Saturday, January 31, 2009

Option ARM--The Toxic Mortgage

'Option ARM' mortgages were agressively marketed by banks because they generated huge amounts of phantom profits. Using generally accepted accounting principles, or GAAP, banks could count as revenue the highest amount of an Option ARM payment -- the so-called fully amortized amount -- even when borrowers made only the minimum payment. In other words, banks could claim "phantom income" that they never received and in the current scenario will never receive. This "phantom income" inflated reported earnings and allowed bank executives playing this game to receive enormous bonus income and enjoy dramatically inflated stock prices. Many now defunct banks, and soon to be defunct banks, reported inflated earnings that were bolstered by this phantom income. It was not unusual for "phantom income" to account for more than half of the earnings being reported.

James Grant wrote that negative-amortization accounting is "frankly a fraudulent gambit. But what it lacks in morality, it compensates for in ingenuity."--Grant's Interest Rate Observer

He wrote this back in 2006.

Default rates on so called 'Option ARM' mortgages are rising fast.

As of December, 28% of option ARMs were delinquent or in foreclosure, according to LPS Applied Analytics, a data firm that analyzes mortgage performance.

Nearly 61% of option ARMs originated in 2007 will eventually default, according to a recent analysis by Goldman Sachs.

This sobering news indicates that the bad news from the housing market is far from over and is not likely discounted in the stock markets.

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An 'Option ARM' is typically a 30-year adjustable rate mortgage that initially offers the borrower four monthly payment options: a specified minimum payment, an interest-only payment, a 15-year fully amortizing payment, or a 30-year fully amortizing payment. These types of loans are also called "pick-a-payment" or "pay-option" ARMs.

'Option ARMs' are particularly toxic because they allow the borrower to make a small minimum payment each month with the unpaid part of the monthly payment being added to the principle of the mortgage outstanding. In other words, these mortgages are subject to severe negative amortization. If you make the minimum payment, the principle amount you owe on the mortgage loan goes up each and every month. Current statistics indicate that 80 percent of the consumers owning these loans selected the minimum payment option.

Let's say, for example, that the fully amortized monthly payment is set at $1500. The homeowner decides to elect the minimum payment (the option) and pays $1000. The unpaid $500 is then added to the mortgage's principle balance outstanding. It only gets worse. Not only does the amount owed grow each month; this higher loan balance is immediately reflected in the next month's calculation.

The owner of an 'Option ARM' is borrowing the difference between the minimum payment and fully amoritized amount of the loan each month. In effect, the option arm mortgage holder is making a new loan each month and this amount is tacked onto the existing mortgage. Then the mortgage holder ends up paying interest not only on the increasing principle but also interest on interest. Sounds a little like loan sharking--doesn't it?

It is easy to see that the amount owed on an option ARM mortgage could grow fast. Imagine watching the amount you owe on your mortgage go up each month as you make the minimum payment. It only gets worse. This 'ticking time bomb" of a mortgage has another toxic feature built in--they reset once the principle balance owed hits 110-125% of the original loan. This fully amortized amount includes the original loan amount plus all the negative amortization. So while it appears that an 'Option ARM' works like a typical adjustable rate mortgage this in not true. A standard adjustable rate mortgages has an annual cap and the interest rate can only rise by 1-2% a year. This is true in an "option ARM" with one exception--when the 110-125% cap is hit the mortgage fully amortizes and the morgage resets to the market. This means a monster sized jump in the monthly payment. It is likely that the owner of the 'Option ARM' will see the monthly mortgage payment nearly double when the cap is hit.

Current owners of these "time bombs" are now in the unenviable postion of watching the amount they owe on the mortgage go up, the amount of their monthy payment skyrocket, and the value of the house drop like a lead stone. Talk about a double edged sword. Or is that three edges?

It appears most American's are making an easy decisions on these loans--walk away, stop paying, and go to foreclosure.

Nearly $750 billion of option adjustable-rate mortgages, or option ARMs, were issued from 2004 to 2007, according to Inside Mortgage Finance, an industry publication.

Rising delinquencies are creating fresh challenges for companies such as Bank of America Corp., J.P. Morgan Chase & Co. and Wells Fargo & Co. that acquired troubled option-ARM lenders.

Interestingly, most 'Option ARMs' were issued to people with an above sub-prime credit rating. However, it is well known that many of these mortgage holders bought homes they intended to sell "quickly" for a profit. In effect, they were speculating in the housing market. What better way to keep the payment low than with the 'Option ARM' mortgage.

'Option ARM' mortgages were agressively marketed by banks because they generated huge amounts of phantom profits. Using generally accepted accounting principles, or GAAP, banks could count as revenue the highest amount of an Option ARM payment -- the so-called fully amortized amount -- even when borrowers made only the minimum payment. In other words, banks could claim "phantom income" that they never received and in the current scenario will never receive. This "phantom income" inflated reported earnings and allowed bank executives playing this game to receive enormous bonus income and enjoy dramatically inflated stock prices. Many now defunct banks, and soon to be defunct banks, reported inflated earnings that were bolstered by this phantom income. It was not unusual for "phantom income" to account for more than half of the earnings being reported.

James Grant of Grant's Interest Rate Observer wrote that negative-amortization accounting is "frankly a fraudulent gambit. But what it lacks in morality, it compensates for in ingenuity."

He wrote this back in 2006.

Many banks moved defaulted 'Option ARMs' into "held for sale accounts". This shady accounting practice allowed banks to sequester or "hide" the loans from investors. Under normal economic conditions these loans would be sold to collection agencies or investors. However, given the enormous amounts of these loans, their uncertain futures, and the uncertainty in the market place they are now nearly impossible to sell.

When you hear proposals for the Federal government to buy "toxic assets" these are the types of loans that bankers want taxpayers to take off their hands. The bankers that issued three quarters of a billion dollars of Option Arms did so to enrich themselves.

They have already received obscene bonuses and sold inflated stock bolstered by "phantom income".
They now want to pass these assets to taxpayers via the bailout.
They want us to bail them out so they can stay in their jobs.

I continue to wonder if anyone in Washington understands this scam? Or, are they going to perpetuate the scam and pass the buck to our children?

It should be mentioned that banks paid higher than usual commissions on these loans to the "hordes" of unregulated independent salespeople they used to "huckster" this product. It is already well documented that many of these so called "mortgage bankers" used pressure tactics to convince consumers that an 'Option ARM' was a good thing and that they would benefit. They might have failed to mention the onerous prepayment fees that came with these mortgages and it not likely that they explained the how negative amortization worked. I wonder if they fully disclosed that the loan became full amortized when the 110-125% cap limit was hit? Did they explain that the cap limit would be hit within five years if they made the minimum payment; and that, the monthly payment could nearly double or worse?

I believe most stock market investors think that the effects of the housing crisis has been discounted by the markets. This is not likely and the potential fallout from the coming 'Option ARMs' explosion is still to be seen.

We have not yet reached the worst part of the 'Option ARM' cycle. The news on these toxic loans is going to get worse beginning in April when thousands of Option ARM mortgage holders are going to see their monthly payments spike. This phenomena is going to continue until 2010 once it starts.

I wonder if investors understand how this will effect the banks that are still holding these loans? How the shock wave from this explosion is likely to effect banks that do business with these banks? How this might effect consumers, employment, and the psyche of investors? Uncertainty does not usually lead to sustained rallies in the markets. Of course, the market might take a tumble and discount this information at any time.

Option ARM--The Toxic Mortgage

Friday, January 30, 2009

Bank Bailout Could Cost Up to $4 Trillion: Economists

I ran across this article on CNBC.com. Talk about giving me a stomach ache.

The cost of restoring confidence in U.S. financial firms may reach $4 trillion if President Barack Obama moves ahead with a "bad bank" that buys up souring assets.

This dovetails Roubini Predicts U.S. Losses May Reach $3.6 Trillion. He wrote

“I’ve found that credit losses could peak at a level of $3.6 trillion for U.S. institutions, half of them by banks and broker dealers,” Roubini said at a conference in Dubai today. “If that’s true, it means the U.S. banking system is effectively insolvent because it starts with a capital of $1.4 trillion. This is a systemic banking crisis.”

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Bank Bailout Could Cost Up to $4 Trillion: Economists

The cost of restoring confidence in U.S. financial firms may reach $4 trillion if President Barack Obama moves ahead with a "bad bank" that buys up souring assets.

The figure far exceeds even the most pessimistic estimates of how great the loan losses might be because there is so much uncertainty about default rates, which means the government may need to take on a bigger chunk of bank debt to ease concerns.

Goldman Sachs economists said ideally the public sector would step in to remove the hardest-to-value assets, which would alleviate nagging worries about future losses and hopefully help get lending going again.

"Unfortunately, with an unprecedented meltdown in mortgage credit and a deep recession in the broader economy, there is a great deal of uncertainty about the value of almost every asset," they wrote in a note to clients.

Obama and his economic advisers are expected to lay out their policy plan as early as next week. One idea that seems to be gaining traction is setting up an entity to buy troubled assets and hold them until they mature or resell them.

The hope is that once banks get rid of those bad loans, they can attract private investors, get back to the business of lending, and help revive the economy.

Biden: Stimulus Package Will Get Better With Changes
Obama: Wall Street Bonuses 'Outrageous'
Obama's First 100 Days: What He's Done So Far
Vice President Joe Biden said Thursday that Treasury Secretary Timothy Geithner was considering all options to restart normal lending, but that no decisions had been made.

Goldman Sachs estimated that it would take on the order of $4 trillion to buy troubled mortgage and consumer debt. That number could shrink if the program were limited to only certain loans or banks, but it could also grow if other asset classes such as commercial real estate loans were included.

New York Sen. Charles Schumer has said that a number of experts thought that up to $4 trillion may be needed to buy the bad assets, an estimate that a Senate aide said was based on informal conversations with people in the industry.

The Wall Street Journal said government officials had discussed spending $1 trillion to $2 trillion to help restore banks to health, citing people familiar with the matter.

At $4 trillion, that would be the equivalent of nearly 1/3 of U.S. gross domestic product. If the government had to fund that amount by issuing additional debt, it would intensify investor concerns about massive supply scaring off demand.

Depending on how the plan is structured, the government may not have to put up the full amount, and since the majority of people are still paying their mortgages and credit card bills, there is a reasonable expectation that taxpayers would recoup a substantial portion of the cost.

However, the potential loss is huge, and if more public money is needed to boost capital even after the bad assets are removed, the total would undoubtedly climb.

The International Monetary Fund said Wednesday that worldwide losses on U.S.-originated loans may hit $2.2 trillion, well above its October estimate of $1.4 trillion. It said banks in the United States, Europe and elsewhere probably needed to raise $500 billion to cover losses coming this year and next.

Cutting Out a Zero

For U.S. lawmakers who are already taking grief from voters over a $700 billion bailout approved last fall, passing another big spending measure carries significant political risk.

At the same time, Obama's team wants to take action that is bold enough to fix the problem once and for all, hoping to avoid the sort of ad hoc approach that has been criticized for adding to investor uncertainty.

Time is not on Obama's side. The more the economy weakens, the longer the list of potentially dodgy debt grows. That is why he faces enormous pressure from Wall Street to act fast.

The government would not necessarily have to spend the full $4 trillion to buy the assets. If it follows the model used in a Federal Reserve program to support consumer and small business loans, the government could potentially put up just 10 percent of the total.

Spending $400 billion would certainly be more palatable to Congress than $4 trillion. It may not even require that much additional funding. Economists estimate that perhaps $250 billion of what remains in the $700 billion bailout fund could be devoted to the "bad bank."

That money could buy bad assets, which would then be repackaged and sold to investors to raise more money which could then by recycled to buy more assets.

Stephen Stanley, chief economist at RBS Greenwich Capital, said although that sounds similar to the sort of financial engineering that spawned the credit crisis in the first place, it would be structured so that the central bank or whichever agency oversees the program is last in line to take losses.

"If things turn out so bad that the Fed ends up on the hook for $1 trillion in losses, then the financial sector, the economy, and everything else will be dead anyway," he said.

Copyright 2009 Reuters. Click for restrictions.
URL: http://www.cnbc.com/id/28918543/

PIMCOs Gross: Find ways to prop up the Values of Assets

To PIMCO, the remedy for this deflationary delevering and mini-depression is simple and almost axiomatic: stop the decline in asset prices.

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Investment Outlook
Bill Gross | February 2009

BEEP BEEP!

The current financial and economic crisis is difficult to appreciate, not only for the drop in elevation, but because of the swiftness of the declines. It’s been a Wile E. Coyote 12 months – straight down like a dead weight. A year ago, global equity prices were nearly twice today’s levels and recession was only a whisper on the lips of the gloomiest of economists. Today, descriptions drawing parallels to the Great Depression make it obvious that a major shift in economic growth and its historic financial model, as well as policy prescriptions for its revival, are underway. Most of the world’s connected economies and its citizens are in shock, conscious but not fully aware of the seismic shifts that will unfold in future years.

PIMCO’s thesis for several years has held that the levered global economy long ago morphed from a banking-dominated regime to one that hid behind securitized lending and structures resembling a “shadow banking” system. SIVs, hedge funds, CDOs and increasingly levered mortgage and investment banks fueled asset appreciation in all investment markets, which in turn propelled real economic growth and employment to unsustainable levels. But, with U.S. housing prices as its trigger, the delevering process did a Wile E. Coyote and headed over the cliff in mid-year 2007, dragging down almost all asset prices except government bonds. The real economy followed shortly thereafter, not just in the U.S., but globally, proving that linkages work on the “down” as well as the upside. To PIMCO, the remedy for this deflationary delevering and mini-depression is simple and almost axiomatic: stop the decline in asset prices. If that can be done, the real economy will level out as well. When home prices stop going down, newly created households will be more willing to take a chance on ownership as opposed to renting. If stock prices consolidate, recently burned investors will be more willing to invest, as opposed to stuffing their 401(k) mattresses with Treasury bills. Business investment, jobs, and profits should follow quickly behind.

The simplicity of the solution, however, is not easily achieved once deflationary momentum takes hold. Animal spirits, once dampened, are hard to reignite; “fear of fear itself” dominates greed. Under such circumstances, the benevolent hand of government is required and Keynes is reincarnated in an attempt to plug the dike via fiscal spending and imaginative monetary policies that support asset prices. PIMCO has recently been contracted to assist in several publically announced programs which have helped in that effort: the CPFF, which has benefitted commercial paper yields, and the Federal Reserve’s purchase program for agency-backed mortgage loans, which has lowered 30-year mortgage rates to 4.5% and fostered the affordability of new and secondary housing prices. These two programs, in our opinion, have been the major policy successes to date – not because of our involvement – but because they have supported and increased asset prices whose decline has been the major deflationary thrust behind the real economy. Stop asset prices from going down and with a 12-month lag, unemployment will stop going up, and President Obama’s targeted three million new jobs will have a fighting chance of being achieved.

But stopping the decline of asset prices can be and has been attempted in numerous, seemingly uncoordinated ways. Recapitalization of the banks has been the major thrust, in the hopes that banks would extend credit which would reinvigorate asset pricing. Those who argue strongly for a recapitalization of the banking system, however, may be missing the distinction between the banking system as we once knew it, and the “shadow banking” system that superseded it. Jim Bianco, who heads up the research tank bearing his own name, brought the difference to mind in a recently produced piece entitled, “When Will The Banks Start Lending?” His conclusion was that banks already were – lending – but it was the “shadow system” (my words) that was holding up the parade. According to his analysis, shown in Chart 1, securitization has for several years exceeded bank loans as a percentage of private credit market debt. In contrast to recent headlines, however, banks have been picking up their lending, but it has been the “shadow banks” that have faltered. That makes sense. While banks may have tightened their lending standards, fresh capital from the TARP has made it possible to make new loans. The shadow banks, however – hedge funds, investment banks, and structured financial conduits – have been forced to delever as government funds have been directed to more visible institutional lenders. Granted, Goldman Sachs and Morgan Stanley have been TARP recipients, but only under the conditions of downsizing and degearing on their way to becoming regular banks, which have cut their holdings of assets significantly in percentage and actual dollar terms. It should not surprise, therefore, that with the exception of specifically directed government programs directed at commercial paper rates and 30-year mortgage yields, past policies have been unsuccessful. Banks have been recapitalized – yes – and banks have cautiously started to lend. But shadow banks are still delevering due to disappearing and unavailable fresh capital and, as they do, they continue to drag asset prices with them. PIMCO’s Ramin Toloui has produced Chart 2 which correlates the contraction in household debt to the decline of the securitization market. He estimates that there is a one trillion dollar hole that needs to be filled by policymakers in this area alone.

Stressing the importance of the shadow banks is not the same thing as suggesting that they should be next in line for government largesse and bailouts. Lord knows, the Obama Administration is not going to bail out hedge funds, CDOs, private equity firms (Cerberus?), or Donald Trump. There are levered risk takers that will be, and should be, allowed to fail. But in permitting failure, policymakers must still be cognizant of the need to support asset prices – hopefully by inducing confidence and trust in private investors, as pointed out by Robert Shiller in a recent Wall Street Journal op-ed, but if need be by the financing or purchase of assets themselves. It’s not so much that the stock market needs to go back to 10,000. That would be nice for millions of 401(k)s that have been cut in half over the past 12 months, but it is not likely. Rather, asset prices securitizing commercial real estate and credit card receivables, as well as plain old-fashioned municipal bonds, must stop going down if the real economy has any chance to revive by 2010.

Example: CMBS or commercial real estate mortgage-backed securities are now priced to yield over 12% vs. 5% in recent years. As real estate financing comes due and rolls over in the next few years, it is imperative these yields return to mid-single digits if shopping centers, retail malls, and office buildings are to remain viable. How best to bring those yields down is debatable: another CPFF-like structure with self-insurance and contributed fees as its equity backstop? A generous portion of remaining TARP billions providing a reserve cushion for Federal Reserve funding? A good bank, bad (aggregator) bank structure? All three are being debated by policymakers and we should have clarity within a week’s time. But one thing is certain: an economic recovery is dependent upon commercial real estate prices stabilizing and most retail stores staying open for business in the months and years ahead.

Similarly, municipal yields are now trading at nearly twice their Treasury counterparts, implying that municipal bonds are trading at 80 cents on the dollar instead of 113 cents like the average Treasury. To enable states and cities to return to normal functioning, those bonds must return to par. Modern day capitalism depends on the successful refinancing and issuance of securities at a price and yield level not significantly divorced from past experience. That is the same thing as saying that current yields must come close to matching the economy’s embedded cost of debt if default is to be avoided. Not only municipalities, but the efficient operation of hospitals, nursing homes and even universities depend on the leveling and returning of municipal bond prices to higher levels. Similar arguments can be made for corporate bonds as well.

PIMCO’s advice to policymakers is as follows: you can’t bail out everyone, yet economic recovery is not possible unless certain critical asset sectors are not only reliquefied, but rejuvenated in price. The prior Administration’s focus on the banks has been critical but unidimensional. The shadow banking system with its leverage and financial innovation, powered a near 25-year global economic expansion, but it is the delevering of those hidden quasi-banks that is now threatening its petrification. Policymakers should not focus entirely on one-off bailouts of large real estate developers, municipalities, or even credit card issuers like they have with Citi, BofA, and AIG. Rather, they should recognize that supporting critical asset prices such as municipal bonds, CMBS, and even investment grade corporate bonds is a necessary step towards eventual economic revival. Capitalism at its philosophical and practical center depends on credit, and while new loans can be and are being advanced via the banking system, it’s a much more difficult task to force shadow banks to lend. That lending depends on securitization which in turn depends on stable and eventually higher asset prices than currently exist. The original focus of the TARP was on asset prices, but the prior Administration quickly lost its way or perhaps its nerve. Like his Road Runner nemesis, Wile E. Coyote must now extend some infrequently used figurative wings to avoid the deflationary precipice below. Support asset prices. Beep Beep!

William H. Gross
Managing Director
Investment Outlook

PIMCOs Gross: Find ways to prop up the Values of Assets

Random Walk Author Likes Templeton China Fund

Princeton professor Burton Malkiel is best knows for his book, A Random Walk Down Wall Street.

His newest book is also a worthwhile read for investors interested in China--From Wall Street to the Great Wall: How Investors Can Profit from China's Booming Economy.

Here is a quick look at Malkiel's portfolio:

20% Vanguard Total Stock Market ETF (VTI) (Tracks a broad index of U.S. companies)
20% Vanguard FTSE All-World ex-US ETF (VEU) (Tracks a broad index of stocks from developed and emerging foreign markets.)
20% Vanguard Total Bond Market ETF (BND) (Tracks a broad index of high-quality U.S. bonds)
10% Vanguard Capital Opportunity (VHCOX) (An actively managed fund that likes big growth companies down on their luck)
10% Vanguard Emerging Markets ETF (VWO) (Tracks an index of stocks developing nations)
10% Templeton Dragon (TDF) (Invests in stocks from China and nearby nations)
10% Matthew's India (MINDX) (Invests in stocks from India)

It should be noted his portfolio consists mostly of passively managed and exchange-traded funds. You might be surprised he is heavily invested in stocks with a third of his portfolio invested in emerging markets.

If you are looking to get up to snuff on China I recommend his book. You might also want to take a close look at his portfolio holdings listed above.

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Random Walk Author Likes Templeton China Fund

Is the next shoe ready to drop in the Housing market?

The Wall Street Journal is reporting that defaults on so called 'Option ARM' mortgages are rising fast.

As of December, 28% of option ARMs were delinquent or in foreclosure, according to LPS Applied Analytics, a data firm that analyzes mortgage performance.

Nearly 61% of option ARMs originated in 2007 will eventually default, according to a recent analysis by Goldman Sachs

This is sobering news and indicates the bad news from the housing market is far from over.

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Nearly $750 billion of option adjustable-rate mortgages, or option ARMs, were issued from 2004 to 2007, according to Inside Mortgage Finance, an industry publication. Rising delinquencies are creating fresh challenges for companies such as Bank of America Corp., J.P. Morgan Chase & Co. and Wells Fargo & Co. that acquired troubled option-ARM lenders.

Another example of Dumb and Dumber. Who is Dumb and Who is Dumber?

Original content: Is the next shoe ready to drop in the Housing market?

Global Economy Grinding to a Halt

The International Monetary Fund (IMF) is now forecasting the global economy to grow at one half of one percent (.5%) in 2009. This is stunning news. Just two months ago the same group was forecasting annual growth at 2.2 percent. Olivier Blanchard, the IMF's chief economist offered these sobering words:

"We expect the global economy to come to a virtual standstill in 2009."

The situation in China continues to deteriorate as growth is forecast an annual rate of 6.7% about half the growth rate they reported in 2007. The forecast of 6.7 percent is suspect due to the way the numbers are calculated in China. One can only wonder if their is a "silent" backlash toward China brewing in the U.S. Helping foster the growing negative attitude in China yesterday Vice President Joe Biden said:

the U.S. would be “blunter with the Chinese” and that China must “play by the rules.”

The U. S. long term bond market reacted by dropping a whopping three points.

In a seperate report the IMF forecast that

financial institutions face much larger losses on U.S. securities than foreseen just weeks ago. Losses now are expected to reach $2.2 trillion, up from the $1.4 trillion estimated last fall.

This can only be regarded as more bad news in the financial sector.

The IMF is predicting that in order to prevent further deterioration in their ability to lend, major U.S. and European banks require an additional $500 billion in new capital, the report said. One can only wonder how these enormous capital needs are going to be met.

This news does not bode well for equities world wide. It is not likely that these continued dire forecasts have been digested into the equity market. And worse, most forecast continue to become more dire with each new release.

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Thursday, January 29, 2009

Japanese Stocks Sink On Record Plunge in Industrial Output

Japan's Nikkei 225 Stock Average is down 3.3% at 7975.05. The combination of dismal earnings news in the U.S. and the dismal 9.6% plunge in Japan's December industrial output are causing the price. The 9.6% plunge is a record.

Macquarie Research economist Richard Jerram described the results as "disastrous beyond belief. In the last two months you've already lost more output than you usually see through the whole course of a recession."

Japan's seasonally adjusted unemployment rate rose to 4.4% in December from 3.9%. The data indicates that Japan continues to slide into a deep recession.

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Posted late night on January 28.

30 Year Bond Drops on Biden China remarks

The 30-year bond future dropped more than three points over concerns about Joe Biden's comments on China. Biden said the U.S. would be “blunter with the Chinese” and that China must “play by the rules.”

The bond is now down more than 14 points from the peak price of 141-06 reached in late December. At the time of this writing, the bond is on its lows trading down at 127-04. This is down more than 4 points from the Wednesday close of 131-06.

The bond was already trading down from the December peak based on continued concerns about increasing supply. Biden's comments exacerbated the drop and sent addition jitters through the market.

China owns more than $1.9 trillion of foreign reserves, and about 70 percent of this is in dollar denominated securites. The exact numbers are not known but it is clear that much of this is in U.S. Treasuries.

The recent action in the long term Treasury market reminds me of the action in the late 1980's. During that period the Japanese owned enormous amounts of Treasury securities and were the biggest players in the Treasury auction market. Daily trading ranges of 3 points or more were common at that time.

I think we can now expect to see extreme volatility in the ten and thirty years market as it tries to adjust to both supply and news developments concerning China. This is likely to have a destabilizing effect on stocks.

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Debt Binge--The Perfect Financial Storm

When historians look back they will be writing about the Debt Binge.

A binge is any behavior indulged to excess.

In America, we now have a series of binges coming together to form the perfect financial storm. The components of the perfect storm include:

excessive governement borrowing from foreigners to finance enormous debt in the public sector,
excessive borrowing by consumers in the form of mortgages, mortgage refinancings, and credit cards,
and, the enormous borrowing by investment banks and bank banks to leverage up their balance sheets with credit default swaps.

The most recent of the borrowing binges--the stimulus package. Or should I say--packages.

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If you saw the movie the Perfect Storm you might remember at one point in the movie it appeared that the fishermen on the Andrea Gail had ridden out the perfect storm. For a brief moment, a hole appeared in the sky and the sun peaked through. The fishermen in an almost euphoric moment thought they had ridden out the monster storm. But, as quickly as the sky opened it closed. Soon the ship was being battered with a series of monster waves that kept getting bigger and bigger. In spite of efforts of the fisherman the Andrea Gail was consumed by a giant wave that consumed the boat and sent it to the bottom of the sea. This where we are today in the financial markets.

I am a proponent of the stimulus package. It is better than nothing (nothing equals depression). Nevertheless, the stimulus package is a continuation of the same binge pattern--

curing a debt problem with more debt.

Soon we will be calling on the world to lend us enormous amounts of money. Treasury debt offerings will come to the market in bigger and bigger waves--a key component of the perfect storm. Corporation will be crowded out of the market and unable to borrow more in an attempt to pay for their past sins. Consumers, leveraged to the hilt, will begin to default on their debt in greater and greater numbers as unemployment marches higher and higher. Hedge funds will be the next to follow the trend. In case you haven't noticed investment banks are now extinct. Not only did Bear Stearns and Lehman Brothers implode; but, the venerable Goldman Sachs is now a bank bank. Weak hedge funds now hanging by a thread will join the party during the next downside in the market. As hedge funds near extinction, they will be selling assets as fast as they can--the equivalent of a fire sale. Prices of stocks will get very cheap (a good thing if you were a squirrel during this period).

It seems like much of this is happening unnoticed as history unfolds right before our eyes.

The best way out of this trap is a massive inflation that bastardizes the U.S. currency and lessens the debt burden by cheapening it. Of course, there is the Argentinian solution--default.

We should be looking around and noticing that every major economy in the world is wounded. The situation came about because of excessive debt and leveraging--the World Debt Binge.

The cure to excessive debt is savings. The only good thing I hear out there is talk about wringing out the excesses in our government to bring about costs savings and lessen the need for future borrowing. What is the likelihood of that happening soon? In case you haven't noticed over the last 25 years the quickest way to cut costs is to "fire" people. Instead, we are trying to put more people on the government payroll by creating projects funded with government dollars via the stimulus package.

Something has to give. The massive leveraging of the U.S. economy leaves us in debt to the tune of three and a half times times the output of our economy. The big credit card in the sky is being leveraged to the max. What if the lenders pull the plug? The likely result is higher and higher interest rates to finance the borrowing--or worse.

We have not learned our lesson--excessive leverage via borrowing is not a good thing. There are only two possible solutions to this problem: inflation or default. Both are ugly but the only way out of the trap.

Coming soon: Tsunami.

Wednesday, January 28, 2009

Meet Virtual Margaret, A Chicken on the Hill Special

I am starting to feel "frisky" about the market. Well, not frisky enough to jump in with both hands and feet. But, I am starting to feel like there is some "serious chicken on the hill" out there. I find myself thinking about "tech stocks" all the time. I am particularly interested in Cisco (CSCO) and Juniper Network (JNPR). So anyway, I am reading an article about the stimulus package and I learn it is loaded with money for Health Care Reform. Next thing I know I am over on http://geekdoctor.blogspot.com. The geek doctor is John D. Halamka, a Chief Information Officer. Ten percent of this staff work from home.

What is the impact? 35 people x 260 workdays = 9,100 days per year saved in commuting. That's 9,100 car-days off the road. This reduces the demand for parking, office space, and most importantly the employee stress/strain of fighting traffic.

So I start thinking to myself: Obama wants to spend a lot of money on technology, people that work at home don't use gasoline to commute, and if there was a really effective, efficient way to keep your best talent by allowing them to telecommute this would be a great management tool.

Next thing I know I am over at the Cisco website looking for Cisco TelePresence. I bump into --Meet Virtual Margaret.

This a long story that you can read below. But, here is the point. Margaret is a valued employee who wants to improve her quality of life.

She loves her job, her supervisor, and the team that he has built in San Jose, California. But the cost of living, the cost of California housing, and the ability, as a single mom, to adequately raise her 9-year-old daughter in the Bay Area was getting harder to maintain as the years went by. Margaret began looking for alternative places to raise her daughter, and, in the spring of 2006, decided to relocate to Dallas, Texas.

So here is the problem. Margaret is making a life decision around family. CSCO has a great employee they don't want to lose. The solution: TelePresence.

"Every morning that I dial in, I think to myself, is this really happening? I can live where I want, work at a company that I love, and still have a full-time presence. That's amazing." - Margaret, Executive Administrator, Cisco Systems

This is at the wave of the future. I am particular interested in all the gasoline that will get saved--but that is a different story. You might want to take a look at Cisco. I still prefer Juniper but we will get to that down the road.

In this story Cisco wins, Margaret win, the economy wins and we get an investment idea.

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Margaret has lived in the Bay Area for 10 years and has worked at Cisco Systems® for the past 3 years. She loves her job, her supervisor, and the team that he has built in San Jose, California. But the cost of living, the cost of California housing, and the ability, as a single mom, to adequately raise her 9-year-old daughter in the Bay Area was getting harder to maintain as the years went by. Margaret began looking for alternative places to raise her daughter, and, in the spring of 2006, decided to relocate to Dallas, Texas.
When she informed her supervisor, Marthin De Beer, vice president and general manager of the Emerging Markets Technology Group (EMTG) at Cisco Systems, of her intention to relocate, he genuinely felt conflicted. Although he did not want to lose a valuable Cisco employee, he did want her to enjoy life, and feel comfortable about raising her daughter under good circumstances. Over the past 3 years, Margaret and Marthin had built a solid, working relationship that was successful. He really did not want to lose her because of the move. They needed a solution that would allow Margaret to work in her new chosen state of Texas, but in another Cisco office location. However, due to the nature of her job as his executive administrator, whatever solution they chose had to provide the ability to communicate and collaborate effortlessly, despite her geographical location. In her position, face-to-face contact with team members is critical, as is immediate accessibility. As Marthin's executive assistant, she engages with all levels of employees in the San Jose office, and the need for her to maintain that constant interaction with anyone who approached her desk throughout the day was essential. Besides her own team members, she needed to remain a valuable resource to any employee needing help or direction, should they pass by her desk in San Jose. The solution used must allow for her to continue working as if she were still seated at her desk in San Jose-allowing her to perform her everyday duties as effortlessly as possible.

Solution
At first, Marthin thought of alternatives to the move to Texas. One such alternative was for Margaret to consider moving further out of the Bay Area, where real estate was cheaper. Marthin offered for her to telecommute one day a week in order to ease the commute burden. However, this suggestion did not really allow her to improve her family's quality of life as she desired. Therefore, it was decided that the best option for Margaret was to try the new Cisco TelePresence solution, which his team was planning to release shortly after Margaret's planned out-of-state move. The timing was right. The purpose was right. It was a win-win situation for everyone. The Cisco TelePresence Meeting solution combines life-size, ultra high-definition video images with spatial audio and interactive elements to create the feeling of being "in person" with participants in remote locations. The Cisco TelePresence Meeting Solution offers two different endpoints: the Cisco TelePresence 3000, for larger group meetings, and the Cisco TelePresence 1000, meant for smaller groups and individual offices.

"Every morning that I dial in, I think to myself, is this really happening? I can live where I want, work at a company that I love, and still have a full-time presence. That's amazing." - Margaret, Executive Administrator, Cisco Systems

The Cisco TelePresence 1000 consists of a 65-inch high-definition plasma screen (720p and 1080p support), a camera, codec, microphone, speaker, and lighting array. When the product was ready for beta testing in June 2006, it was installed in Margaret's existing workspace in San Jose as well as her new office location in Richardson, Texas. This system can be used in small-footprint spaces, such as executive offices, general conference rooms, hotel lobbies, bank branches, or doctors' offices-anywhere that a one-on-one or small group conversation is desired. In addition to the system hardware, Cisco TelePresence includes a suite of software solutions, known as Cisco TelePresence Manager, which interfaces with enterprise groupware to enable scheduling directly from a calendar. Cisco TelePresence is also integrated with Cisco Unified CallManager, which enables one-button simplicity for call launch and control directly from a Cisco Unified IP Phone.

According to Margaret, the transition was easy after her move. She and Marthin were able to continue working together as a team. "Marthin and I read each other really well, which is very key to a successful relationship between administrator and supervisor," she says. "I thought that we would lose that connection and interaction when I moved to Texas, but with the Cisco TelePresence solution, we are able to see each other in life-size proportions, look each other directly in the eye, and speak naturally without any audio delay. We can still read each other's body language-which is critical in our particular business relationship. We joke now that Marthin can still clearly see me smirk while raising my eyebrows in typical Margaret fashion-nothing has changed."
This solution has worked so well that there are now two systems installed at the San Jose office. One is at Margaret's old, San Jose desk, and the other one is in Marthin's back conference room, which they use for one-on-one meetings, other weekly meetings that she must attend with Marthin, as well as for quick discussions and decisions that need to occur throughout the day. With one push of a button, Margaret vanishes from her location outside of Marthin's office, and then instantaneously reappears in his conference room-it is fast, reliable, and truly amazing. "I love the fact that I can still actively participate in any and all meetings required. If I was forced to dial in via audio only for such meetings, I would feel remote and disengaged-with this solution, I am virtually present, as if I were there with the team in person," says Margaret.
"In the beginning, there were a lot of people stopping by," she says. "Mouths would drop open when people saw me, as if in disbelief and amazement of what they were seeing. Now, as folks get used to seeing me day in and day out, it is business as usual. One interesting thing that I noted in the beginning was that I felt like I was on camera all the time, and it made me feel a little self-conscious. Now, I don't even remember that I'm on camera. It feels like I'm still in San Jose-for 8 hours a day, I'm fully engaged in the business at Cisco's headquarters. If it were not for the clock on my back wall here in Richardson indicating central time, I would completely forget that I'm in Texas!"

Business Results
Both Marthin and Margaret are reaping the benefits of the TelePresence Solution. Marthin was able to keep a key member of his team, and Margaret was able to keep the job that she loves at the company that she loves, while living, raising, and providing for her daughter in a more affordable area. "It is the best of both worlds," says Margaret. "I am so lucky. Not many companies would take a chance like this."

Marthin's endorsement and use of the TelePresence solution make a statement to both internal and external markets about the direction of Cisco TelePresence technology and the effect that it will potentially have on the way that we live and work. Professionals who use the Cisco TelePresence solution can stay intimately connected with team members and have a full-time presence, even if they live in other areas of the country. This enables enhanced collaboration and productivity with remote workers and gives corporations a better option for attracting as well as retaining valuable employees, even when they move out of the area.
The Cisco TelePresence solution helps remote workers connect to customers, partners, and coworkers with confidence, and builds trust and understanding despite distance. Travel time and expenses are reduced significantly. Additionally, the solution leads to faster time to market by facilitating more rapid decision making, since remote resources are more readily available. Most importantly, professionals can enjoy an improved quality of life.
"People are intrigued with the possibilities that the solution has to offer," says Margaret. "I cannot even begin to tell you how many new faces I have seen in both San Jose and Richardson over the past few months because they come by to see me and the TelePresence solution-employees and potential customers, with whom I probably would have never have had the opportunity to interact with. As a result, I have been able to network better at Cisco, making it easier for me to reach out to folks in an administrative fashion, with faster results to better assist the EMTG team."
Margaret's use of the TelePresence solution also provides Cisco with a venue for thoroughly and continuously beta-testing the product. On a daily basis, Margaret logs in her progress and observations, and, when necessary, reports any bugs or issues that she may encounter.
"Every morning that I dial in, I think to myself, is this really happening? I can live where I want, work at a company that I love, and still have a full-time presence. That's amazing." she says.
The Cisco TelePresence 1000 is designed to be a flush-mounted plasma screen along a wall space for easier use in smaller footprint areas such as an individual office. It is a single panel plasma screen, designed to be installed in a variety of environments as a free-standing unit.
The Cisco TelePresence Manager is a separate application running on an MCS 7835 server, capable of supporting up to 1000 Cisco TelePresence endpoints. It collects information about Cisco TelePresence systems from Cisco Unified CallManager and associates those systems to their physical location or conference room, as defined in Active Directory and Microsoft Exchange (Lotus support will follow in 2007). This allows users to schedule Cisco TelePresence meetings from their calendars and have that schedule automatically sent to phones associated with each of the Cisco TelePresence systems involved in the call. As a result, the user can launch the Cisco TelePresence call with "one button to push" simplicity by merely selecting the meeting from the list of scheduled meetings on the display of the phone.

FOR MORE INFORMATION
To find out more about the Cisco TelePresence solution, go to: http://www.cisco.com/go/telepresence.

Ray Dalio on the current state of affairs in the market

Bridgewater Associates founder Ray Dalio is a smart investor.

His actively managed hedge fund strategy, called Pure Alpha, reported an 8.7% net gain in 2008, a year when almost all asset classes declined in value.

Dalio's annual letter to investors is well worth reading. It is loaded with insight and perspective. All of which could be very helpful in the current environment.

“If you optimize your investment strategy to work in a certain period without having a deep enough understanding of how it would work in all circumstances, including circumstances that did not occur within the period that’s your frame of reference, you will inevitably do very badly – and that is what happened to a lot of people in 2008,” he writes.

To read the Bridgewater Letter written by Ray in its entirety go here.

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This is an exceprt of his analogy comparing current circumstances to the game of Monoply. It is worth the time to read the complete version contained in his year end review of 2008.

For example, if you understand the game of Monopoly®, you can pretty well understand what happened to the economy and to people’s financial circumstances last year. Early in the game of Monopoly®, people have a lot of cash and few hotels, and it pays to convert cash into hotels. Those who have more hotels make more money. Seeing this, people tend to convert as much cash as possible into property in order to profit from making other players have to give them cash. So, as the game progresses, more hotels are acquired, which creates more need for cash (to pay the bills of landing on someone else’s property that has lots of hotels on it) at the same time as many folks have run down their cash to buy hotels. When they are caught needing cash, they are forced to sell their hotels at discounted prices. So, early in the game “property is king” and later in the game “cash is king.” Those who are best at playing the game understand how to hold the right mix of property and cash, as this right mix changes.
Now let’s imagine how this Monopoly® game would work if we changed the role of the bank so that it can make loans and take deposits. Players would then be able to borrow money to buy hotels and, rather than holding their cash idly, they would deposit it at the bank to earn interest, which would provide the bank with more money to lend. If Monopoly® were played this way, it would provide an almost perfect model for the way our economy operates. More money would be put into hotels sooner than it would be if there were no lending, the amount owed would quickly grow to multiples of the amount of money in existence, and the cash shortage for the debtors who hold hotels would become greater, so the cycles would become more pronounced. The bank and those who saved by depositing their money in it would also get into trouble when the inability to come up with needed cash caused withdrawals from the bank at the same time as debtors couldn’t come up with cash to pay the bank. That’s what happened in 2008.
By the way, I suspect that, if the game of Monopoly® were played with the bank operating this way, and more kids played it from an early age, we would have more astute investors, businesspeople and bankers and, as a result, we would have less dramatic economic cycles.
If we wanted to train our kids to have really rich appreciations of how the economy works, we would have to make our Monopoly® game only slightly more complex. Most importantly, we would allow the bank to print money. Really, that’s all that we’d have to do to make the game very realistic. But, if we really wanted them to become sophisticated global macro investors – i.e., to get them to learn about currency trading and “global macro” investing – we would have a few Monopoly® games going at the same time with each one having a different currency and allowing players to freely play in any or all of them.

Dear XXXXXXXX,
2008 was a year to remember, so now is a good time to reflect on it and to extract the important lessons from it. Most importantly, it was a year in which a lot of mistakes occurred, so there is lots of learning and improvement that can come from looking at these mistakes analytically. It was a year in which all investors were stress–tested, and big differences surfaced, which are important to understand. It was also a year that has embedded in it lots of clues about the risks and opportunities that lie ahead, which we want to be sure to mine. So please indulge me while I attempt to do this reflecting in my usual circuitous and opinionated way.
It seems to me that, above all else, what happened last year reflected human nature. No exogenous shocks caused what happened. The crisis was completely caused by people operating in a manner consistent with their individual natures and together in ways typical of group dynamics. In other words, people caused their circumstances, which they reacted to, which caused new circumstances that they reacted to, and so on. And they did this in ways that weren’t very complex or unique.

For example, if you understand the game of Monopoly®, you can pretty well understand what happened to the economy and to people’s financial circumstances last year. Early in the game of Monopoly®, people have a lot of cash and few hotels, and it pays to convert cash into hotels. Those who have more hotels make more money. Seeing this, people tend to convert as much cash as possible into property in order to profit from making other players have to give them cash. So, as the game progresses, more hotels are acquired, which creates more need for cash (to pay the bills of landing on someone else’s property that has lots of hotels on it) at the same time as many folks have run down their cash to buy hotels. When they are caught needing cash, they are forced to sell their hotels at discounted prices. So, early in the game “property is king” and later in the game “cash is king.” Those who are best at playing the game understand how to hold the right mix of property and cash, as this right mix changes.
Now let’s imagine how this Monopoly® game would work if we changed the role of the bank so that it can make loans and take deposits. Players would then be able to borrow money to buy hotels and, rather than holding their cash idly, they would deposit it at the bank to earn interest, which would provide the bank with more money to lend. If Monopoly® were played this way, it would provide an almost perfect model for the way our economy operates. More money would be put into hotels sooner than it would be if there were no lending, the amount owed would quickly grow to multiples of the amount of money in existence, and the cash shortage for the debtors who hold hotels would become greater, so the cycles would become more pronounced. The bank and those who saved by depositing their money in it would also get into trouble when the inability to come up with needed cash caused withdrawals from the bank at the same time as debtors couldn’t come up with cash to pay the bank. That’s what happened in 2008.
By the way, I suspect that, if the game of Monopoly® were played with the bank operating this way, and more kids played it from an early age, we would have more astute investors, businesspeople and bankers and, as a result, we would have less dramatic economic cycles.

If we wanted to train our kids to have really rich appreciations of how the economy works, we would have to make our Monopoly® game only slightly more complex. Most importantly, we would allow the bank to print money. Really, that’s all that we’d have to do to make the game very realistic. But, if we really wanted them to become sophisticated global macro investors – i.e., to get them to learn about currency trading and “global macro” investing – we would have a few Monopoly® games going at the same time with each one having a different currency and allowing players to freely play in any or all of them.

If the bank could print the money, it would certainly do so when there was a cash shortage – i.e., when people need a lot of cash, when they can’t pay their debts, when they are selling their hotels, and when banks struggle to come up with enough money to meet demand, because the players aren’t servicing their debts. Our kids would soon learn that, all things being equal, printing more money causes its value (i.e., the currency) to fall and the increased money supply to buy hotels drives their prices up. But, if the bank prints more money when the demand for it is high, and there is a shortage of money when hotels are being dumped, and hotel prices are falling, then the currency would not fall in value and the prices of hotels would not rise, because the increased supply of money would simply negate the effects of the shortage of it. That’s also what happened in 2008.

In other words, in the years immediately prior to 2008, players in the economy took on a lot of debt to buy assets at high prices, so in 2008 the game progressed to the stage where cash is in short supply, there are debt problems, and assets are written down or liquidated. Naturally, the central bank printed a lot of money, but this didn’t cause its value to fall or inflation to rise, because this increased supply of money negated some of the effects of the shortage.

In Section II of the attached report, “A Template For Understanding What’s Going On”, we explain this debt/economic dynamic in a more fleshed out way. If you only have a limited amount of time to read what we are sending, please stop reading this (and anything else that we gave you), and go read that.

Because human nature and the basic elements of economics remain essentially the same over time, what happened in 2008 has happened many times before. However, unlike recessions that occur more frequently, the dynamic that occurred in 2008 has happened less frequently and has not happened within most people’s lifetimes. Because it is in most people’s “nature” to learn from their experiences, and because investors, businessmen, and government officials did not previously experience the dynamic that happened in 2008, most of them 1) did not plan for it, 2) considered it implausible, and 3) didn’t understand it. That, more than any other reason, is why so many of them were hurt in 2008.

In other words, 2008 was a year in which those who built their strategies on the basis of what happened in their recent lifetimes did not understand what happened in 2008 and so did badly, while those who had a perspective of what happened in long ago times and faraway places (and why these things happened) did well. Said differently, if you optimize your investment strategy to work in a certain period without having a deep enough understanding of how it would work in all circumstances, including circumstances that did not occur within the period that’s your frame of reference, you will inevitably do very badly – and that is what happened to a lot of people in 2008.

You have heard us speak of the importance of having a “timeless and universal” investment process, probably so much that you are sick of this phrase. What we mean by it is that we believe that one’s investment process needs to have worked well in ALL COUNTRIES AND ALL TIME FRAMES in order to continue to work as things change, because it must be based on essential truths that include understandings of how things change over time. We believe that, if investors don’t do this, their process will work until it inevitably doesn’t work (i.e., until it blows up), because things will inevitably change in ways that aren’t understood and incorporated into the process. So, in my opinion, 2008 was a very important year of differentiating those who operate this way from those who don’t.
Since I believe that a big common mistake that caused many investors problems in 2008 was not having a broad enough perspective, I believe that one of the most important lessons for those who did badly in 2008 is to have a “timeless and universal investment” perspective, which means to broaden your perspective to understand what happened in long ago times (e.g., in the 1930s) and faraway places (like Japan and Latin America). Ask yourself, “what would it be like if we had another year, or another two years, like last year,” because an examination of history shows that this is well within the realm of possibilities. Nobody really knows what will happen, but we all need to consider the full range of possibilities, make sure that our strategies make the worst case scenarios tolerable (i.e., really control risk!) and look for ways to maximize our opportunities. Taking a timeless and universal perspective helps us to do that.

Another reason so many investors did badly in 2008 was that they had big, concentrated exposures to assets and portfolios that do well when the economy does well and badly when the economy does badly – and the economy did badly. They had these skewed exposures because:

1) The beta (i.e., asset allocation) exposures were not diversified; they were (and still are) typically much more heavily concentrated in assets that do well in good times and badly during bad economic times (e.g., public equities, private equity, real estate, high yielding debt, etc.) than in assets that do well in bad times (e.g., Treasury bonds). How did they get this way? It came about because of human nature – i.e., people are prone to do those things that worked in the past without thinking hard about why they worked or whether they will work in the future. In other words, investors are biased to invest in those assets that performed best during the timeframes that are in their frame of references.

2) The alpha exposures (i.e., tactical bets) were also typically not diversified and were (and still are) skewed to do well in good times and to do poorly in bad times. For example, the average “hedge” fund was (and still is) about 70% correlated with stocks. How did all these alphas and betas get so skewed toward doing well in good times and badly in bad times, and how is it possible that portfolios were so undiversified? And what happened to absolute returns in absolute return strategies? What happened occurred for the same reason – i.e., because of the tendency to do what would have worked in the past. So, alphas like betas became those strategies that worked in the recent past, which were strategies that worked in good times.

3) The risk and liquidity premiums effects on returns are correlated to the betas and the alphas in the portfolio. So when the economy did badly, these premiums rose and also hurt returns.

So, all three major drivers of returns were prone to do well during good times and, as a result, the average institutional investor’s portfolio was (and still is) heavily skewed to do well in good times (e.g., over 90% correlated with equities) and to do poorly in bad times. And, since 2008 was a really bad time (i.e., economic conditions turned out worse than discounted), all the folks with these skews did badly.

Since most everyone’s portfolios were skewed this way long before the 2008 price decline, and since the disaster scenario for this portfolio had happened in Japan where the stock market is still down about 70% from where it was 20 years ago, why weren’t investors concerned about the possibility that what happened to Japanese investors could happen to them? I believe that it is because of “human nature” – because their own experiences influenced their behaviors more strongly than this peripheral Japanese case. Having seen the most popular asset allocation mixes shift over time, I am confident that following a few bad years, new theories will emerge to justify why portfolios that are biased to do well during bad times are best – e.g., because they are good liability and funding hedges – and that most portfolios will be skewed this way. That is because it is human nature to believe that which has happened most recently is more likely to occur in the future, even though that belief is wrong.

So, in reflecting on 2008 and the lessons for the future, I believe that one of the most fundamental questions investors should ask themselves is whether or not it is logical to have this huge bias to do well in times that are better than are discounted (i.e., to be so concentrated in assets and alpha strategies that are positively correlated with equities). Personally, I believe that having such huge biases is never logical, let alone at this time. So, I believe that another important lesson of 2008 for most investors is to avoid having systemic biases in your portfolio, which means to restructure your portfolio so that it is less vulnerable to any one environment by having better diversification between and within betas, alphas, and risk premiums.

Before leaving this subject of risk premiums and the strong tendency for investors to believe that what happened in the past is likely to persist, I’d like to make one more point that pertains to them, in particular as to how they affect swings in fear and greed and how these swings affect pricing.

While investors tend to look at past returns as an indicator of future returns, all thing being equal, that’s backwards. That’s because high past returns typically cause assets to become more expensive, and, because of investors’ tendencies to buy after price increases for no good reason, prices tend to overshoot. And when investors are making money – which is typically after prices have risen – they’re greedy and fearless. And because investors buy assets on leverage when they are really confident and when the prices are really high, doing the opposite is a good idea.

If, instead of looking at past returns, investors simply looked at yields, they would do the exact opposite and have much better results. In buying an investment, one is making a lump sum payment for a future income stream. The investment will make money if the present value of that income stream is more than the current price. So, to assess value, one has to estimate that income stream, take its present value and compare it to the price to assess its cheapness. If an investment has a higher yield, the growth rate of the income stream can be lower than if it has a lower yield. Said differently, when the investment has a high yield, less growth is discounted, so, all else being equal, it is more likely that the investment will have a higher return. So, buying assets when they have higher yields is better than buying them when they have lower yields. And if they are widely bought on leverage, the price will be higher than it would have been if there were no buying on leverage at the same time as leveraged investments are more susceptible to forced liquidations. So, one should be especially wary of investments that have low yields (therefore high prices) that are bought with leverage. Said differently, human nature causes reactive decision making that leads to psychological swings between fear and greed that is reflected in prices.

In 2006-07 risk premiums became miniscule (so prices got very high) at the same time as leverage levels became enormous, so, in 2008, there wasn’t enough cash flow to pay debts, risk premiums increased, and prices fell, with the whole implosion process enhanced by mark-to-market accounting. Naturally, the Fed lowered interest rates to 0%. So, as we enter 2009, we see risk premiums up to levels that are about the same as in 1982 and nearly as high as in 1974, so they are near their U.S. post-World War II highs. However, the current risk premiums are still low (unattractive) in relation to where they were in the pre-WW II period (especially during 1932-33) and low relative to those in Japan and in Latin America in the worst of their crises. In other words, risk premiums are attractive if you believe that the future will play out the way it did in the U.S. post-World War II period and unattractive if you believe that it will play out in a manner that is similar to these other three cases. Also, there are a couple of important differences between conditions now and conditions in other times during the post-World War II period that are similar to the 1930s, Japan in the 1990s, and in Latin America in the 1980s. Most importantly, 1) debt service burdens are now higher than in the other post-World War II cases and more like those in these other three cases, and 2) monetary policy doesn’t control credit creation (because interest rates are near 0% as in the 1930s and in Japan’s case, and because of hyperinflation in Latin America’s case). Whether the path for the economy and the markets will be more like the paths in the post-World War II period or more like those in these other cases is a matter of conjecture that we will have to objectively and continuously assess based on how events transpire. So, in my opinion, in 2009, as in 2008, the most important driver of your portfolio’s returns: 1) that come from betas will be a) whether or not your beta mix (i.e. asset allocation) has the systematic bias to do well in good times or bad times and, if it does have a bias, b) whether or not we have bad times; and, 2) that come from your managers’ alphas will be a) whether or not they have systematic biases to do well in good times or bad times and, if they are not biased b) whether or not they can tell the difference between the good and bad times and position themselves to take advantage of whatever happens.

Speaking of human nature, greed, and fear, I want to say a few words about character, because I believe it also played a big role in determining investors’ results and economic conditions in 2008, and that looking at how people acted can provide valuable lessons for the future. The greed that led to the bust was not just in the form of investors buying assets at high prices on leverage and driving risk premiums way down. It also came in the form of many investment managers who put making money for themselves ahead of doing what was best for their clients. This urge to make as much money as possible as fast as possible manifested itself in a range of ways and degrees, from downright cheating (e.g., in the case of Bernie Madoff), which happened in a small minority of cases, to being careless and not completely honest, which happened in the majority of cases. For example, I believe investment managers commonly slapped together tantalizing, unreliable investment products and described them to clients in less than totally accurate ways. And I believe that many investors naively didn’t perceive this deception or they accepted it as a reality that they had to try to protect themselves against while investing with these people.

In any case, investors commonly dealt with some managers whose character wasn’t at a high enough level. So, I believe that another important lesson should be to weigh character heavily in deciding whom to associate with. Just as you look at the length and quality of performance, look at the length and track record of character. In the investment business, there are both wonderful and terrible people, and everything in between, so character should be at least as important a factor in choosing your investment managers as past investment performance. Greed hurt the financial markets, the economy, investors, and even the perpetrators severely in 2008, so, if investors learn from this mistake, they will improve their results in 2009 and beyond.

I have one last reflection about 2008 that’s an optimistic one. Periods like the one that we are in are an essential part of the cleansing, learning process that stress-tests people and processes and provides lessons that create improvements. So, in a very fundamental way, we, the markets, and the economy are now on sounder footing than during the boom. While we will inevitably get on a much sounder footing still, we will get there quicker if we and policymakers don’t make the typical mistakes that investors and policymakers have made in similar circumstances in the past. Along these lines, I am very pleased to say that I think that the top people on the Obama economic team are stars, and I have the utmost admiration for the way the Fed is now being managed. So, I believe that the country has a team of great doctors working on a very serious disease that will eventually end and will inevitably leave the markets, the economy, and us on a more sound footing. Of course, that doesn’t mean that all people will eventually be OK. As part of this evolutionary process, there will be great risks and opportunities that will lead to the survival of the fittest. As with all such evolutionary processes, this will eventually be great for the whole, though it will certainly be deadly for some.

In closing I want to thank you again for allowing us to be in this fight with you and to assure you that we will continue doing everything in our power to do our best for you.
Most importantly, I wish you and your loved ones health in the New Year,

Ray
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Tuesday, January 27, 2009

2008 versus 2009 Predictions

I read a good article over on Infectious Greed that highlighted 2008-2009 predictions from several characters.

Here is a taste:

THEN: Nouriel Roubini, a New York University economics professor, predicted a flood of credit defaults and a prolonged bear market. "The debate," he said, "is not whether we're going to have a soft landing or a hard landing. The question is only how hard the hard landing will be."

NOW: Roubini said at a conference last week: "I've found that credit losses could peak at a level of $3.6 trillion for U.S. institutions, half of them by banks and broker dealers. If that's true, it means the U.S. banking system is effectively insolvent, because it starts with a capital of $1.4 trillion. This is a systemic banking crisis."

"The problems of Citi, Bank of America and others suggest the system is bankrupt. In Europe, it's the same thing."

He also said commodities prices could fall "over all another 15 to 20 percent. This outlook for commodity prices is beneficial for oil importers. It's going to imply that economic recovery might occur faster, but from the point of view of oil exporters, this will be very negative."

THEN: John Snow, chairman of Cerberus Capital Management and a former secretary of the U.S. Treasury under President George W. Bush, said that if the United States slipped into recession, it would be "short and shallow."

"That's been the pattern of recessions in the U.S., and there's a reason for it," he said. "There is an inherent resilience in the U.S. economy. We're already seeing an adjustment."

NOW: Snow, asked for his views last week, declined to comment.

Schaden-Davos-freude: 2008 vs 2009 Predictions

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Will the Commercial Paper Market get Tested on Friday?

The Fed launched the Commercial Paper Funding Facility on Oct. 27 to buy short-term debt directly from companies amid the credit market's seizure. Now, the Fed holds about $350 billion of commercial paper in the facility. That is close to 21% of the $1.7 trillion market. About $230 billion of this debt is set to mature by Friday.

The question: Will companies like General Electric or GMAC, which issue this short-term debt to pay their bills and meet other near-term obligations, return to the open market rather than roll over their debt with the central bank.

With the market looking on two additional question will be answered:

Is the open market capable and willing to fund these companies?
If they return to the open market what will be the cost of funding their obligations?

This could result in an interesting test of the commercial paper market. It will also be an interesting test of the bailout. A good result might help stabilize the stock market. A bad result? We shall see.

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Fed Program That Calmed Debt Market Faces a Test

By LIZ RAPPAPORT

This week brings one of the first tests of success for a key Federal Reserve program that has calmed the short-term credit markets.

About $230 billion of three-month debt that the Fed owns, in the form of commercial paper, is set to mature by Friday.

The questions are: Will companies like General Electric or GMAC, which issue this short-term debt to pay their bills and meet other near-term obligations, return to the open market rather than roll over their debt with the central bank, which costs a lot more? Can the still-fragile market absorb so much three-month debt in a single week without sending interest rates much higher? And is the Fed winding down this key program?

The Fed launched the Commercial Paper Funding Facility on Oct. 27 to buy short-term debt directly from companies amid the credit market's seizure, following Lehman Brothers' collapse.

At the time, money-market funds, which are the main buyers of this debt, were hoarding cash to meet redemptions and companies couldn't obtain loans for much more than 24 hours, and at rates as high as 7% or more.

GMAC says it is evaluating all of its funding options, while General Electric Chief Executive Jeffrey Immelt said last week the firm was cutting back its reliance on the commercial-paper market.

As of this past Thursday, the Fed held $350 billion of paper in the facility. That is close to 21% of the $1.7 trillion market.

"Unwinding the Fed's programs is meant to be a natural process, and this is an early test of that," said Lou Crandall, chief economist at Wrightson ICAP.

Some analysts predict the Fed may see its CP purchases cut by half as issuers work their way back into the open market.

It is unlikely all the issuers will roll over their debt for three months as some choose to sell at shorter maturities, of one or two months. Others, like banks, may entirely buy back their debt using cash they have obtained by borrowing at lower rates, using debt guaranteed by the Federal Deposit Insurance Corp. Thursday evening the Fed will report its holdings for the prior week.

Certainly, the CPFF program, along with several others, has helped smooth the problems in the short-term credit markets.

Money-market funds have been buying higher-yielding assets rather than just the safest short-term Treasury bills, which yielded them 0% for several weeks. Investors have moved into "prime" money-market funds, which buy higher-yielding assets. Money-fund managers no longer fear the possibility of "breaking the buck," or having the value of each share fall below $1, given the myriad government programs that ensure liquidity to meet any surge in redemptions.

Commercial-paper rates have also fallen to the point where borrowing from the Fed has become less appealing because it costs more than the open market does -- a phenomenon the Fed engineered. In the open market, companies can issue three-month debt at rates around 1% or less, where the Fed's rates are 1.24% for unsecured commercial paper or 3.24% for paper backed by assets' cash flows.

The Commercial Paper Funding Facility isn't scheduled to expire until the end of April, but as Federal Reserve Chairman Ben Bernanke explained in a Jan. 13 speech in London, "unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities."

The Fed's balance sheet has already shrunk since the start of the year, from $2.26 trillion on Dec. 31 to $2.04 billion as of last Thursday. That said, it's still massively oversized from under $900 billion prior to Lehman's bankruptcy filing last September.

About $60 billion of the shrinkage came from allowing an older, now unnecessary, liquidity facility to expire. About $135 billion is due to a decline in short-term lending facilities, which were heavily used by banks and other financial institutions to get through year-end funding pressures, according to Fed data.

The remainder was due to modest ups and downs in a variety of facilities, and some currency valuation adjustments.

Write to Liz Rappaport at liz.rappaport@wsj.com

Six Errors on the Path to the Financial Crisis

Alan Blinder wrote an interesting article in the New York Times last week. He spells out in easy to understand terms the six errors that led us into this financial mess. He points out that if simple choices has been made along the way the situation would not be as dire as it is today. He goes on to point out that the current situation is not the failure of capitalism but about human errors. By putting a clear, concise "frame" around the current situation he makes it easier to understand. A better basic understanding of the problem would help our politicians in Washington to make decisions about how "taxpaper" money should and could be used to exacerbate the current financial problems. The real issue right

now is whether or not the way taxpayer money is being used is helping or just delaying the inevitable.

My list of errors has six whoppers, in chronologically order. I omit mistakes that became clear only in hindsight, limiting myself to those where prominent voices advocated a different course at the time. Had these six choices been different, I believe the inevitable bursting of the housing bubble would have caused far less harm.

Six Errors on the Path to the Financial Crisis

By ALAN S. BLINDER

WHAT’S a nice economy like ours doing in a place like this? As the country descends into what is likely to be its worst postwar recession, Americans are distressed, bewildered and asking serious questions: Didn’t we learn how to avoid such catastrophes decades ago? Has American-style capitalism failed us so badly that it needs a radical overhaul?

The answers, I believe, are yes and no. Our capitalist system did not condemn us to this fate. Instead, it was largely a series of avoidable — yes, avoidable — human errors. Recognizing and understanding these errors will help us fix the system so that it doesn’t malfunction so badly again. And we can do so without ending capitalism as we know it.

My list of errors has six whoppers, in chronologically order. I omit mistakes that became clear only in hindsight, limiting myself to those where prominent voices advocated a different course at the time. Had these six choices been different, I believe the inevitable bursting of the housing bubble would have caused far less harm.

WILD DERIVATIVES In 1998, when Brooksley E. Born, then chairwoman of the Commodity Futures Trading Commission, sought to extend its regulatory reach into the derivatives world, top officials of the Treasury Department, the Federal Reserve and the Securities and Exchange Commission squelched the idea. While her specific plan may not have been ideal, does anyone doubt that the financial turmoil would have been less severe if derivatives trading had acquired a zookeeper a decade ago?

SKY-HIGH LEVERAGE The second error came in 2004, when the S.E.C. let securities firms raise their leverage sharply. Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1. What were the S.E.C. and the heads of the firms thinking? Remember, under 33-to-1 leverage, a mere 3 percent decline in asset values wipes out a company. Had leverage stayed at 12 to 1, these firms wouldn’t have grown as big or been as fragile.

A SUBPRIME SURGE The next error came in stages, from 2004 to 2007, as subprime lending grew from a small corner of the mortgage market into a large, dangerous one. Lending standards fell disgracefully, and dubious transactions became common.

Why wasn’t this insanity stopped? There are two answers, and each holds a lesson. One is that bank regulators were asleep at the switch. Entranced by laissez faire-y tales, they ignored warnings from those like Edward M. Gramlich, then a Fed governor, who saw the problem brewing years before the fall.

The other answer is that many of the worst subprime mortgages originated outside the banking system, beyond the reach of any federal regulator. That regulatory hole needs to be plugged.

FIDDLING ON FORECLOSURES The government’s continuing failure to do anything large and serious to limit foreclosures is tragic. The broad contours of the foreclosure tsunami were clear more than a year ago — and people like Representative Barney Frank, Democrat of Massachusetts, and Sheila C. Bair, chairwoman of the Federal Deposit Insurance Corporation, were sounding alarms.

Yet the Treasury and Congress fiddled while homes burned. Why? Free-market ideology, denial and an unwillingness to commit taxpayer funds all played roles. Sadly, the problem should now be much smaller than it is.

LETTING LEHMAN GO The next whopper came in September, when Lehman Brothers, unlike Bear Stearns before it, was allowed to fail. Perhaps it was a case of misjudgment by officials who deemed Lehman neither too big nor too entangled — with other financial institutions — to fail. Or perhaps they wanted to make an offering to the moral-hazard gods. Regardless, everything fell apart after Lehman.

People in the market often say they can make money under any set of rules, as long as they know what they are. Coming just six months after Bear’s rescue, the Lehman decision tossed the presumed rule book out the window. If Bear was too big to fail, how could Lehman, at twice its size, not be? If Bear was too entangled to fail, why was Lehman not?

After Lehman went over the cliff, no financial institution seemed safe. So lending froze, and the economy sank like a stone. It was a colossal error, and many people said so at the time.

TARP’S DETOUR The final major error is mismanagement of the Troubled Asset Relief Program, the $700 billion bailout fund. As I wrote here last month, decisions of Henry M. Paulson Jr., the former Treasury secretary, about using the TARP’s first $350 billion were an inconsistent mess. Instead of pursuing the TARP’s intended purposes, he used most of the funds to inject capital into banks — which he did poorly.

To illustrate what might have been, consider Fed programs to buy commercial paper and mortgage-backed securities. These facilities do roughly what TARP was supposed to do: buy troubled assets. And they have breathed some life into those moribund markets. The lesson for the new Treasury secretary is clear: use TARP money to buy troubled assets and to mitigate foreclosures.

Six fateful decisions — all made the wrong way. Imagine what the world would be like now if the housing bubble burst but those six things were different: if derivatives were traded on organized exchanges, if leverage were far lower, if subprime lending were smaller and done responsibly, if strong actions to limit foreclosures were taken right away, if Lehman were not allowed to fail, and if the TARP funds were used as directed.

All of this was possible. And if history had gone that way, I believe that the financial world and the economy would look far less grim than they do today.

For this litany of errors, many people in authority owe millions of Americans an apology. Richard A. Clarke, former national security adviser, set a good example when he told the commission investigating the 9/11 attacks that he wanted victims’ families “to know why we failed and what I think we need to do to ensure that nothing like that ever happens again.” I’m waiting for similar words from our financial leaders, both public and private.

Alan S. Blinder is a professor of economics and public affairs at Princeton and former vice chairman of the Federal Reserve. He has advised many Democratic politicians.

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