would be necessary for Greece to achieve a primary surplus of 5.5% in order to stabilize the debt/GDP ratio. Greece has never achieved this. So why lend them money at all? Well it appears to me that the idea was to prevent contagion until the other peripherals (who’s debt/deficit statistics aren’t as ugly as those of Greece) got their collective acts together and stabilized their fiscal situations – essentially to buy time for the other peripherals. I hope nobody at the EU-IMF summit was kidding themselves about Greece’s ability to achieve the fiscal consolidation necessary to avoid a debt spiral. The calculus appears to have been that the loss which will results from the restructuring of Greek sovereign debt (more on this later) will be outweighed by the ‘cost savings’ of preventing similar crises in Spain, Italy, Ireland and Portugal. This struck me as a relatively reasonable approach to mitigating the impacts of the crisis, despite the enormous agency problems it introduced for the peripherals. Too bad the Greeks ruined it all by rioting and shaking the market’s confidence in Greece’s ability to implement the austerity program and thereby putting enormous market pressure back on the remaining peripherals, with the chaotic results we witnessed in markets this week.
Friday, April 30, 2010
Housing Prices - Further to Fall?
A couple weeks ago, The Economist ran a story on housing prices which stated that a number of developed countries (the United States was a notable exception) faced significant decline in prices in order to realign them with long run historical averages. It included a table summarizing their results (at the bottom, click for a larger image). The long run historical average used tp determine the implied declines was the price-to-rent ratios, which differ from country to country. While there is certainly an argument that the long-run average should persist, I believe that there is a much more thought-provoking argument that there may be a structural break in the price-to-rent ratio.
The fact that the long run average price-to-rent ratio differs from country to country forms the basis for my argument. A number of factors could influence this ratio across countries, such as differences in the difficulty/ease of obtaining financing, differences in marginal utility of owning a house versus renting, differences in available investment opportunities (China?), etcetera. Each of these factors is in turn influenced by a number of other factors, ranging from the social to the political, with the result being a host of factors influencing the price-to-rent ratio. The Economist does not give the long run average price-to-rent ratio in each country, but I suspect that it could be quite wide ranging (otherwise they would not differentiate between countries). Assuming changes in geography dictate a considerable range in price-to-rent ratios, I am positing that the factors which influence this ratio may undergo permanent change over the short term, thereby introducing a structural break to the price-to-rent ratio. The long term is generally defined as at least 25 years. Consider the changes in the social, economic and political landscape which have occurred over the last 25 years in some of these countries. Quantifying some of the relevant measures and crunching the numbers would prove enormously time consuming, but I suspect would add significant value, as The Economist is calling for a significant fall in Hong Kong, Australia, Spain, and France, among other markets. Let us not forget one of (my) primary takeaways from in Rienhart and Rogoff's "This Time is Different": property market busts are often precursors of financial crises.
The fact that the long run average price-to-rent ratio differs from country to country forms the basis for my argument. A number of factors could influence this ratio across countries, such as differences in the difficulty/ease of obtaining financing, differences in marginal utility of owning a house versus renting, differences in available investment opportunities (China?), etcetera. Each of these factors is in turn influenced by a number of other factors, ranging from the social to the political, with the result being a host of factors influencing the price-to-rent ratio. The Economist does not give the long run average price-to-rent ratio in each country, but I suspect that it could be quite wide ranging (otherwise they would not differentiate between countries). Assuming changes in geography dictate a considerable range in price-to-rent ratios, I am positing that the factors which influence this ratio may undergo permanent change over the short term, thereby introducing a structural break to the price-to-rent ratio. The long term is generally defined as at least 25 years. Consider the changes in the social, economic and political landscape which have occurred over the last 25 years in some of these countries. Quantifying some of the relevant measures and crunching the numbers would prove enormously time consuming, but I suspect would add significant value, as The Economist is calling for a significant fall in Hong Kong, Australia, Spain, and France, among other markets. Let us not forget one of (my) primary takeaways from in Rienhart and Rogoff's "This Time is Different": property market busts are often precursors of financial crises.
Tuesday, April 27, 2010
Greece Sliding Towards Oblivion
Given the time-honoured trend of bailouts and deals being made during the two day respite from the whims of the markets (also known as the weekend) I was quite surprised that no meaningful news regarding the progress of the Greek bailout was released on Sunday night. Late last week Greek PM Papandreou formally requested aid and the EU and IMF representatives finally arrived in Athens after being held up by the European resulting from the volcanic eruption in Iceland. I consider this (lack of news) to be very bad news, and it appears the market agrees with me. Greek bond yields have exploded (see images below) over the last few trading days, with the 2-year now yielding north of 15 percent! Despite the pledge of 45 billion euros in EU-IMF loans at 5 percent or less, the markets seem concerned that the cash will not be forthcoming quickly enough to prevent a Greek default when their 8.5 billion euro redemption comes due 19 May. Of particular concern is the provision that the EU portion of the funding must be unanimously approved EU member states, effectively granting each state a veto. Angela Merkel, in particular has been forced to play hardball in the face of sharp domestic opposition to the bailout, as her party is facing elections in Germany's most populous state on 9 May. At a recent rally, she was quoted as saying she "want[s] to see the program" before any proposed funds are released. It is likely that she is simply playing the populist card and looking to score some easy political points with a harsh sound byte and who can blame her? When as many as 80% of your constituents are against anything, you must at the very least pay lip service to their concerns. It is reasonable to expect that Germany will not approve the aid package until after this crucial election, leaving very little time for the implementation of the program.
Timing issues and political maneuvering aside, what exactly Mrs. Merkel meant by her comment confuses me, as Greece has already offered a detailed deficit-reduction program to the EU. Market participants seemingly had a similar reaction. Then, throwing salt in the wound, S&P downgraded Greece from BBB- to BB+ and Portugal from A+ to A-, both with outlook negative (indicating the possibility of further downgrades in the 12-18 month space). Not surprisingly PIIGS bond and CDS spreads, especially those of Greece and Portugal, blew out on this combination of news. With time being of the essence, it appears that the Greek goose is all but cooked. Restructuring strikes me as the only possibility short of a totally open-ended promise of funding from the EU/IMF - politically a near-impossibility. If you haven't had the (dis)pleasure of seeing graphically the widening in peripheral bond and CDS spreads, please see the charts below. Now the discussion over the broader impacts of a Greek default and how to best mitigate them begins...
Timing issues and political maneuvering aside, what exactly Mrs. Merkel meant by her comment confuses me, as Greece has already offered a detailed deficit-reduction program to the EU. Market participants seemingly had a similar reaction. Then, throwing salt in the wound, S&P downgraded Greece from BBB- to BB+ and Portugal from A+ to A-, both with outlook negative (indicating the possibility of further downgrades in the 12-18 month space). Not surprisingly PIIGS bond and CDS spreads, especially those of Greece and Portugal, blew out on this combination of news. With time being of the essence, it appears that the Greek goose is all but cooked. Restructuring strikes me as the only possibility short of a totally open-ended promise of funding from the EU/IMF - politically a near-impossibility. If you haven't had the (dis)pleasure of seeing graphically the widening in peripheral bond and CDS spreads, please see the charts below. Now the discussion over the broader impacts of a Greek default and how to best mitigate them begins...
Monday, April 26, 2010
The Missing Link in Financial Reform
Paul Krugman of the NY Times weighed in yesterday on the need for more meaningful reform of ratings agencies. This is an area of regulatory reform which has fallen by the wayside, to the detriment of the future stability of the financial system. The case against the current setup for ratings agencies is quite simple. Currently, the issuers of debt pay the ratings agencies for their services, and issuers have a choice of which ratings agencies, resulting in agencies having the incentive to 'inflate' the ratings to some extent - as issuers will naturally pay the agency most likely to provide them with the highest rating.
In the run-up to the crisis, investment banks would shop their structured products to a variety of ratings agencies and pay whichever firm was willing to rubber stamp said products with the highest ratings. A number of emails have recently made news for highlighting the misconduct at the ratings agencies which resulted from the pressure to give the ratings that the bankers were seeking. Large scale investors which were either too lazy or lacked the institutional capacity to do their own homework on such structured securities relied heavily on rating agencies to do their due diligence for them, leading to catastrophic losses when the securities experienced heavy losses. Evidence of the distortions created by these incentives is offered by the fact that over an 18-month period of the crisis, Moody's and S&P downgraded more securities than they had in their respective 90 years of preceding history. When these securities were downgraded, institutional investors with investment profiles which included minimum ratings thresholds (Ie. most pension plans are only allowed to invest in AAA securities) were forced to sell their securities into suddenly illiquid markets, thereby compounding their losses, as well as those of others who were marking their assets to market (until the FASB suspended such practices).
Krugman is not convinced that the proposed reforms do not effectively deal with the skewed incentives of ratings agencies it appears that he is right. Krugman supports the proposition that issuers continue to pay the ratings agencies, but a third party, such as the SEC chooses which agency rates which debt. This seems reasonable, although I am skeptical of the SEC's ability to fight their way out of a wet paper bag, let alone invent a reasonable process for assigning rating responsibilities. A similar structure with a more competent 'middle man' strikes me as a reasonable solution to one of the most overlooked shortcomings of our current system.
In the run-up to the crisis, investment banks would shop their structured products to a variety of ratings agencies and pay whichever firm was willing to rubber stamp said products with the highest ratings. A number of emails have recently made news for highlighting the misconduct at the ratings agencies which resulted from the pressure to give the ratings that the bankers were seeking. Large scale investors which were either too lazy or lacked the institutional capacity to do their own homework on such structured securities relied heavily on rating agencies to do their due diligence for them, leading to catastrophic losses when the securities experienced heavy losses. Evidence of the distortions created by these incentives is offered by the fact that over an 18-month period of the crisis, Moody's and S&P downgraded more securities than they had in their respective 90 years of preceding history. When these securities were downgraded, institutional investors with investment profiles which included minimum ratings thresholds (Ie. most pension plans are only allowed to invest in AAA securities) were forced to sell their securities into suddenly illiquid markets, thereby compounding their losses, as well as those of others who were marking their assets to market (until the FASB suspended such practices).
Krugman is not convinced that the proposed reforms do not effectively deal with the skewed incentives of ratings agencies it appears that he is right. Krugman supports the proposition that issuers continue to pay the ratings agencies, but a third party, such as the SEC chooses which agency rates which debt. This seems reasonable, although I am skeptical of the SEC's ability to fight their way out of a wet paper bag, let alone invent a reasonable process for assigning rating responsibilities. A similar structure with a more competent 'middle man' strikes me as a reasonable solution to one of the most overlooked shortcomings of our current system.
Thursday, April 22, 2010
Wisdom from the Gartman Letter
I recently came across a blog which discussed the top 10 rules of trading, according to the Gartman Letter, an excellent daily piece which "addresses political, economic, and technical trends from both long-term and short-term perspectives". I thought they were worth sharing here:
1. Never, ever, ever add to a losing position: To do so will eventually and absolutely lead to ruin. Remember Long Term Capital Management and its legion of Nobel laureates who broke this rule repeatedly and went into forced liquidation. Learn this lesson well and early!
2. Capital comes in two varieties: Mental capital, and that which is in your account: Of the two, mental capital is the more important. Holding losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.
3. The objective is not to buy low and sell high, but to buy high and to sell higher: We can never know what price is “low.” Nor can we know what price is “high.” Always remember that Nortel fell from $85/share to $2 and seemed “cheap” all times along the way.
4. “Markets can remain illogical longer than you or I can remain solvent,” is a brilliant statement from our good friend, Dr. A. Gary Shilling. Illogic often reigns and markets are inefficient despite what the academics try to tell us.
5. Sell that which shows the greatest weakness, and buy that which shows the greatest strength: Metaphorically, when bearish, throw rocks into the wettest paper sack, for they break most readily. In bull markets, ride the strongest winds.
6. Think like a fundamentalist; trade like a technician: It is imperative that we understand the fundamentals driving a trade, and that we understand the market’s technicals also. When we do, then, and only then, should we trade.
7. Understanding psychology is usually more important than understanding economics: Markets are driven by human beings making human errors and also making super-human insights.
8. Be patient with winning trades; be enormously impatient with losing trades: Remember, it is quite possible to make large sums trading/investing if we are “right” only 30% of the time, as long as our losses are small and our profits are large.
9. The Hard Trade is the Right Trade: If it is easy to sell, don’t; and if it is easy to buy, don’t. Do the trade that is hard to do and that which the crowd finds objectionable. Peter Steidelmeyer taught us this 25 years ago and it holds truer now than then.
10. There is never one cockroach: Bad news begets bad news, which begets even worse news.
You Can Lead a Horse to Water...
Okay, so I wrote in the run up to Goldman's earnings that the stock was a good buy on the gut reaction sell/short on the back of news of the SEC's lawsuit. My basic intuition was twofold: the case seemed quite bunk (a feeling that has been reinforced since); and even if Goldman is found guilty, the approximately $14B hit to their market cap was a large overreaction. My expectation was that Goldman would surpass earnings expectations by a mile and they did: EPS of $5.59 vs expectations of $4.16 (beating by approx. 40%). The gross figures were revenues of $12.8B, $7.4B of which was from Fixed Income, Commodities and Currencies (FICC), and profits of $3.29B. Enormous quarterly numbers, but the stock refused to budge.
Clearly the trade I recommended was not much good (although had you bought at open Friday and sold at open Tuesday - the day of the earnings report - you would have netted a couple percent). People who seek to improve themselves look at their decisions, and aided with the benefit of hindsight they isolate where they went wrong in order to avoid such mistakes in the future. My mistake hereis quite clear. The overriding negative sentiment from the SEC case (no matter how bunk) made it impossible for this stock to bounce nicely on a very strong earnings report. The lesson? In the short term, perceptions (animal spirits) outweigh fundamentals. I feel very strongly that Goldman will continue to outperform and my ideas will be vindicated in the long run.
Clearly the trade I recommended was not much good (although had you bought at open Friday and sold at open Tuesday - the day of the earnings report - you would have netted a couple percent). People who seek to improve themselves look at their decisions, and aided with the benefit of hindsight they isolate where they went wrong in order to avoid such mistakes in the future. My mistake hereis quite clear. The overriding negative sentiment from the SEC case (no matter how bunk) made it impossible for this stock to bounce nicely on a very strong earnings report. The lesson? In the short term, perceptions (animal spirits) outweigh fundamentals. I feel very strongly that Goldman will continue to outperform and my ideas will be vindicated in the long run.
Monday, April 19, 2010
What About Greece?
With all the furor surrounding the SEC's case against Goldman, a lot of people have lost sight in Greece. There is has been an interesting wrinkle in the ongoing epic surrounding Greece's debt crisis. Thanks to the volcanic eruption in Iceland, delegates from the EU and the IMF have been unable to fly to Athens, presumably to negotiate the details of the bailout, which is becoming more necessary by the day. CDS and Greek government bond spreads to bunds are trading at all-time highs, effectively forcing the Greek government to tap the liquidity program agreed upon the weekend before last. As I mentioned before, any bailout package will have to be much bigger than what has been agreed upon, as well as much cheaper. It should be interesting to see what happens through the course of the week/end.
Sunday, April 18, 2010
The SEC's Lawsuit Against Goldman - Revised
As I mentioned on Friday, my initial impression was that the 13% haircut Goldman's stock took in reaction to the SEC's lawsuit was an excellent opportunity to buy heading into their earnings report on Tuesday. After having some more time to reflect and read up further, my conviction has been strengthened.
Forget about reading confusing, conflicting news reports about the SEC's allegations against Goldman. The SEC has released a surprisingly readable (not full of legal jargon) report detailing their case. If you don't want to read the 22 pages, I'll give you a summary.
Goldman was approached by John Paulson, who was looking to short the housing market. Goldman figured that the best way to do this was to create a synthetic CDO which replicates the return on a reference portfolio of residential mortgage-backed securities (RMBSs). To quote the SEC's report, the difference between a CDO and a synthetic CDO is that
Operating under the incorrect assumption that Paulson was an equity investor, ACA went ahead with the deal. It was subsequently marketed to other parties with ACA identified as the portfolio selection agent. Ultimately the majority of the credit exposure was sold to a few European banks and they ended up taking a combined $1B in write downs, with the proceeds collected by Paulson's fund.
The SEC takes issue with Goldman's conduct on two fronts:
As for the charge that Goldman intentionally misled ACA re: Paulson's interests in Abacus, does anyone at the SEC really believe the evidence in support of this charge (as laid out in point 47) is going to stand up to Goldman's legal defense team? I think that more substantial evidence of Goldman intentionally misleading ACA will prove necessary to return a guilty verdict on this charge. However, I do think that the case as laid out certainly casts Goldman as grossly negligent in the very least. Proving beyond a reasonable doubt that Goldman behaved in a fraudulent manner may prove quite difficult, but the damage to their reputation will be done regardless of the verdict.
I think that the timing of this announcement is another interesting consideration. Over the last few weeks, Goldman has engaged in an aggressive PR campaign to exonerate themselves of responsibility for the crisis. Highlights of this campaign include a cover story in Business Week complete with interviews with upper management as well as a letter to shareholders defending their conduct in the crisis which appeared in their 2009 annual report. Perhaps the SEC was looking to undermine this PR blitz? Maybe, but I think it a more likely explanation is linked to the push for financial reform. Some politicians are becoming complacent and reluctant to back proposed reform to reign in the big banks. Now the supporters can point to the SEC lawsuit and say "See, these guys are defrauding investors, we need to come down hard on them to teach them a lesson", thereby acquiring support for reform. By the time this case is settled in any fashion (court decision, settlement or dropped) it will have served its purpose in this regard. Bruce Krasting at Seeking Alpha does a better job fleshing out this argument than I do.
It is also quite possible that I am dead wrong in my analysis. Let us examine the consequences in this situation. Goldman gets taken to task by the SEC and ends up paying a huge fine. How big could it be? Dick Bove, an influential analyst who covers the financial sector, estimates as much as $2 billion. Other industry analysts offer considerably lower estimates. Compare this to the drop in Goldman's market cap Friday ($12 billion). That implies there needs to be six cases of this magnitude filed and won against Goldman to justify the drop. There is an argument that Goldman will lose a lot of business on the back of this announcement. Maybe, but who is going to stop looking to Goldman when they need to buy or sell fixed income on the basis of this story? That's where Goldman is earning all their money these days anyways. At the end of the day, Goldman losing a some business isn't going to change their earnings figure (the medium term impact is more uncertain) and on this basis I stand by Friday's call to buy.
Forget about reading confusing, conflicting news reports about the SEC's allegations against Goldman. The SEC has released a surprisingly readable (not full of legal jargon) report detailing their case. If you don't want to read the 22 pages, I'll give you a summary.
Goldman was approached by John Paulson, who was looking to short the housing market. Goldman figured that the best way to do this was to create a synthetic CDO which replicates the return on a reference portfolio of residential mortgage-backed securities (RMBSs). To quote the SEC's report, the difference between a CDO and a synthetic CDO is that
"CDOs are debt securities collateralized by debt obligations including RMBS. These securities are packaged and generally held by a special purpose vehicle (“SPV”) that issues notes entitling their holders to payments derived from the underlying assets. In a synthetic CDO, the SPV does not actually own a portfolio of fixed income assets, but rather enters into CDSs that reference the performance of a portfolio" (point 13 of SEC report)The implication of this difference is that in a synthetic CDO, there must, by definition, be a long and a short party. Remember this, it is an important point. Back to the story. Goldman got ACA Management LLC, a firm quite experienced with this type of transaction (having performed upwards of 25 similar transactions prior to the one under discussion) to sign on as the manager of the proposed synthetic CDO (from this point forward referred to as Abacus). Intending to short Abacus, Paulson had an incentive to have what he considered poor-quality RMBSs to be included in the reference portfolio. ACA and Paulson met on a number of occasions and after some back and forth, a portfolio was finally agreed upon which included a large number of Paulson's suggestions. Another very important point is that ACA had the final say of which mortgages went into the portfolio. At one point ACA wanted more information on what exactly Paulson's role in the transaction was. This is where things get particularly contentious. Point 47 of the SEC report details the charge that Goldman misled ACA on this issue. Since it is so important, I will include the entire point.
"On January 10, 2007, Tourre emailed ACA a “Transaction Summary” that included a description of Paulson as the “Transaction Sponsor” and referenced a “Contemplated Capital Structure” with a “[0]% - [9]%: pre-committed first loss” as part of the Paulson deal structure. The description of this [0]% - [9]% tranche at the bottom of the capital structure was consistent with the description of an equity tranche and ACA reasonably believed it to be a reference to the equity tranche. In fact, GS&Co never intended to market to anyone a “[0]% - [9]%” first loss equity tranche in this transaction." (point 47 of the SEC report)What exactly does the SEC mean by "referenc[ing] a 'Contemplated Capital Structre' with a '[0]% - [9]%: pre-committed first loss' as part of the Paulson deal structure"? While I am not privy to the jargon of the CDO industry, this looks more like obfuscation than misrepresentation by Goldman. It is clear when reading the report in its entirety that the SEC had excellent access to Goldman's internal communications, as well as their communications with parties in the deal. I feel that if Goldman had unequivocally indicated that Paulson was going long Abacus, the SEC would have been able to present a quote more condemning than this. To me, point 47, the crux of the case, says effectively nothing. Especially the final sentence. May I have the rest of the quote to substantiate the SEC's claim that Goldman never intended to sell an equity tranche? The next few points of the SEC's report detail evidence of ACA being of the impression that Paulson was long the equity tranche and Goldman failing to correct this misconception.
Operating under the incorrect assumption that Paulson was an equity investor, ACA went ahead with the deal. It was subsequently marketed to other parties with ACA identified as the portfolio selection agent. Ultimately the majority of the credit exposure was sold to a few European banks and they ended up taking a combined $1B in write downs, with the proceeds collected by Paulson's fund.
The SEC takes issue with Goldman's conduct on two fronts:
- Goldman misled investors by failing to mention Paulson's role in the selection of securities in Abacus' reference portfolio
- Goldman misled ACA over Paulson's interest Abacus
As for the charge that Goldman intentionally misled ACA re: Paulson's interests in Abacus, does anyone at the SEC really believe the evidence in support of this charge (as laid out in point 47) is going to stand up to Goldman's legal defense team? I think that more substantial evidence of Goldman intentionally misleading ACA will prove necessary to return a guilty verdict on this charge. However, I do think that the case as laid out certainly casts Goldman as grossly negligent in the very least. Proving beyond a reasonable doubt that Goldman behaved in a fraudulent manner may prove quite difficult, but the damage to their reputation will be done regardless of the verdict.
I think that the timing of this announcement is another interesting consideration. Over the last few weeks, Goldman has engaged in an aggressive PR campaign to exonerate themselves of responsibility for the crisis. Highlights of this campaign include a cover story in Business Week complete with interviews with upper management as well as a letter to shareholders defending their conduct in the crisis which appeared in their 2009 annual report. Perhaps the SEC was looking to undermine this PR blitz? Maybe, but I think it a more likely explanation is linked to the push for financial reform. Some politicians are becoming complacent and reluctant to back proposed reform to reign in the big banks. Now the supporters can point to the SEC lawsuit and say "See, these guys are defrauding investors, we need to come down hard on them to teach them a lesson", thereby acquiring support for reform. By the time this case is settled in any fashion (court decision, settlement or dropped) it will have served its purpose in this regard. Bruce Krasting at Seeking Alpha does a better job fleshing out this argument than I do.
It is also quite possible that I am dead wrong in my analysis. Let us examine the consequences in this situation. Goldman gets taken to task by the SEC and ends up paying a huge fine. How big could it be? Dick Bove, an influential analyst who covers the financial sector, estimates as much as $2 billion. Other industry analysts offer considerably lower estimates. Compare this to the drop in Goldman's market cap Friday ($12 billion). That implies there needs to be six cases of this magnitude filed and won against Goldman to justify the drop. There is an argument that Goldman will lose a lot of business on the back of this announcement. Maybe, but who is going to stop looking to Goldman when they need to buy or sell fixed income on the basis of this story? That's where Goldman is earning all their money these days anyways. At the end of the day, Goldman losing a some business isn't going to change their earnings figure (the medium term impact is more uncertain) and on this basis I stand by Friday's call to buy.
Friday, April 16, 2010
Good time to buy Goldamn Sachs
On Wednesday I commented on how I thought Goldman was going to post a huge quarter on trading revenues and thought the stock could go to $200. Well today, the SEC sent Goldman a Wells notice which indicates that Goldman is likely to face a civil suit over one of their CDO products backed by mortgage backed securities. The essence of the lawsuit appears to be that Goldman advertised to clients that the bonds put into the CDO were chosen by an independent asset manager, while the SEC contends that in fact they were picked by John Paulson, who was looking to short the housing market, and therefore picked bonds which he expected to be downgraded/lose value. For those unfamiliar with the structuring of a CDO transaction, a relatively accurate simplification is that it tracks the value of the bonds "put into" the CDO. If these bonds fall in value, so does the CDO. If I understand correctly, Paulson was short this CDO via CDS contracts on it purchased from AIG as a part of the deal.
Whether or not Goldman ends up paying a fine, they are still going to post a huge quarter and the 10% drop in the stock in my opinion represents an excellent buying opportunity if you share this expectation. Also, this news has wiped out over $10B in market cap, when the total value of the CDO was $2B. I find it hard to believe that if Goldman loses the case (or settles), they will make a payout anywhere near this size. It would be totally unprecedented. This aside, it will be interesting to see whether Goldman includes a contingent liability for this lawsuit in their quarterly figures.
Whether or not Goldman ends up paying a fine, they are still going to post a huge quarter and the 10% drop in the stock in my opinion represents an excellent buying opportunity if you share this expectation. Also, this news has wiped out over $10B in market cap, when the total value of the CDO was $2B. I find it hard to believe that if Goldman loses the case (or settles), they will make a payout anywhere near this size. It would be totally unprecedented. This aside, it will be interesting to see whether Goldman includes a contingent liability for this lawsuit in their quarterly figures.
Wednesday, April 14, 2010
Other News
The Canadian dollar closed above par with the US dollar for the first time since June 2008 today. Next stop $1.05?
Also, the market has spoken on the big fat Greek band-aid offered by the EU. Some commentators tried to talk up massively over allotted 6 and 12 month T-bill auctions. Is over allotment surprising, considering that the EU/IMF has package has effectively guaranteed Greek financing for the next 12 months? Oh did I mention the yields were extremely rich at 4.55 and 4.85 percent respectively? Isn't the current ECB rate at 1%?
After dropping significantly Monday, Greek spreads to bunds and CDS spreads widened Tuesday and Wednesday, closing above Friday's levels Wednesday. This is the market screaming from the clock tower that while addressing the prospects of a liquidity crisis, the announced package does nothing to address the (much larger) solvency issue. More on why the Greek situation is hopeless to come this weekend.
Also, the market has spoken on the big fat Greek band-aid offered by the EU. Some commentators tried to talk up massively over allotted 6 and 12 month T-bill auctions. Is over allotment surprising, considering that the EU/IMF has package has effectively guaranteed Greek financing for the next 12 months? Oh did I mention the yields were extremely rich at 4.55 and 4.85 percent respectively? Isn't the current ECB rate at 1%?
After dropping significantly Monday, Greek spreads to bunds and CDS spreads widened Tuesday and Wednesday, closing above Friday's levels Wednesday. This is the market screaming from the clock tower that while addressing the prospects of a liquidity crisis, the announced package does nothing to address the (much larger) solvency issue. More on why the Greek situation is hopeless to come this weekend.
JPMorgan Q1 2010 Earnings
So JPMorgan was the first of the big US banks to report Q1 2010 earnings today. The figures beat expectations of 64 cents per share by a dime and led to a significant stock market rally driven by the financial sector. CEO Jamie Dimon was also quite upbeat on the economy, venturing as far as to say that various economic indicators were indicative of a strong recovery. The firm even reversed $462M in provisions for credit losses, an indication that writedowns in the loan book will not be severe as earlier estimates. This is very bullish for the US economy. Trading continued to be the driver of performance, with fixed income trading revenue coming in at a record $5.46B and the investment bank as a whole contributing $2.47B to bank's total earnings of $3.33B.
The fact that JPMorgan was actually able to surpass Q4 earnings ($3.28B) on the back of another record for fixed income trading is very bullish Goldman Sachs. GS made $21.77 last year, riding enormous windfall profits in fixed income trading as their competitors scaled back operations. GS is relative cheap right now at 8.5 trailing earnings on expectations that they will not be able to provide the same sort of returns moving forward, as competition re-enters fixed income trading in a big way and chips away at GS' bread and butter. GS is known for managing earnings expectations and I remember making a mental note of an interview in January with COO David Cohn in which he said that he expects fixed income trading numbers to maintain or expand from levels seen in Q4. Unless JPMorgan has been stealing GS's market share (something I view as quite unlikely) JPMorgan's figures indicate that the largest book runners have been able to defy expectations and maintain market share despite the heightened competition in this market, thereby supporting Cohn's comments. On this basis, I am expecting GS to post a big number when they report. If they continue to bow to populist pressure and keep the compensation ratio low, it could be an enormous number. I won't be making a whole lot of calls on this blog, but I think GS is a good trade right now ($185). They could run to $200 if Greece doesn't ruin the party in financials right now.
Bank of America should also be boosted by trading profits at Merrill, but they have a much uglier loan book than JPMorgan and on that basis cannot recommend BAC stock.
One addendum. JPMorgan's figures included a $2.7B write off for expected charges resulting from lawsuits surrounding the WaMu takeover. I haven't heard a whole lot about said lawsuits, but will keep an eye out for more information.
The fact that JPMorgan was actually able to surpass Q4 earnings ($3.28B) on the back of another record for fixed income trading is very bullish Goldman Sachs. GS made $21.77 last year, riding enormous windfall profits in fixed income trading as their competitors scaled back operations. GS is relative cheap right now at 8.5 trailing earnings on expectations that they will not be able to provide the same sort of returns moving forward, as competition re-enters fixed income trading in a big way and chips away at GS' bread and butter. GS is known for managing earnings expectations and I remember making a mental note of an interview in January with COO David Cohn in which he said that he expects fixed income trading numbers to maintain or expand from levels seen in Q4. Unless JPMorgan has been stealing GS's market share (something I view as quite unlikely) JPMorgan's figures indicate that the largest book runners have been able to defy expectations and maintain market share despite the heightened competition in this market, thereby supporting Cohn's comments. On this basis, I am expecting GS to post a big number when they report. If they continue to bow to populist pressure and keep the compensation ratio low, it could be an enormous number. I won't be making a whole lot of calls on this blog, but I think GS is a good trade right now ($185). They could run to $200 if Greece doesn't ruin the party in financials right now.
Bank of America should also be boosted by trading profits at Merrill, but they have a much uglier loan book than JPMorgan and on that basis cannot recommend BAC stock.
One addendum. JPMorgan's figures included a $2.7B write off for expected charges resulting from lawsuits surrounding the WaMu takeover. I haven't heard a whole lot about said lawsuits, but will keep an eye out for more information.
Sunday, April 11, 2010
Greece Gets Bailed Out
In a nod to the late-2008 era of the weekend bailout, it has been announced that Greece will receive up to 45 billion euros in financing over the coming 12 months. 30 billion of this will come from the EU in the form of 3-year loans at 5%, about 2% lower than the current yield on 3-year Greek debt, and the other 15 billion will come from the IMF, presumably at even lower rates. This is approximately double the size of the previously announced package. In agreeing to this package, the EU leaders have effectively said "here is the financing you need to get over the hump until you get your deficit under control, thereafter you should be able to obtain reasonably priced financing in the private markets". I can only imagine the tug-of-war that must have gone on behind closed doors to get this done. What happened to the talk of "financing at market rates"? German representatives must be fuming.
Anyways so the million dollar question is what does this change? According to Bloomberg this figure will not entirely cover Greece's financing needs over the coming 12 months, but clearly the lion's share of financing needs are spoken for. The Greek's are playing it cool, with Finance Minister George Papaconstantinou claiming that they are going to go ahead with financing as planned - including the rumored 10B USD dollar that Greece is preparing the roadshow for. It will certainly be interesting to see how much lower Greek yields/CDS open tomorrow. I don't have time to run all the numbers, but assuming that they do tap this financing at 5%, they will effectively save 2% of 45 billion euros annually. Savings of 900M euros annually for an economy of circa 250 billion euros (forgive me if I err here, I am in a rush and pulling these numbers from memory), that equates to annual savings of less than .5% of GDP. My initial reaction is that this package is a band-aid rather than a game changer. More tomorrow when I have had a chance to think/read a little more about it.
Anyways so the million dollar question is what does this change? According to Bloomberg this figure will not entirely cover Greece's financing needs over the coming 12 months, but clearly the lion's share of financing needs are spoken for. The Greek's are playing it cool, with Finance Minister George Papaconstantinou claiming that they are going to go ahead with financing as planned - including the rumored 10B USD dollar that Greece is preparing the roadshow for. It will certainly be interesting to see how much lower Greek yields/CDS open tomorrow. I don't have time to run all the numbers, but assuming that they do tap this financing at 5%, they will effectively save 2% of 45 billion euros annually. Savings of 900M euros annually for an economy of circa 250 billion euros (forgive me if I err here, I am in a rush and pulling these numbers from memory), that equates to annual savings of less than .5% of GDP. My initial reaction is that this package is a band-aid rather than a game changer. More tomorrow when I have had a chance to think/read a little more about it.
Friday, April 9, 2010
Friday Night Linkfest
Well what can I say? Studying for the CFA is making it difficult to post as much as I would like. Here is some weekend reading for inquiring minds.
Greece moves to make it more difficult to short their debt by eliminating naked shorting of Greek bonds. Fair enough. Story here.
Regulators of Fannie Mae claim that the business was felled its the business model. Hmm I thought it was tragically comedic risk management practices?
UBS' risk appetite indicator is approaching extremes, indicating that downside risk is building in the equity markets.
Citi's Prince and Rubin get excoriated on Capitol Hill, while maintaining that Citi had the best risk management on Wall Street? Now there's a tough sell.
James Chanos argues that China is on the 'treadmill to hell'. His hedge fund was among the first to spot problems at Enron and he claims that 60% of China's economy is dependent on construction. Claims definitely worth following up on. I will post the link to the full Charlie Rose interview when it becomes available.
Interesting chart detailing the maturity/yield trade-off for various asset classes.
The Economist weighs in on Greece.
Fitch downgrades Greece to BBB- from BBB+.
Greece moves to make it more difficult to short their debt by eliminating naked shorting of Greek bonds. Fair enough. Story here.
Regulators of Fannie Mae claim that the business was felled its the business model. Hmm I thought it was tragically comedic risk management practices?
UBS' risk appetite indicator is approaching extremes, indicating that downside risk is building in the equity markets.
Citi's Prince and Rubin get excoriated on Capitol Hill, while maintaining that Citi had the best risk management on Wall Street? Now there's a tough sell.
James Chanos argues that China is on the 'treadmill to hell'. His hedge fund was among the first to spot problems at Enron and he claims that 60% of China's economy is dependent on construction. Claims definitely worth following up on. I will post the link to the full Charlie Rose interview when it becomes available.
Interesting chart detailing the maturity/yield trade-off for various asset classes.
The Economist weighs in on Greece.
Fitch downgrades Greece to BBB- from BBB+.
Wednesday, April 7, 2010
So Apparently It's Not Just Me
I honestly did not create this blog to rant about a Greek default, but sovereign debt is certainly the theme of the year in financial markets (an excellent call by the Economist at the end of 2009). Anyways, by this point, my internal dialogue has moved past the discussion of whether or not Greece is going to default to over what time horizon I should expected it to happen (I am currently thinking 3-7 years), what the ramifications will be, and where the EU authorities will be forced to step in. Bloomberg ran a story today detailing the opinions of one Mr. Stephen Jen (formerly of the IMF), now a manager at BlueGold Capital. Jen apparently is even more concerned than I am. He says that without an aid package several times the size of the one tabled by the ECB/IMF, Greek default is inevitable, possibly before the end of the year. The article also discusses the esteemed Mr. El Erian's gloomy outlook on the Greek situation.
I also recently came to the realization that I have yet to flesh out all the arguments for why a Greek default is an inevitability. Stay tuned.
I also recently came to the realization that I have yet to flesh out all the arguments for why a Greek default is an inevitability. Stay tuned.
Tuesday, April 6, 2010
Why Financial Journalists Should be Trained in Economics
Today the Canadian dollar reached parity with the US dollar for the first time since June 2008. Back then, oil (one of Canada's primary exports) was circa $140/barrel. As has been the case for all currencies, it has been a pretty wild ride since then. In response to this development, Reuters ran a story on the Canadian dollar's rise today. After an overview of the more conventional causes of the Canadian dollar's rise - expectations of divergence with American monetary policy and strengthening commodity prices - the article identified Friday's US payrolls number as the most recent driver of the Canadian dollar's rise, on the basis that this was a sign of strength in Canada's largest trading partner.
I could understand how this might strengthen the Canadian dollar versus a 3rd country's currency, but using improving American fundamentals to rationalize the bullish moves in CAD/USD is nothing less than a failure of financial journalism.
I could understand how this might strengthen the Canadian dollar versus a 3rd country's currency, but using improving American fundamentals to rationalize the bullish moves in CAD/USD is nothing less than a failure of financial journalism.
PIMCO's Bhansali on Tail Risks
I recently came across this interesting Q&A with Vineer Bhansali who is a Portfolio Manager and Managing Director of PIMCO. For those of you unfamiliar with the concept of tail risk, as explained in the interview, it is essentially the unpredictable, very low probability events which have a large impact on the value of the portfolio. Most portfolio managers do not properly understand the tail risks in their portfolios, and therefore do not hedge them appropriately (for evidence, see the recent financial crisis, the ultimate tail event). Mr. Bhansali describes tail events as "systemic risks in which every investor desires liquidity...but nobody is willing to provide it." He elaborates that such events "often challenge traditional risk diversification models, because these periods may simultaneously exhibit substantial equity market declines, credit spread widening, increased market volatility and disorderly moves in the currency markets." The conversation moves on to detail the litany of instruments which can be used to hedge against tail risk, as well as PIMCO's process when approaching tail risk. Worth a read for anyone interested in risk management.
Tuesday, March 30, 2010
Commentary on Greece's Latest Bond Issue
Yesterday Greece sold 5 billion euros worth of 7-year bonds via syndication. The deal priced at mid-swaps plus 310 basis points to yield 6%, a level double what Germany would pay to borrow at the same tenure. The bid-to-cover ratio was only 1.4, compared to more than 3 for Greece's 5-year, 5 billion euro auction held on 4 March. Foreigners bought 57% of this deal, versus 77% in the aforementioned 5-year offering.
While the jury is out to some extent (see linked story), the perception around my office was that this syndication went quite poorly, especially considering that issue's yield widened 24 basis points in the secondary market today. Additionally, today there was an unannounced reopening of the Greek 12-year of up to 1 billion euros, which only managed to attract 390 million euros in orders. Unsurprisingly, Greek CDS spreads were wider on the day.
Many people were looking to the 7-year auction as a gauge of markets' perception of the EU plan for offering financial assistance to Greece. Some of the finer details still need some fleshing out, but broadly, there is to be a pool of 20-22 billion euros available from the EU and the IMF (providing 2/3 and 1/3 respectively) for Greece to tap in the situation that it cannot raise funds via the private market. While an effective bridge for any short-term financing issues, this does nothing to address the fact that if Greece continues refinancing in the private markets at 6%, they will end up be paying more than 7% of GDP in interest payments alone. Does anyone else see a dizzying debt spiral? See my previous post for a longer discussion of what constitutes sustainable a debt burden. Also, perhaps the ability of any euro zone country (read: Germany) to veto any potential action removes some of this bill's legitimacy?
Regardless of what aspect(s) of the bill the market did not like, this auction shows that investors are still very skeptical of Greece's ability to right the ship - arguably more so than in early March (the time of the preceding, better received syndication). Greece has a tough slog ahead of them if they are to avoid default. I am generally an optimist, but the realist in me is saying that Greece doesn't have what it takes.
While the jury is out to some extent (see linked story), the perception around my office was that this syndication went quite poorly, especially considering that issue's yield widened 24 basis points in the secondary market today. Additionally, today there was an unannounced reopening of the Greek 12-year of up to 1 billion euros, which only managed to attract 390 million euros in orders. Unsurprisingly, Greek CDS spreads were wider on the day.
Many people were looking to the 7-year auction as a gauge of markets' perception of the EU plan for offering financial assistance to Greece. Some of the finer details still need some fleshing out, but broadly, there is to be a pool of 20-22 billion euros available from the EU and the IMF (providing 2/3 and 1/3 respectively) for Greece to tap in the situation that it cannot raise funds via the private market. While an effective bridge for any short-term financing issues, this does nothing to address the fact that if Greece continues refinancing in the private markets at 6%, they will end up be paying more than 7% of GDP in interest payments alone. Does anyone else see a dizzying debt spiral? See my previous post for a longer discussion of what constitutes sustainable a debt burden. Also, perhaps the ability of any euro zone country (read: Germany) to veto any potential action removes some of this bill's legitimacy?
Regardless of what aspect(s) of the bill the market did not like, this auction shows that investors are still very skeptical of Greece's ability to right the ship - arguably more so than in early March (the time of the preceding, better received syndication). Greece has a tough slog ahead of them if they are to avoid default. I am generally an optimist, but the realist in me is saying that Greece doesn't have what it takes.
Monday, March 29, 2010
Jeremy Grantham Weighs In on Where We Stand and What is to Come
I recognize Jeremy Grantham as a very intelligent person, and always take time to ruminate on his opinions at considerable length. Although not quite headline news any more, as it was released in January, GMO's Quarterly Letter is definitely worth a read. Mr. Grantham speaks highly of the re-emergence of Volcker in the regulation debate, and very lowly of the Supreme Court ruling to remove caps on corporate political donations (ironically, in defense of free speech - who are they kidding?). But I digress.
Given that his publication marked the turn of the decade, Mr. Grantham offered his opinions on what the coming decade had in store, as well as reviewing his firm's predictions over the last decade. Looking forward, Mr. Grantham is not particularly optimistic:
"I still believe that after the initial kick of the stimulus, we will move into a multi-year headwind as we sort out our extreme imbalances. This is likely to give us below-average GDP growth over seven years and more than our share of below-average profit margins and P/E ratios, so that it would feel more like the bumpy (bumpy, but not so disastrous) 1970s than the economically lucky 1990s and early 2000s."
Broadly, I agree with this forecast, which is quite similar to that of Mr. El-Erian of PIMCO (more on Mr. El-Erian in some other post). Admittedly, the conclusions of his analysis are not particularly novel. However, I consider the following observations particularly astute.
"Now, though, after our massive stimulus efforts, the Fed’s balance sheet is unrecognizably bad, and the government debt literally looks as if we have had a replay of World War II. The consumer, meanwhile, is approximately as badly leveraged as ever, which is to say the worst in history. Given this, we would be well advised to avoid a third goaround in the bubble forming and breaking business. Up until the last few months, I was counting on the Fed and the Administration to begin to get the point that low rates held too long promote asset bubbles, which are extremely dangerous to the economy and financial system. Now, however, the penny is dropping, and I realize the Fed is unwittingly willing to risk a third speculative phase, which
is supremely dangerous this time because its arsenal now is almost empty." (Grantham's emphasis)
As far as I am concerned, it is this insight which should be the crux of any policy debate moving forward. There really is no room for error moving forward. In "This Time is Different", Reinhart and Rogoff calculated that government debt expands 86% in the 3 years following a domestic banking crisis. Assuming history is any guide (a classic folly, but current deficit figures are mind-numbing, lending support to Reinhart and Rogoff's findings) this implies that there won't be any more room on the government balance sheets to bear the costs of any further crises. The Fed's balance sheet stands at $2.4 trillion. How much larger can it realistically get without threatening the government's financial integrity? While there are strong arguments for extreme monetary stimulus, every meeting the Fed decides to hold off on raising rates, they increase the probability of inflating another asset bubble. This has the effect of inching the global economy (back) towards the precipice through the heightened risk of future asset bubbles, while simultaneously hauling it from the brink via extremely accommodative monetary policy. Are the benefits of loose monetary policy worth the risk of catastrophe in the form of another ugly asset bubble? I cannot claim to have this grand calculus mastered, but I sure would like to hear this question being asked a little more often.
Back to Grantham's piece. From this discussion, he ruminates on where investors may find value in the coming decade, as well as reviewing his calls from the end of 1999, which are amazingly accurate. For those who don't have time to read it, he considers the S&P 500 to be worth something around 850 (keep in mind that this was published in January and therefore this figure may have changed). Definitely worth the half hour it will take to read the report in its entirety.
Given that his publication marked the turn of the decade, Mr. Grantham offered his opinions on what the coming decade had in store, as well as reviewing his firm's predictions over the last decade. Looking forward, Mr. Grantham is not particularly optimistic:
"I still believe that after the initial kick of the stimulus, we will move into a multi-year headwind as we sort out our extreme imbalances. This is likely to give us below-average GDP growth over seven years and more than our share of below-average profit margins and P/E ratios, so that it would feel more like the bumpy (bumpy, but not so disastrous) 1970s than the economically lucky 1990s and early 2000s."
Broadly, I agree with this forecast, which is quite similar to that of Mr. El-Erian of PIMCO (more on Mr. El-Erian in some other post). Admittedly, the conclusions of his analysis are not particularly novel. However, I consider the following observations particularly astute.
"Now, though, after our massive stimulus efforts, the Fed’s balance sheet is unrecognizably bad, and the government debt literally looks as if we have had a replay of World War II. The consumer, meanwhile, is approximately as badly leveraged as ever, which is to say the worst in history. Given this, we would be well advised to avoid a third goaround in the bubble forming and breaking business. Up until the last few months, I was counting on the Fed and the Administration to begin to get the point that low rates held too long promote asset bubbles, which are extremely dangerous to the economy and financial system. Now, however, the penny is dropping, and I realize the Fed is unwittingly willing to risk a third speculative phase, which
is supremely dangerous this time because its arsenal now is almost empty." (Grantham's emphasis)
As far as I am concerned, it is this insight which should be the crux of any policy debate moving forward. There really is no room for error moving forward. In "This Time is Different", Reinhart and Rogoff calculated that government debt expands 86% in the 3 years following a domestic banking crisis. Assuming history is any guide (a classic folly, but current deficit figures are mind-numbing, lending support to Reinhart and Rogoff's findings) this implies that there won't be any more room on the government balance sheets to bear the costs of any further crises. The Fed's balance sheet stands at $2.4 trillion. How much larger can it realistically get without threatening the government's financial integrity? While there are strong arguments for extreme monetary stimulus, every meeting the Fed decides to hold off on raising rates, they increase the probability of inflating another asset bubble. This has the effect of inching the global economy (back) towards the precipice through the heightened risk of future asset bubbles, while simultaneously hauling it from the brink via extremely accommodative monetary policy. Are the benefits of loose monetary policy worth the risk of catastrophe in the form of another ugly asset bubble? I cannot claim to have this grand calculus mastered, but I sure would like to hear this question being asked a little more often.
Back to Grantham's piece. From this discussion, he ruminates on where investors may find value in the coming decade, as well as reviewing his calls from the end of 1999, which are amazingly accurate. For those who don't have time to read it, he considers the S&P 500 to be worth something around 850 (keep in mind that this was published in January and therefore this figure may have changed). Definitely worth the half hour it will take to read the report in its entirety.
Sunday, March 28, 2010
About Time Somebody Stood up to China
I have long been quite critical of Western nations' unwillingness to stand up to China. Whether it's currency manipulation, domestic human rights abuses, providing diplomatic and financial support for brutal regimes, environmental degradation, domestic political repression, or an unwillingess to back tougher sanctions on Iran at the UN Security Council, no one seems willing to make any meaningful statements backed up by any action. To be honest, I am not sure what exactly I looking for, but the lack of backbone that Western countries have displayed in their dealings with China has been cause for shame.
Well finally somebody has had enough of China's shenanigans. In January, Google reported that they had been the target of a cyber-attack which targeted primarily the Gmail accounts of Chinese human rights activists. Unsurprisingly, China flatly denied the claims. After negotiations failed (what exactly were they negotiating?), Google decided enough was enough and announced that, with the intention of providing Chinese users with uncensored search results (something they could not provide at Google.cn), they were redirecting visitors to Google.cn to the uncensored Google.com.hk (Google's Hong Kong based site). This strikes me as a major loss of face for China and I am sure that they Chinese government will be doing everything they can from this point forward to make Google's operations a nightmare. I however, applaud Google for standing up to China, and it appears that Google is not alone. GoDaddy has also recently announced that, in response to cyber-attacks launched from China, they will no longer be registering new domain names in China. Anyone arguing that the timing of this announcement is merely coincidental has a tough sell. It seems quite likely that this is a statement of solidarity with Google. Here's to hoping that other firms follow suit, perhaps forcing China to think twice before applying their usual bull tactics.
Well finally somebody has had enough of China's shenanigans. In January, Google reported that they had been the target of a cyber-attack which targeted primarily the Gmail accounts of Chinese human rights activists. Unsurprisingly, China flatly denied the claims. After negotiations failed (what exactly were they negotiating?), Google decided enough was enough and announced that, with the intention of providing Chinese users with uncensored search results (something they could not provide at Google.cn), they were redirecting visitors to Google.cn to the uncensored Google.com.hk (Google's Hong Kong based site). This strikes me as a major loss of face for China and I am sure that they Chinese government will be doing everything they can from this point forward to make Google's operations a nightmare. I however, applaud Google for standing up to China, and it appears that Google is not alone. GoDaddy has also recently announced that, in response to cyber-attacks launched from China, they will no longer be registering new domain names in China. Anyone arguing that the timing of this announcement is merely coincidental has a tough sell. It seems quite likely that this is a statement of solidarity with Google. Here's to hoping that other firms follow suit, perhaps forcing China to think twice before applying their usual bull tactics.
Wednesday, March 24, 2010
Fed Paper on Asset Purchases
The Federal Reserve recently published a noteworthy paper on the Large Scale Asset Purchase (LSAP) programs. A little background: when the Federal Reserve reach the effective lower bound of traditional monetary policy in December 2008 (Fed Funds rate between 0 and 25 basis points), they had a strong conviction that the economy was in need of more stimulus than the ultra-low Fed Funds rate was providing. Specifically, Fed staffers were looking to lower long term borrowing rates, a goal which cannot be achieved by manipulating the short end of the yield curve. This forced the Fed to resort to unconventional monetary policy. The desired effects were ultimately obtained through 3 LSAPs which, combined, totaled over $1.7 trillion. The purchases were divided as follows: (1) $300 billion worth of Treasuries concentrated in the 2-10 year term (2) $175 billion in agency debt and (3) $1.25 trillion in agency mortgage backed securities. As the latter two of these facilities are scheduled to wind down at the end of the month (the Treasury purchase program ended in October) the Fed published a timely paper discussing the execution and cumulative impact of the LSAPs on long term interest rates.
The Fed figures that the impact of their purchases were twofold. Initially, most of the impact can be attributed to increased liquidity in the targeted markets, thereby reducing the enormous liquidity premiums present in these markets in early 2009. The second impact was what they termed the "portfolio effect", the mechanics of which are essentially as follows: by purchasing such an enormous volume of securities currently held on private balance sheets, the supply of said securities is meaningfully reduced, increasing their price and reducing their yields. The purchases also create more reserves in the system, and force investors to turn to other markets in the search for yield, thereby bringing down interests rates (and borrowing costs) in a wide cross-section of markets. The sheer size of these purchases is put in perspective as
"22 percent of the $7.7 trillion stock of longer-term agency debt, fixed-rate agency MBS and Treasury securities outstanding at the beginning of the LSAPs...We believe that no investor - public or private - has ever accumulated such a large amount of securities in such a short period of time"
I had not given it much consideration, but I was quite surprised by how large this proportion was. Armed with this knowledge, I am (even) more willing to accept the conclusions of the study. The qualitative discussion is brought to a close with the statement that, as a result of the portfolio effect, "the winding down of LSAPs need not cause a meaningful rise in market interest rates". In other words, the effects of these programs are seen as largely permanent (a point of much contention in the markets) by the Fed.
Also included are number of statistical analyses (primarily event studies) designed to determine the cumulative impact of the operations on long term yields. A number of classes of securities are examined. The results are as follows (for the baseline 8-event set): 2y Treasury, -34 basis points (bps); 10y Treasury, -91 bps; 10y agency debt, -156 bps; Agency MBS, -113 bps; 10y term premium, -71 bps; 10y swap, -101 bps; Baa index, -67 bps. I was not surprised by the conclusions of their study - in fact I fully agree - but proving it statistically is no enviable task. There is just too much noise. All told, the discussion preceding the statistical analysis, as well as the charts (two of which are below) are definitely worth a read. The statistical analysis, on the other hand, was a bit of a slog.
The Fed figures that the impact of their purchases were twofold. Initially, most of the impact can be attributed to increased liquidity in the targeted markets, thereby reducing the enormous liquidity premiums present in these markets in early 2009. The second impact was what they termed the "portfolio effect", the mechanics of which are essentially as follows: by purchasing such an enormous volume of securities currently held on private balance sheets, the supply of said securities is meaningfully reduced, increasing their price and reducing their yields. The purchases also create more reserves in the system, and force investors to turn to other markets in the search for yield, thereby bringing down interests rates (and borrowing costs) in a wide cross-section of markets. The sheer size of these purchases is put in perspective as
"22 percent of the $7.7 trillion stock of longer-term agency debt, fixed-rate agency MBS and Treasury securities outstanding at the beginning of the LSAPs...We believe that no investor - public or private - has ever accumulated such a large amount of securities in such a short period of time"
I had not given it much consideration, but I was quite surprised by how large this proportion was. Armed with this knowledge, I am (even) more willing to accept the conclusions of the study. The qualitative discussion is brought to a close with the statement that, as a result of the portfolio effect, "the winding down of LSAPs need not cause a meaningful rise in market interest rates". In other words, the effects of these programs are seen as largely permanent (a point of much contention in the markets) by the Fed.
Also included are number of statistical analyses (primarily event studies) designed to determine the cumulative impact of the operations on long term yields. A number of classes of securities are examined. The results are as follows (for the baseline 8-event set): 2y Treasury, -34 basis points (bps); 10y Treasury, -91 bps; 10y agency debt, -156 bps; Agency MBS, -113 bps; 10y term premium, -71 bps; 10y swap, -101 bps; Baa index, -67 bps. I was not surprised by the conclusions of their study - in fact I fully agree - but proving it statistically is no enviable task. There is just too much noise. All told, the discussion preceding the statistical analysis, as well as the charts (two of which are below) are definitely worth a read. The statistical analysis, on the other hand, was a bit of a slog.
Tuesday, March 23, 2010
Great SocGen Piece on Sovereign Debt
Okay, I know I am a little late to the party when it comes to discussing sovereign debt, but I read an article a while back that really struck a cord and I thought should be shared. Fear not, I am not here to rattle off a bunch of platitudes about the causes of and potential solutions to the situation in Greece. What I want to discuss is an excellent piece from SocGen's Popular Delusions series which honestly examines the bigger picture, specifically, western countries' sovereign debt situations.
The authors begin with an examination of people's (and governments') tendency to put off tough decisions and responsible action "for later", within the context of irresponsible government spending. The discussion then transitions to an examination of government off-balance sheet obligations, before moving to the arithmetic of sustainable government debt. Summarizing the (extensive) literature on the topic, the authors assert that "maintaining a stable debt to GDP ratio requires governments to run a primary balance [surplus before interest] proportionate to the difference between interest rates and GDP growth" - a rule of thumb so logical it is irrefutable. This rule is applied to various countries' debt situations based on the very conservative assumption that current costs of financing will persist in the future. Their findings are summarized in the following bar chart.
For those with a thorough knowledge of governments' recent fiscal histories, this graph is all that is necessary to differentiate the sinners from the saints. For those not as familiar with this history, the next chart summarizes it nicely for you.
Putting the two together is the real show-stopper...
This series of charts make it clear that a number of countries in the West (and Japan) have a lot of fiscal consolidation to do in the coming years - not a particularly original insightful. Now consider what will happen when this year's deficits are added to the governments' respective mountains of debt and government funding costs tick upward as monetary policy tightens - whenever that may be. If a host of countries couldn't get their finances in line over the last decade, what is there to make us believe that they will be able to do so in the "New Normal" economic environment of high unemployment and sluggish growth? Hope may spring eternal, but the latest CBO baseline forecast - and its analogues from other developed countries - aren't cause for much optimism.
The entire SocGen report is definitely worth the 20 minutes.
The authors begin with an examination of people's (and governments') tendency to put off tough decisions and responsible action "for later", within the context of irresponsible government spending. The discussion then transitions to an examination of government off-balance sheet obligations, before moving to the arithmetic of sustainable government debt. Summarizing the (extensive) literature on the topic, the authors assert that "maintaining a stable debt to GDP ratio requires governments to run a primary balance [surplus before interest] proportionate to the difference between interest rates and GDP growth" - a rule of thumb so logical it is irrefutable. This rule is applied to various countries' debt situations based on the very conservative assumption that current costs of financing will persist in the future. Their findings are summarized in the following bar chart.
The entire SocGen report is definitely worth the 20 minutes.
Friday, March 19, 2010
Bank of Canada's Next Move?
Lately there has been a slew of good economic data out of Canada. Employment, retail sales, housing starts, you name it, they have all beat expectations this month.
This trend continued today with some surprising CPI data. Core CPI came in at 2.1% versus expectations of 1.7%. For those of you not fully in touch with what's going on up North, allow me to fill you in. On 21 April 2009 the Bank of Canada (BoC) reduced the overnight rate to the effective lower bound of .25% and pledged to keep it there until the end of Q2 2010, "conditional on the outlook for inflation". The BoC also effectively put their money where their mouth was by "rolling over a portion of its existing stock of one- and three-month term Purchase and Resale Agreements (PRAs) into six- and twelve-month terms at minimum and maximum bid rates that correspond to the target rate and the Bank Rate, respectively." Since then, at each Fixed Announcement Date (FAD), the same (now tiresome) message has been repeated. To paraphrase somewhat, it is as follows: 'the outloook for inflation remains steady, therefore we aren't going to hike until the end of Q2 2009, conditional on the outlook for inflation.'
Well, now the game has changed. In their quarterly Monetary Policy Report, published in January, the BoC forecast core inflation to average 1.6% in Q1 and 1.7% in Q2. If this were to materialize, it was implicit that rates would stay on hold. With core CPI in January coming in at 2% and now a 2.1% print in February, this forecast is beginning to look sanguine. The BoC shrugged off higher than expected inflation in their press release after the FAD on 2 March, stating that it was "the result of both transitory factors and the higher level of economic activity". With inflation being more sticky than expected and the next FAD scheduled for 21 April, there should be some vigorous debate behind closed doors at the BoC over the next few weeks. Governor Mark Carney (formerly of Goldman Sachs for all you conspiracy theorists out there) holds the veto at FADs. He is highly regarded in Canada for his handling of the crisis and is surely aware that a lot of the BoC's credibility rests on the right decision on 21 April.
Addendum:
The BoC has repeatedly fingered the strengthening Canadian dollar as a downside risk to inflation. Ironically, traders have been bidding up the Canadian dollar of late in expectation of a rate hike by the BoC. If this momentum trade continues, the feedback on inflation could provide Governor Carney the inflation data necessary to eschew the very rate hike that said traders are looking for.
This trend continued today with some surprising CPI data. Core CPI came in at 2.1% versus expectations of 1.7%. For those of you not fully in touch with what's going on up North, allow me to fill you in. On 21 April 2009 the Bank of Canada (BoC) reduced the overnight rate to the effective lower bound of .25% and pledged to keep it there until the end of Q2 2010, "conditional on the outlook for inflation". The BoC also effectively put their money where their mouth was by "rolling over a portion of its existing stock of one- and three-month term Purchase and Resale Agreements (PRAs) into six- and twelve-month terms at minimum and maximum bid rates that correspond to the target rate and the Bank Rate, respectively." Since then, at each Fixed Announcement Date (FAD), the same (now tiresome) message has been repeated. To paraphrase somewhat, it is as follows: 'the outloook for inflation remains steady, therefore we aren't going to hike until the end of Q2 2009, conditional on the outlook for inflation.'
Well, now the game has changed. In their quarterly Monetary Policy Report, published in January, the BoC forecast core inflation to average 1.6% in Q1 and 1.7% in Q2. If this were to materialize, it was implicit that rates would stay on hold. With core CPI in January coming in at 2% and now a 2.1% print in February, this forecast is beginning to look sanguine. The BoC shrugged off higher than expected inflation in their press release after the FAD on 2 March, stating that it was "the result of both transitory factors and the higher level of economic activity". With inflation being more sticky than expected and the next FAD scheduled for 21 April, there should be some vigorous debate behind closed doors at the BoC over the next few weeks. Governor Mark Carney (formerly of Goldman Sachs for all you conspiracy theorists out there) holds the veto at FADs. He is highly regarded in Canada for his handling of the crisis and is surely aware that a lot of the BoC's credibility rests on the right decision on 21 April.
Addendum:
The BoC has repeatedly fingered the strengthening Canadian dollar as a downside risk to inflation. Ironically, traders have been bidding up the Canadian dollar of late in expectation of a rate hike by the BoC. If this momentum trade continues, the feedback on inflation could provide Governor Carney the inflation data necessary to eschew the very rate hike that said traders are looking for.
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