The Ratings Game

The bond rating agencies are taking a lot of heat lately because of their unwillingness to downgrade various mortgage-backed bonds whose collateral is clearly in distress as delinquencies and foreclosures climb to 10-year highs. Various money managers, bond traders, et. al. are blaming them for not taking more decisive action. Sadly, however, this is yet another instance of lack of understanding of how the system really works: rating agencies are not in the prediction business. They analyse the here and now and thus their ratings actually reflect the past since financial statements, defaults, etc. are historical data. At the top of the economic cycle everything is firm: defaults are low, collateral prices are rising and thus a high percentage of loans go into the AAA tranches. That and the explosion in derivatives trading created the massive structured finance sector.

So what are rating agencies doing now as things are softening? They are sitting on their hands and waiting. The whole mortgage default process, from late payment to foreclosure and final sale at auction takes many months - almost a year. There is no way for the rating agencies to predict what the bond holders will recoup in the form of sale proceeds, i.e. how adequate the collateral is and therefore what the new ratings of the various CDO tranches should be, particularly within the "cascade" structure all of them use. Over the next 6+ months there will be a full set of historical data and the rating agencies will act.

Knowledgeable finance professionals have long been aware of the lagging nature of bond ratings, particularly when it involves securitizations of various loan obligations. We can all argue that rating agencies "should know better", but in truth that's not their role in the game. It is the various money managers who buy the stuff that are supposed to be able to interpret a particular rating as being ex post facto, rather than containing firm evidence of financial strength.

But in this era of waning pension fund contributions, higher life expectancies and zooming medical costs, what is a money manager to do to get an extra 10 basis points and still maintain the minimum required average rating for his/her portfolio? Holding his nose firmly closed (some even shut their eyes...) he buys the stuff and prays.

Bottom line: yes, rating agencies are complicit in this developing MBS mess - but only to the extent that they did not alter their usual practice, developed over decades of professional experience. Their "crime" is more one of omission rather than commission. For real "perps" we should be looking elsewhere - but this is a subject for another post.

A Bear Bit Them

Troubles are back in CDO-land and the various indexes tracking credit default swaps for mortgage securities are all making fresh new lows. You can follow all the charts at Markit - here are just a few.

This one tracks residential mortgages, the tranches with BBB- ratings. Collapse is a fair description.

But the better quality A rated stuff is taking it on the chin, too.
Things are not much better on the commercial mortgage side.

These charts are inverted because they track yield spreads, so the higher they go the worse things are. Merely for comparison purposes I have included charts for the same ratings as above.

The reasons for this new debacle are easily found by reading the financial press. A certain investment bank, highly involved in the issuance and trading of mortgage-backed securities, is presently living up to the first part of its name.

I'm Back...

Thank you all for your kind words about my (forced) absence. Blame it all on a (very) delayed telecom re-location.

I will be back posting starting Monday...

Best wishes to all.


P.S. In re feathers in my house...

Let's see...

1. In real life I am a neighborhood kosher chicken butcher.

2. I live next to Frank Perdue's house (RIP).

3. Pillow fights.

4. Tarred and feathered on a regular basis.

5. For CPI calculation purposes BLS has switched "down-filled" duvets with "chicken feather-filled" and I am just being a good American.

Inflation Is Dead...

...but it depends on who's counting and what is being counted.

"Core" inflation for May came in "lower than expected" and markets cheered. But regular inflation, the one that includes such trivial items like food and fuel, came in higher than expected and, indeed, matched the highest one month rise in at least 15 years (+0.7%), with the exception of one month in 2005 when fuel prices soared after hurricane Katrina.


I think the usefulness of "core" data has reached its limit. The items being left out are essential and the higher prices are hitting middle-class household budgets the hardest.

Some calculate the difference between core and headline inflation and assume that corporate profit margins are getting squeezed. If this was my daddy's BLS (Bureau of Labor Statistics) I would agree without a second thought. But the way CPI is calculated these days has made any serious comparisons a Kafkaesque experience. Take hedonic pricing, for example:

Is olive oil for your salad getting too expensive? The government statisticians say that you, the educated consumer, will immediately switch to cheaper vegetable oil - no matter that it makes your salad taste like greasy chopped cardboard. And if greens for your salad get too expensive, too, how about bean salad, instead? You could produce your own methane gas and save on fuel (note to BLS: if bean prices rise, make sure to cut natural gas price indexes to balance).

I actually have a personal experience to relate on this matter: I was shopping for a vacuum cleaner a couple of months ago and I stupidly ended up buying one with a reputable brand on it (once famous for making sewing machines) for what seemed like an absolutely bargain-basement price: $35. Made in China, of course. Well, it worked for exactly three times and then the cheap-o shell wouldn't close properly after changing the bag, the vacuum escaped and the best it could manage was to suck up chicken feathers. Slowly.

I went back to the store and this time I chose a real machine made in Germany for 8 times the going price of the worthless p-o-s (which I am giving away for free, but no takers). The story does not end here: as I was walking to the cashier with my new vacuum, I noticed a young man carrying the exact same p-o-s I had bought two months ago and a saleslady trying to talk him out of it (she didn't exactly say it was garbage, but damn near in salesperson talk). "You really don't want to buy that", I chimed in. "I am not trying to be a busybody, but look: I bought the same vacuum as you a month ago and here I am again... see what I am carrying?"

The young man was quickly convinced to buy something else, but I bet the BLS is not so discriminating. If I am wrong on the bet, the prize is a vacuum cleaner - like new and entirely useless at any price.

Interest Rates

After hitting a new 12-month high, long rates eased off yesterday and equity markets immediately breathed a sigh of relief. But the question still remains: why are long rates going up all of a sudden?

• Negative carry: bond dealer inventory is typically financed with short-term repos. With the yield curve inverted, carry was negative, i.e. it cost more to finance the bonds on the trading books than they paid in interest. Until recently the negative carry was more than made up from capital gains, since credit spreads kept narrowing. But this has now come to an end (see the ABX, CMBC, CDX indexes), so holding positions becomes unprofitable. As they say on the trading desks: "the spread will eat you alive".
  
• There is huge borrowing demand from M&A activity. In the first four months of 2007 there have been more such deals announced (in dollar terms) than in all of 2006.
• Adjustable mortgages are being reset in record amounts (see June 9 post for chart), also creating demand for longer-term money.
• There are reports of slowing foreign demand for US bonds. Since the main recycler of US consumer debt is China, the current economic slowdown in the US could mean there are less exports, less dollars to recycle and thus fewer bond purchases.

The 10-year yield chart below is about a month old (now at 5.22%), but it is useful for a long-term perspective, particularly when we consider that such historically low rates are happening at a time when total debt/GDP is breaking all-time record highs.

Note: I will not be posting for a few days due to phone line technical reasons. See you soon.

Flat-Earth Finance

In Euclidian geometry the two most important axioms are:

1) The shortest distance between two points is a straight line and,
2) Parallel lines never intersect.

In finance, the equivalents are:

a) Money makes the world go round and,
b) Interest rates regulate the amount of money.

Following logically from (a) and (b), when interest rates rise, money creation is reduced and the world spins slower.

Now, the money crowd is so tightly wrapped around itself, so myopically attached to the micro-reality of markets, that it believes that the whole world is defined by the ups and downs of a couple of share indexes and the pronouncements of a few central bankers. In that, they are just a bunch of flat-earthers scared silly of getting too close to the edge, dropping off their pancake world and vanishing forever. Unlike geometry, finance unfortunately never progressed past Euclid.

Fact is, finance is not even a science at all. It is not ruled by natural law, but by a near-religious belief system, complete with priests and rituals, gods, demi-gods, fallen angels and devils. Marx had it wrong: money is the opium of the people - and this is why communism failed so miserably in practice. Just try taking away that drug from the addicts. But, I digress...

Every major move in financial markets that I have experienced in the past 25 years has come from a shift in interest rates, up or down. As the winds we call interest rates get stronger, the ship of finance-fools gets pushed further away from the safe haven of the pancake's center and closer to the presumed abyssal edge. The sailors first try to row harder and then make sacrificial offerings to the gods, but eventually panic takes over and they just jump ship. Some drown, others get devoured by sharks and a few make it to shore, cursing the gods for their wretched fate. The ship sails on, of course... the winds eventually shift, the ship gets back closer to the "center", some sailors get aboard and the whole process starts all over again. The Earth is in fact round, after all.

Right now, the winds are getting stronger and the sailors are getting antsy. Some are mumbling about their mates that already jumped ship (they call them sub-primates). Others bring out their amulets, talismans and charts; yet more beseech the on-board diviner to tell them what is to be. Even Greenspan is heard from, free from his curse to speak solely in gobbly-gook and mumbo-jumbo.

With long rates reaching 5-year highs and credit spreads widening once again (eg see the ABX and CDX indexes), I sense a good old fashioned "panicke" coming on, something perhaps straight out of the South Seas; after all, that particular bubble had everything to do with debt, too.

Overcoming Dependence

As long ago as 1945, when FDR met with Kind Ibn Saud aboard the USS Quincy, the US has made foreign oil dependency the cornerstone of its geopolitical strategy. No policy is left untouched by this choice: defence and domestic security, fiscal, monetary and economic development - all are heavily influenced by our need to secure and import ever growing volumes of foreign crude oil. The negative implications are profound and are currently becoming increasingly obvious: wars in the Middle East and Central Asia, terrorist attacks, the re-emergence of adversarial relationships between super-powers. Even the harmful effects to our environment is becoming an important topic when global leaders meet (eg the recent G8).

And yet, our foreign oil policy has not been without positive aspects, if dubious. The global thirst for oil priced in dollars has allowed the US to run up enormous deficits and debts without the need to maintain large foreign exchange reserves. The so-called Dollar Hegemony is based on the near-universal acceptance of our oil-backed currency and this, in turn, allows for the American Way of Life. If the US had not itself become the world's single largest importer and consumer of oil - the most indispensable and fungible commodity of them all - it is unlikely that the US dollar would possess the global reserve status it has today. Crude oil, the US dollar and the profound reach of American military and economic power have become inextricably linked.

But as remaining oil reserves become concentrated in the hands of fewer key producers, we are increasingly hostage to their desires and expectations, those quid pro quos that go beyond merely meeting the asking price in cash. Informed readers need no further elaboration; suffice it to say that just three countries, Saudi Arabia, Iraq and Iran control approximately 45% of global oil reserves. From a monetary policy perspective alone, it is extremely unwise to base the ultimate value of the dollar on such a narrow foundation - even before the very serious threat of geological Peak Oil.

What is to be done, purely from the viewpoint of monetary and fiscal policy? In order to retain the dollar's supreme position, the US must possess goods and services that the rest of the world wishes to buy and pay for in dollars. At this point nothing matches crude oil in such importance: if we were to suddenly replace oil with another source of energy not priced in dollars (eg solar or wind), the US economy would suffer mightily from the need to service so much debt without recourse to a universally accepted dollar.

But change we must: oil is running out and so is our ability to be the overwhelming influence-setter in the important oil and natural gas producing regions (e.g. Venezuela, Russia, Iran). Putting aside geologic considerations, if we do not soon replace oil as the main backing for our currency we will simply become yet another imperial has-been that is gradually impoverished from interest payments to foreign lenders and constant currency devaluation. Every great empire the world has ever seen has gone down that slippery route: Rome (West and East), the Ottomans, Spain, Great Britain, USSR. We, too, are not impervious to bad judgement and an over-abundance of false confidence when conditions change and actions are needed sooner, rather than later.

In my opinion, we must do two things, starting immediately:

a) Cut down on oil consumption via a significant fuel tax that will finance a modern Moon Shot-type project to replace every single watt generated by oil (foreign AND domestic) with solar, wind, nuclear, fusion, geothermal, or whatever else we come up with. Spend the money domestically and the economy will grow based on R&D and capital spending, instead of consuming imports. I am aware of the EROEI limitations of more diffuse energy sources, but that whole discussion misses the point: changing our energy regime is not something we could do, it's something we must do. The sooner we start the better the chances of adjusting our economy and society with few major disruptions.

b) Start reclaiming the manufacturing base of our domestic economy via a variety of positive and negative inducements (subsidies and import duties). Such industrial capabilities are absolutely necessary for the development and application of a new energy regime, one that will also create a range of highly lucrative export goods and services and thus support the value of the dollar. This is anathema to globalization adherents but, after all, globalization is itself entirely dependent on the ready availability of cheap energy (containerships and bulk carriers criss-crossing the oceans, state-subsidized energy in China, etc.). When that is taken away, whoever has an alternative-energy economy already in full operation will have a tremendous comparative advantage.

In closing, establishing a new US energy regime will benefit the economy, the environment and our national security and will help maintain the attractiveness of the dollar as a global reserve currency. Doing nothing is simply not an option.

Housing Fundamentals

Let me start by saying that I am not a housing economist; what follows is an analysis based on what I perceive to be common sense fundamentals. Please correct me if I am wrong.

House construction must be correlated with the formation of new households, particularly those consisting of more than one person. The chart below shows annual house starts and new households with two or more persons. From this perspective, the housing "bubble" can be at least partly explained by the unusual spikes in new households in 2001 and 2003, further boosted by record-low interest rates in the same period.

Data: Census Bureau

There are a few observations that can be made from the above chart:

a) Spikes in household formation, rising much above the median (754.000/yr), are rare. There have been only three in the past 45 years (1980, 2001, 2003). The unusual 2001-2003 sequence must have driven housing demand beyond normal and caused builders to become overly optimistic.
b) When the difference between housing starts and household formations widens too much, a significant correction follows, with starts dropping as low as 1 million units/yr. As of April 2007 starts were still running at 1.53 million units/yr.
c) Will household formations spike upwards again in the near future, thus driving housing demand anew? I am not a demographer, but logic argues against it.

I must conclude that, from a fundamental point of view, housing construction will continue to decline, particularly now that interest rates are also ramping up, creating affordability issues.

The Rise In Long Interest Rates - Another Take

I was saying yesterday that the rapid increase in home mortgages outstanding may be responsible for the sharp rise in long interest rates, caused by a rush to hedge all the CMO/CDO bonds created by their securitization. Such loans more than doubled from $4.8 trillion at the end of 2000 to $9.7 trillion at the end of 2006, a compound annual growth rate of 12.5%.

We know that many of those loans were of the "innovative finance" type, i.e. variable rate, balloon, negative amortization, etc. Their basic feature was that monthly payments were not fixed but were ultimately benchmarked against short-term interest rates, which were at historic lows in the 2001-04 period. As such loans start to reset (see chart below from Credit Suisse, click to enlarge), borrowers have a choice: pay the higher variable rate or re-finance to a fixed mortgage. Given the flat shape of the yield curve (Fed Funds = 5.25%, 30-year Treasury = 5.22%) many borrowers may decide to go for the certainty offered by a fixed rate mortgage, since staying with the variable loan will result in similar monthly payments, anyway.

I have added the "We are here" arrow to the CS chart above, pointing to 5 months after the data was published, i.e. now. Notice the sharp jump in mortgages being reset from May to June: from $25 billion/mo. to $40 billion/mo. There must be significant added demand for long-term money from all those mortgages switched to fixed rate, causing long rates to rise. The pressure from resets is going to increase further to $50 billion/mo. and stay high for another 13 months.

Again, this has nothing to do with the "strengthening" economy or inflation: the Debt Bubble is creating its own technical interest rate dynamics, shaping the yield curve in unexpected ways.

Is This Better?

I have changed the color scheme of the blog - it is less dramatic but hopefully it improves "readability".

Yesterday's drop in equity markets is being blamed on the bond market, which supposedly sank because the economy is "improving". I don't know about the "economy improving" part, but historically the most potent poison for financial markets was higher interest rates - and more so in this Debt Bubble Era.

10-Year Treasury Rates

Ten year Treasury rates are at 5.10%, very near a 5-year high. I think we can safely say that mortgage refinancing for all real estate purchased and financed during the Real Estate Bubble period of 2002-2005 is now near impossible: The yield curve is flat as a pankace and painful all over. This removes the last refuge of the highly-indebted consumer, who now faces rising interest rates to go with already high fuel and food prices.

April and May retail sales were weak to begin with; given the above I think June - traditionally retailers' second most important month after December - is going to be soft, too.

But if the economy is soft why are long interest rates rising? I don't for a second buy the "stronger global economy" argument - I think what is happening is more technical and with broader consequences for markets. The Debt Bubble of the past 5 years has created trillions in new non-government debt, particularly in longer maturities. US mortgage debt owed by households alone increased by $4.4 trillion during 2002-06, all under extremely low interest rates. Most of it became securitized as CMO/CDO's and further derivativized through CDS's. This process has created a huge new mass of bonds, all vulnerable to losses as long interest rates rise; hedging them against interest rate risk is most commonly accomplished through selling short the 10-year Treasury (cash and/or futures).

What may be going on is a rush to hedge this huge pool of relatively newly-issued mortgage-backed bonds, thus creating its own vicious cycle of persistent selling. Nothing to do with the economy...