Sense on Cents

Is the Government Bond Bubble Getting Ready to Burst? UPDATE>>

Posted by Larry Doyle on May 7th, 2009 2:59 PM |

I have tried to highlight my concerns on interest rates for the entire year. Despite the Federal Reserve “cutting checks” to buy hundreds of billions in U.S. Treasury bonds and mortgage-backed securities, the global demand for credit (meaning global governments, companies, and municipalities issuing MASSIVE supply of bonds) is driving rates higher.

As I wrote in my post from April 30th, the U.S. Treasury market has been faced with underwriting tens and now hundreds of billions in government debt on a regular basis. The 30yr government bond auction today was not well received and interest rates have moved higher by 10-20 basis points (.10 to .20%).

What are the implications of higher rates?
   1. Increased cost of financing the deficit.
   2. Upward pressure on other rates, primarily mortgage rates.
   3. Longer time for economy to improve given higher interest costs.
   4. Given the massive global government deficits, the access to credit for private enterprise is negatively impacted. This is known as crowding out.

As I referenced the other day, “We Still Have To Pay The Bill.”

Bloomberg reports, Treasuries Tumble as Bond Sale Draws Higher Than Forecast Yield.

From my piece at the end of April:

The equity markets have rebounded significantly over the last seven weeks. The Dow and S&P are now down approximately 4-6% on the year. The tech heavy Nasdaq has distinguished itself and is up approximately 10% on the year.

At this juncture, if the equity markets are implying that the economy will not slip into Depression, then the bill for the stability in equities is being transferred to participants in the bond market. Government bonds are facing an almost weekly avalanche of tremendous supply. This week the market is absorbing over $100 billion in 2yr, 5yr, and 7yr Treasury securites. Take a deep breath and next week the market is faced with over $75 billion in 3yr, 10yr, and 30yr government securities. The Treasury is likely going to sell 30yr government debt on a monthly basis!!

The Federal Reserve has been the biggest buyer of Treasury and mortgage-backed securities. The Fed’s balance sheet may be large but it is not endless. What have 10 yr. Treasury securities done on the year? Even in the face of massive buying of these securities by the Fed, the 10yr has backed up almost 1% to a current level of 3.1%. That rise in rates is very significant.

I have maintained and continue to maintain that interest rates will move higher given the overwhelming demand for funds by global governments to pay for deficit spending. Central banks around the world may try to hold the respective bond markets up and interest rates down but investors will continue to demand a higher rate of interest in the process.

As government rates move higher, mortgage rates, and other corporate rates will likely move higher as well. If we get a whiff of early signs of inflation which I believe is coming these rates could ratchet higher and the bubble in the government market would not merely burst but would actually explode.

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Does Populism Take Precedence Over Rule of Law?

Posted by Larry Doyle on May 7th, 2009 11:09 AM |

Bill Gross of Pimco recently wrote:

If the government indeed becomes your investment partner, you should keep the big Uncle in clear sight and without back turned.

Will the manner in which Chrysler has been handled up to now and is handled going forward serve as legal precedent for future bankruptcies? We will learn a lot VERY quickly as General Motors is in very much the same predicament. Given the issues raised by Tom Lauria, attorney for some of the non-TARP Chrysler creditors, are our markets witnessing populism taking precedence over the rule of law? Will our courts try to “thread the needle” under the guise of these automotive companies being special situations?

Answers to these questions will likely develop over time. Different justices may read the law in a different manner. I caution investors, though, that costs associated with parsing the rule of law may be postponed but are not foregone.

To that end, I believe it is also wise to take heed from Jeff Matthews of Ram Partners who raises these questions in a recent short interview on TechTicker:

Additionally, for those who have not listened to the ten minute interview Tom Lauria provided Frank Beckmann on WJR Radio, I will provide my recap and link here: Is Barack Obama Going Tony Soprano? This interview is a MUST LISTEN!!

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Bill Gross Gives Sage Advice

Posted by Larry Doyle on May 7th, 2009 5:30 AM |

Bill Gross provides a healthy perspective on the market in his May 2009 Investment Outlook. Gross is a seasoned professional. While many money managers blatantly display their biases, Gross is too polished not to shoot straight. I share his views in this piece including:

2007 was a screaming mimi with the subprimes – if only because the liar loans and no-money-down financing were reminiscent of a shell game, Ponzi scheme, or some other type of wizardry that was bound to lead to tears.

Stating the obvious here, but I appreciate the fact that a Wall Street pro will implicate those within his industry for effectively running a scam.

2009 is a similar demarcation point because it represents the beginning of government policy counterpunching, a period when the public with government as its proxy decided that private market, laissez-faire, free market capitalism was history and that a “private/public” partnership yet to gestate and evolve would be the model for years to come. If one had any doubts, a quick, even cursory summary of President Obama’s comments announcing Chrysler’s bankruptcy filing would suffice. “I stand with Chrysler’s employees and their families and communities. I stand with millions of Americans who want to buy Chrysler cars (sic). I do not stand…with a group of investment firms and hedge funds who decided to hold out for the prospect of an unjustified taxpayer-funded bailout.” If the cannons fired at Ft. Sumter marked the beginning of the war against the Union, then clearly these words marked the beginning of a war against publically perceived financial terror.

I have defined the future of investing as a Brave New World. In a similar tone, Gross is highlighting the shot across the bow taken by President Obama. As an investor, one needs to be on guard and not turn our back on Uncle Sam.

The threat, of course, falls under the broad umbrella of “burden sharing” and is a difficult one to interpret and anticipate, if only because the concept is evolving in the minds of policymakers as well. But clearly, as this financial crisis has morphed from Bear Stearns to FNMA, Lehman Brothers, AIG and now Chrysler, the claims of stockholders and in some cases senior debt holders have suffered. Please hear me on this. That is the way it should be. Capitalism is about risk taking and if you’re not a risk taker, you should have your money in the bank, Treasury bills, or a savings bond, not the levered investment of a bank or an aging automobile company. Let there be no company too big, too important, or too well-connected to fail as long as the systemic health of the economy is not threatened.

Gross is making a stand here for capitalism and against the non-systemic government bailouts. I personally believe some basic tenets of capitalism have suffered excessively in the process of promoting Obama’s social agenda.

How does one invest during such a transition? Investors should recognize that this grassroots trend signals – most importantly – an increasing uncertainty of cash flows from financial assets. Not only will redistribution and reregulation lead to slower economic growth, but the financial flows from it will be haircutted and “burden shared” by stakeholders. In turn, the present value of those flows should reflect an increasing risk premium and a diminishing multiple of annual receipts.

Gross’ commentary here is telling us that with slower growth we should not expect rising equity markets (despite the recent rally). Look for wider bond spreads and/or higher rates given the increased risks and uncertainties in cash flows.

Slower growth can be a public good if it avoids the cataclysmic effects of double-digit unemployment, escalating foreclosures, and fear of financial insecurity. But the Obama cannon shot will have financial consequences. Do not be deceived by the euphoric sightings of “green shoots” and the claims for new bull markets in a multitude of asset classes. Stable and secure income is still the order of the day.

Gross is not pulling any punches in telling us not to “be deceived by the euphoric sightings of green shoots.” Gross is not buying the perceived improvements in the economy. Given his rapport with those in Washington, he would not make this statement publicly.

Sage advice from a seasoned pro.

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“The Subprime 25”

Posted by Larry Doyle on May 6th, 2009 8:09 PM |

I came across the Center for Public Integrity in my travels today. I commend them and those supporting this initiative.

They produced a very interesting piece today: Who’s Behind The Financial Meltdown?

WASHINGTON, D.C., May 6, 2009 — The top subprime lenders whose loans are largely blamed for triggering the global economic meltdown were owned or backed by giant banks now collecting billions of dollars in bailout money, according to Who’s Behind the Financial Meltdown?, a new investigation by the Center for Public Integrity.

“The mega-banks that funded the subprime industry were not victims of an unforeseen financial collapse, as they have sometimes portrayed themselves,” said Center Executive Director Bill Buzenberg. “These banks were deliberate enablers that bankrolled the type of lending that’s now threatening the financial system.”

These are among the findings that emerged from the Center’s computer analysis of government data on nearly 7.2 million “high-interest” or subprime loans made from 2005 through 2007, a period that marks the peak and collapse of the subprime boom. The analysis also revealed “The Subprime 25“ — the top 25 originators of the high-interest loans, accounting for nearly $1 trillion and about 72 percent of industry — who reported subprime loans during that period.

The Center found that U.S. and European banks poured huge sums into the subprime lending market due to unceasing demand for high-yield, high-risk bonds backed by home mortgages. The banks — including household names like Lehman Brothers, Merrill Lynch, Citigroup, Credit Suisse/First Boston, and Goldman Sachs & Co — made huge profits while their executives collected handsome bonuses until the bottom fell out of the real estate market.

According to the analysis:

• At least 21 of the top 25 subprime lenders were financed by banks that received bailout money — through direct ownership, credit agreements, or huge purchases of loans for securitization.
• Nine of the top 10 lenders were based in California, including all of the top 5 — Countrywide Financial Corp., Ameriquest Mortgage Co., New Century Financial Corp., First Franklin Corp. and, Long Beach Mortgage Co.
• Twenty of the top 25 subprime lenders have closed, stopped lending, or been sold to avoid bankruptcy. Most were non-bank lenders.
• Eleven of the lenders on the list, including four recipients of bank bailout funds, have made payments to settle claims of widespread lending abuses.

A second story in the package, “Predatory Lending: A Decade of Warnings,” details the troubling history of congressional oversight involving abusive lending practices. The story traces how obscure laws passed by Congress in the 1980s paved the way for creation of the subprime lending industry, and documents how lawmakers essentially ignored repeated warnings that high-cost loans represented a systemic risk to the American economy.

Included in the Center’s online package are extensive maps and tables detailing the extent of the companies’ subprime lending nationwide, the banking industry’s backing of subprime lenders, and political contributions and lobbying expenditures by the real estate and financial industries.

Although this particular piece does not present any new information, I always appreciate a venture dedicated to bringing increased integrity and transparency into our business and political worlds. I am adding this site to my favorites.

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Senate Approves Safe Harbor Mortgage Modification; Property Rights? What’s That?

Posted by Larry Doyle on May 6th, 2009 3:55 PM |

The assault on property rights continues as the Senate just passed the Safe Harbor Mortgage Modification legislation. Recall how I wrote the other day in Mortgage Magic or Mortgage Mayhem that this legislation would protect mortgage servicers from suit by mortgage investors.

Why would investors sue servicers? Servicers are charged with processing monthly principal and interest payments of mortgages and distributing the cash flow to investors. If they do not perform, then to this point they would and should be sued. Investors have the right to those payments for which they committed their funds.

The Safe Harbor Mortgage Modification legislation will protect servicers from lawsuits in the cases where mortgages have been modified and investors’ interests supposedly remain protected. One would think that covers all the bases. As I highlighted, however, the legislation may very well promote self-dealing amongst a number of the larger banks which both service mortgages and hold second mortgages.

From Bloomberg’s article, Senate Defeats TARP Measures To Move Safe-Harbor Bill:

The Mortgage Bankers Association and consumer advocates have endorsed the safe-harbor provision to protect mortgage servicing companies from being sued by mortgage-bond investors if they modify loans in accordance with President Barack Obama’s Making Home Affordable anti-foreclosure program.

“Safe harbor is something that you want as a servicer,” said Ajay Rajadhyaksha, the head of fixed-income strategy at Barclays Capital in New York. “Without the safe harbor, you’re far more skittish about doing anything.”

Corker said in a speech on the floor that the measure is a boon to larger servicers including JPMorgan Chase & Co., Citigroup Inc., Wells Fargo & Co. and Bank of America Corp. An amendment Corker sponsored that would have required borrowers to seek other forms of aid before their loans could be modified failed.

Mortgage bond buyers including Clayton DeGiacinto of Tower Research Capital in New York said allowing the safe harbor provisions removes any accountability servicers have to minimize investor losses and may make the process more susceptible to political pressure and more costly for borrowers.

“It ultimately makes bond investors skeptical and adds an additional layer of risk that will need to be priced into the securities,” said DeGiacinto, who manages a distressed mortgage fund.

I am all for credible and equitable legislation which promotes decreasing foreclosures. In the process, however, the legislation should be airtight in making sure there is no self-dealing and conflicts of interest. That question regarding this legislation remains outstanding.

While this legislation may help limit foreclosures in the near term, the real cost may be borne in the years ahead in the form of higher mortgage rates. Why might that happen? If banks which service mortgages are influenced and incentivized not to protect the investors’ property rights and thus don’t, the investors will sell their holdings, and take their bat and ball to another field.

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All The King’s Horses and All The King’s Men . . .

Posted by Larry Doyle on May 6th, 2009 11:37 AM |

Can Barack Obama’s horses and men in the persons of Ben Bernanke, Tim Geithner, Larry Summers, Paul Volcker, Rham Emanuel, Sheila Bair, and their minions put Wall Street together again? The glue and putty in the form of trillions of dollars of taxpayer funds and commitments is still wet. Mr. “Humpty Dumpty” Wall Street is still on the ground.

Humpty’s most severe injury is the breakdown of the securitization process in which Wall Street promoted a pure “originate to distribute” model. Obama himself offered in the May 3rd Sunday New York Times Magazine:

. . . we’re going to have to figure out what we do with the nonbanking sector that was providing almost half of our credit out there. And we’re going to have to determine whether or not as a consequence of some of the steps that the Fed has been taking, the Treasury has been taking, that we see the market for securitized products restored.

I’m optimistic that ultimately we’re going to be able to get that part of the financial sector going again, but it could take some time to regain confidence and trust.

Time for the cement to harden and for Humpty to get back on his feet. Why will it take so much time? Very simply, Humpty was not an honest broker in the process of originating, securitizing, and distributing poorly written – if not fraudulently written – loans over the last 5 to 7 years. The Financial Times highlights this fact this morning in “Securitization Is Crucial for Revitalizing Lending.” The FT reports:

Securitisation is a way to raise money by repackaging securities based upon underlying assets such as mortgages.

The US government is seeking to restart this market with up to $1,000bn of funding for purchases of securitised debt. But the complexity and risks involved mean it remains difficult to replicate the scale of the market that collapsed under the weight of losses and the departure of leveraged investors.

Meredith Whitney, of Meredith Whitney Advisory Group, says about $2,200bn less in funds has been raised by means of the US capital markets since the start of the credit crunch in July 2007, with $2,700bn less money raised globally.

She said: “With debt issuance to date seeing year-on-year gains, it is suggestive to say that things aren’t getting much worse. They just aren’t getting any better.”

The US government’s programme to revive securitisation – the Term asset-backed securities loan facility (Talf) – has made some funds available and it has also led spreads on some asset classes to narrow, reducing the potential funding costs. The programme works by lending money to hedge funds, which can increase the returns on triple A rated securities by means of the cheap loans.

In a sign of a big pick-up in demand, the Federal Reserve said late yesterday that investors requested $10.6bn worth of loans in its most recent round of the programme. This included $2.2bn worth of requests for auto loan bonds and $5.5bn for bonds backed by credit card loans.

If we review those statistics, the government’s TALF (Term Asset-Backed Lending Facility) has facilitated $18.5 billion in sales since its launch in March. While the Fed views the demand as picking up, be mindful that the $18.5 billion figure represents approximately .008 of the total credit that has evaporated from the economy via the shadow banking system. In layman’s terms, we just gave Humpty a swab with a warm cloth while his limb is holding on by a thread.

My concern with the TALF is that the buyers will cherry pick bank assets and simply purchase those which have the most rigorous underwriting. The dregs will be left for the banks and taxpayers to absorb.

If Uncle Sam does get Humpty somewhat propped back up against the wall (note that I’m not even hinting at Humpty getting “on the wall”), how do we make sure Humpty does not once again fall down and take us all with him?

We need to make sure Humpty plays by strict rules and regulations, both in terms of underwriting and business engagement. The FT addresses proposed underwriting rules in “Watchdog Proposes Strict Rules.” The FT reports,

Yesterday’s Iosco (International Organization of Securities Commissions) report called for minimum levels of due diligence by the originators and suggested mandating far greater disclosure to investors of what checks had been carried out. It also called for ongoing disclosure to investors of the performance of the underlying assets and for originators to be forced to hold on to some tranches of each deal.

Other proposals included imposing standards forcing originators to check that products were suitable for each investor and looking into developing alternative measures of assessing risk other than the credit ratings agencies that were relied on by investors previously.

Wow, you mean Humpty actually has to display a measure of integrity in his operations? What a novel idea! Who may be keeping an eye on Humpty to make sure he plays by the rules going forward? The SEC and FINRA (Financial Industry Regulatory Authority).

Hey, wait a second. When Humpty fell off the wall, we have very credible evidence that FINRA was actually one of his playmates. None other than Harry Markopolos said that FINRA was on the wall (“in bed”) with Humpty. I have highlighted issues within FINRA that still need to be addressed: FINRA Is Supposed To Police The Market.

President Obama, what do you prescribe for Humpty given his relationship with FINRA? Obama told the Times,

. . . the fact that we had such poor regulation means — in some of these markets, particularly around the securitized mortgages — means that the pain has been democratized as well. And that’s a problem. But I think that overall there are ways in which people have been able to participate in our stock markets and our financial markets that are potentially healthy. Again, what you have to have, though, is an updating of the regulatory regimes comparable to what we did in the 1930s, when there were rules that were put in place that gave investors a little more assurance that they knew what they were buying.

Putting Humpty back together is going to be very challenging. Sense on Cents will be monitoring the operation very closely.

For newer readers who may want to more fully understand how Humpty “had a great fall,” I strongly recommend The Wall Street Model Is Broken….and Won’t Soon Be Fixed.

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Water Finds Its Own Level

Posted by Larry Doyle on May 6th, 2009 5:15 AM |

If housing led us into this mess and is going to lead us out, then bring an extra pair of boots because we still have a long way to go.

Could the government intervention in the housing market promote short term support but also long term pressure? What do I mean? As I wrote yesterday in Mortgage Magic or Mortgage Mayhem, the government is providing real subsidies in terms of mortgage rates, guarantees, closing costs, and points. These subsidies are generating support to segments of the housing market. That said, housing in general remains under severe pressure in many regions. The higher priced markets with very limited government intervention are virtually stagnant.

Pressure from the higher end is actually prompting some banks to allow for short sales in which the bank absorbs the loss from a home sold below the outstanding mortgage balance. Why would a bank do that? Very simply because the bank believes a sale now, even at a loss, is better than a foreclosure later generating an even greater loss.

I think we will see further downward pressure on prices and a delay in real improvement in housing due to the fact that more homeowners are now under water on their mortgages. The WSJ reports, House Price Drops Leave More Underwater. How many are underwater? Almost a third of American homeowners!!

Government intervention is simply attempting to apply sandbags to this problem. While I fully empathize with the families impacted, these sandbags are no remedy or foundation for a long term fix. In fact, I think these sandbags are potentially causing pools of private capital to refrain from entering the market. Why is that? A market that is being artificially supported will always cause real money to wait in the wings.

As the water finds its own level, the private capital will definitely enter. In so doing, it is very likely the private capital will ultimately push the market to levels even higher than current.

Any market participant knows, though, that a market that is manipulated may stay elevated for a short stretch but will move lower, find its natural clearing level, and then move higher. Housing is no different.

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AIG Bonuses and Lockups: Add Another $454 Million!!

Posted by Larry Doyle on May 5th, 2009 7:35 PM |

Do the letters AIG make you nauseous? Recall the uproar over AIG paying $165 million in bonuses last year? Well, get the barf bag ready because Reuters just reported that AIG also paid the following in bonuses in 2008, along with commitments in 2009:

. . . paid some $454 million in previously undisclosed performance bonuses to employees for 2008, the company said in answers to questions from a U.S. lawmaker that released on Tuesday.

Why were these bonuses not previously disclosed? AIG is a government owned entity!! What’s going on? Where’s the transparency and accountability?

. . . about $120 million corporate bonus pool designated for holding company employees and executives at subsidiary companies.

Why? Is this what government work pays these days? Where do I apply?

The payments are separate from $1 billion in retention payments to entice employees to stay with the company.

Are you kidding me? With unemployment in the financial industry off the charts, and this firm having cost the government billions, the idea of paying retention bonuses is APPALLING!!!

Lastly, what is up with Reuters final statement:

The company also told Cummings [Representative Elijah Cummings, a Maryland Democrat] AIG’s bonus plans for 2009 were under development, “in consultation with the Federal Reserve and Treasury.”

What am I missing? What consultation is necessary? The consultation should be nothing more than, “when the company returns to profitability and Uncle Sam gets a return on his capital, we may consider paying bonuses. That may not happen anytime soon. Please get back to work . . . oh, have a nice day.”

Shouldn’t take more than 20 seconds, maybe 30.

What am I missing? What is America missing? Who is accountable?

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We Still Have To Pay The Bill

Posted by Larry Doyle on May 5th, 2009 4:16 PM |

Equity markets have rallied back to unchanged on the year. Libor is back to 1%. Housing is showing signs of life. Other economic indicators are declining at a less rapid rate. Fed chair Bernanke provides a cautiously optimistic tone in his testimony today. So why am I as concerned as ever?

Perhaps I do not fully appreciate the benefits of the massive government injections of capital into our economy. Why? I view any short term benefit from the capital injections as merely covering for losses which are still embedded in the system. The bills associated with those losses, in terms of increased interest costs and principal writedowns, are yet to be paid.

Where are the losses? Well, the results of the Bank Stress Tests have been leaked and 10 of 19 banks will supposedly need more capital. The commercial real estate market is totally dependent on the government committing to 5 yr loans via the TALF. I view the rebound in the residential real estate market as mortgage mayhem, not mortgage magic. None other than the IMF continues to highlight that our economy has another $1 trillion plus in losses.

I will grant Obama and Bush and their respective administrations credit for succeeding to this point in what they were trying to accomplish. However, that success, in my opinion, only means that longer term costs will be steeper and longer term benefits will be further off as a result.

Nouriel Roubini and Matthew Richardson address these points in today’s WSJ, We Can’t Subsidize The Banks Forever.

From my perch, I view Obama and team as indiscriminately allocating capital across too many programs. I am becoming somewhat concerned that Bernanke is wondering if they have put too many chips on the table.

Roubini and Richardson offer:

. . . stress tests aside, it is highly likely that some of these large banks will be insolvent, given the various estimates of aggregate losses. The government has got to come up with a plan to deal with these institutions that does not involve a bottomless pit of taxpayer money. This means it will have the unenviable tasks of managing the systemic risk resulting from the failure of these institutions and then managing it in receivership. But it will also mean transferring risk from taxpayers to creditors. This is fair: Metaphorically speaking, these are the guys who served alcohol to the banks just before they took off down the highway.

While the tone feels better, there is no doubt we still have challenges. Private enterprise’s interaction with Uncle Sam is one of the biggest challenges.

All this said, the government had a choice between immediate losses with excruciating pain or buying time with long term underperformance. They chose the latter.

We still have to pay the bill.

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Hedge Fund Manager Responds to Barack’s Bullying

Posted by Larry Doyle on May 5th, 2009 11:41 AM |

Kudos to Zero Hedge for posting this commentary written by hedge fund manager, Clifford S. Asness. Major kudos to Mr. Asness for having the heart and courage to stand up for capitalism and free market principles. Asness addresses the implications of President Obama’s browbeating hedge funds’ representation and management of client interests involved in the Chrysler bankruptcy.

Our country was founded on the principles of free speech, fair and equitable trade, property rights, and the ability to operate without intimidation. In writing and publishing this post, Mr. Asness has done our country a great service. I commend him!! I strongly encourage people to share this message with friends and colleagues. Please share your sentiments here as well!! ~LD

Unafraid In Greenwich Connecticut
Clifford S. Asness
Managing and Founding Principal
AQR Capital Management, LLC

The President has just harshly castigated hedge fund managers for being unwilling to take his administration’s bid for their Chrysler bonds. He called them “speculators” who were “refusing to sacrifice like everyone else” and who wanted “to hold out for the prospect of an unjustified taxpayer-funded bailout.”

The responses of hedge fund managers have been, appropriately, outrage, but generally have been anonymous for fear of going on the record against a powerful President (an exception, though still in the form of a “group letter”, was the superb note from “The Committee of Chrysler Non-TARP Lenders” some of the points of which I echo here, and a relatively few firms, like Oppenheimer, that have publicly defended themselves). Furthermore, one by one the managers and banks are said to be caving to the President’s wishes out of justifiable fear. Read the rest »

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