Hints from Credit Markets?

Eurodollar futures are down & 2yr swap spreads are up. The nationalization chatter (especially in Europe) is growing, and it's spreading over here as well, and I had someone tell me that they fully agree that fear is creeping back in (coming from the floor of the CME) & that talk is that 3 mo. LIBOR may reset 5 bps higher tomorrow & that no 3 mo. money is being lent right now. Have had a few discussions about this today with a few different people. Thought I'd pass along some thoughts I sent to someone else to see what you have to say:


Feels like FEAR is creeping back in the market. All this implies higher LIBOR, lower MBS rolls, and thus more bad news for the MBS basis (if there is such a thing anymore). But, I think it's good news in absolute terms & the beginnings of another flight-to-quality run on UST, Agency debt, MBS, and everything else that is being supported by the govt. And as has happened for the past 18 months, looks like the credit markets are leading equities. So, I'm thinking long MBS & UST, selling some MBS rolls, and I'd be tempted to short equities & some of the spread product that snapped tighter over the past few weeks.

MTGEFNCL

For historical perspective, here is a chart of the FN current coupon going back to Jan 2003. Today, we are closing in on the 2003 lows. Wow. If sustained, this could really spark some biz & hopefully prop up home prices, which will help staunch defaults because people will be able to sell their homes instead of losing them, all of which are required for a bottom in the housing market and thus the economy. So, these early signs of life make me happy - there is something new and big to give Thanks for on Thursday.

Re:update

TODD - sent this to a guy and thought I'd share with you.


I think the talk of a 0.75 bps cut by the Fed is misplaced. I think it's due to a lot of pundits and newspapers who don't understand how the Fed Funds market works.

Here is Bloomberg's description of how it works:
"The Fed Fund futures contract is cash settled to the simple average overnight Fed Funds Rate (the effective rate) for the delivery month. The overnight rate is calculated and reported daily bythe Federal Reserve Bank of New York. To access the rate, type FEDL01 <Index> <GO>."

So, if you look, the effective rate has been trading well below the target rate for many weeks now. The 10-day MA = 0.6125, 21-day MA = 0.6548, and 30-day MA = 0.7042. So, the Nov contract (FFX8) settles on Nov. 28th. There is no Fed meeting in Nov. Currently, FFX8 is trading at 99.13, which implies a rate of 0.87. Pundits are reading this as 100% chance of 50 bps and 50% chance of 75 bps. That would be true, if the market expected the effective funds rate to trade at (or close to) the target, but as you can see above, that hasn't happened in quite a while.

So, this all introduces some noise into this market - because of the way the effective rate has been trading, I don't think we can read the tea leaves in Fed Funds Futures the way we used to be able to. I think the Fed goes 50 and the dollar pops from here (just as a metric, EURUSD is now @ 1.2863). Also, I think TY follows it up some, and we'll see some pullback in stocks. Mortgages? Hell, who knows anymore...flip a coin. Though, we are near the bottom of our recent range, which is why I think we saw some buying this morning. So, over the next week or so, think we see MBS take another trip thru the range (which means higher dollar prices).

Economist.com: The crisis and fair-value accounting

This is from the Sept 20th issue, but it's still a great article. Finally, someone who agrees with me...and for those who are against fair value, I bet if you were a debt-holder of Lehman, you would have been happy to have known the fair value of the assets, in order to figure out what the liquidation value is. And, as many have said (mainly Merton), a stock is nothing more than a call option with the strike price the liquidation value. This is a great read and offers a great perspective on all this. I have been meaning to email this out, but was finally moved to do it with the announcement today that FASB & IASB are forming a task force to study issues and possibly continue to make small changes, as they have done recently.

 

 
Accounting

All's fair

Sep 18th 2008
From The Economist print edition

The crisis and fair-value accounting

Illustration by S. Kambayashi

SO CONTROVERSIAL has accounting become that even John McCain, a man not known for his interest in balance sheets, has an opinion. The Republican candidate for the American presidency thinks that "fair value" rules may be "exacerbating the credit crunch". His voice is part of a chorus of criticism against mark-to-market accounting, which forces banks to value assets at the estimated price they would fetch if sold now, rather than at historic cost. Some fear that accounting dogma has caused a cycle of falling asset prices and forced sales that endangers financial stability. The fate of Lehman Brothers and American International Group will have strengthened their conviction.

In response America's Financial Accounting Standards Board (FASB), and the London-based International Accounting Standards Board (IASB) have not budged an inch. So, for example, banks will have to mark their securities to the prices Lehman receives as it is liquidated. The two accounting bodies already act cheek by jowl, and America will probably soon adopt international rules. Are they guilty of obstinately pursuing an abstract goal that is causing mayhem in financial markets?

Banks' initial attack on fair value was self-serving. In April the Institute of International Finance (IIF), a lobbying group, sent a confidential memorandum to the two standard-setters. This said it was "obvious" markets had failed and that companies should be allowed to suspend fair value for "sound" assets that had suffered "undue valuation". Even at the time this stance lacked credibility; Goldman Sachs resigned from the IIF in protest at "Alice in Wonderland accounting". Today it is abundantly clear that those revelations were not a figment of accountants' imagination. For example, in July Merrill Lynch sold a big structured-credit portfolio at 22% of its face value-less than what was entered on its balance sheet. Bob Herz, FASB's chairman, argues that fair value is "essential to provide transparency" for investors.

Yet not all criticism of fair value can be so easily dismissed. The credit crunch has raised three genuinely awkward questions. The first of these concerns "procyclicality". Bankers say that in a downturn fair-value accounting forces them all to recognise losses at the same time, impairing their capital and triggering firesales of assets, which in turn drives prices and valuations down even more. Under traditional accounting, losses hit the books far more slowly. Some admire Spain's system, which requires banks to make extra provision for losses in good times, so that when loans turn sour their profits and thus capital fall by less.

It is too soon to know if prices exaggerate the ultimate losses on credit products. Some people argue that swift write-downs in fact help to re-establish stability: Yoshimi Watanabe, Japan's minister for financial services, says Japanese banks exacerbated their country's economic woes by "avoiding ever facing up to losses". But the principle defence of standard-setters is that enhancing financial stability is not the purpose of accounting.

Over to the regulators

In other words, if procyclicality is a problem, it is someone else's. Already central banks have relaxed their rules on what they will accept from banks as collateral, which has helped to support the prices of risky assets. And the mayhem in the swaps market has shown the importance of on-exchange trading, so that trading remains orderly in times of stress.

Ultimately, though, responsibility for interposing a circuit-breaker between market prices and banks' capital adequacy falls on bank regulators, not accountants. They are already examining "countercyclical" regimes, which would force banks to save more capital in years of plenty. They could go further by suspending capital rules during times of stress if they think asset prices have overreacted. Europe's national regulators already use some discretion when defining capital adequacy. There is a precedent in pension regulation, where corporate schemes are marked to market but the cash payments companies make to keep them solvent are smoothed over time. Banks' financial statements could be modified to show assets at cost as well as fair value, so that if regulators or investors wanted to use traditional accounting to form a view, they could.

Even if they leave procyclicality to bank regulators, standard-setters still have a lot on their plates. The second-and immediate-question is how to value illiquid (and sometimes unique) assets. A common solution is to use banks' own models. But some investors are concerned that this gives banks' managers too much discretion-and no wonder, because highly illiquid (or "Level 3") assets are worryingly large relative to many banks' shrunken market values. Such is the complexity of many such assets that it may not be possible to find a generally acceptable method. The best answer is to disclose enough to allow investors to form their own views. This week IASB gave new guidance which should help in this regard.

The third problem is a longer-term one: the inconsistency of fair-value rules. Today the treatment of a financial asset is determined by the intention of the company. If it is to be traded actively, its market value must be used. If it is only "available for sale" it is marked to market on the balance sheet, but losses are not recognised in the income statement. If it is to be "held to maturity", or is a traditional loan, it can be carried at cost, subject to impairment. This is a dog's breakfast. Different banks can hold the same asset at different values. According to Fitch, a ratings agency, at the end of 2007, Western banks carried about half of their assets at fair value, but the dispersion was wide: from 86% at Goldman Sachs to 27% at Bank of America (see chart).

The obvious solution is to use fair value for all financial assets and liabilities. This is exactly what both FASB and IASB propose. In parallel they want to clean up the income statement, so that changes in the value of assets or liabilities are separated clearly from recurring revenues and costs.

For low-risk banks, this would make little difference: both HSBC and Santander report that the fair value of their loan books is slightly above their carrying value. But it could mean big losses for riskier institutions. When Bank of America bought Countrywide, a big mortgage lender, it was forced, under another quirk, to mark its troubled acquisition's loans at fair value, wiping out Countrywide's equity. Bankers are therefore likely to resist the idea of fair value for loans fiercely: one executive calls it "lunacy". Here standard setters' quest for intellectual consistency will run into a political quagmire.

Marks out of ten

Has accounting had a good credit crunch? The last year has shown that standard-setters are now truly independent and focused on investors' needs rather than the wishes of management, regulators and the taxman. Reforms to IASB's governance should bolster this independence. That is to be welcomed. For all fair value's flaws, banks ought not to have licence to carry their dodgy credit exposures at cost.

At the same time the fair-value revolution is incomplete. Regulators may need to abandon the traditional, mechanistic link between accounting and capital adequacy rules if they really want to try to fight banking crises. That is no bad thing either. Investors and regulators should be able to share a market-based language to describe financial problems, even if they disagree about what needs to be done.

Copyright © 2008 The Economist Newspaper and The Economist Group. All rights reserved.

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Bottom today?

I don't think we'll have a bottom today - EVERYBODY on TV is calling today as the bottom, and tops and bottoms come when no one is looking for them. Let's keep in mind that everyone on TV screaming BUY last year at the top. That's more like the traditional turning point. We may see a bounce in here - lot of program trading and people with itchy fingers looking to buy the bottom. But don't think we see a bottom. However, I do find the following interesting, especially for those of you who like to watch market timing (as in Gann et al):

SPX all-time intraday high: 10/11/2007
SPX low that marked the end of the 2000-2002 bear: 10/10/2002
SPX low after Black Monday: 10/20/1987

So, around this time of the year is often a turning point in markets. Interesting...and more fuel for a temp. bottom. Lots of faces may get ripped off on a good bounce.

Brief thoughts on the bailout

I've waited a while to type this up, but here are my brief thoughts on the bailout - if you want more details, let me know.

1. This is a bailout, despite the spin that is put on it. The biggest issue is the price paid. Bernanke said that there are 2 prices to consider, "fire sale" (where they are marked) and held-to-maturity (intrinsic value). Paulson & Bernanke (PB) have said that we may turn a profit. One of their selling points is that Warren Buffett, Bill Gross et al have said that taxpayers can profit. Bernanke has said that we need to pay close to the HTM price - this will minimize write-offs and even create write-ups, which is a huge help to the companies and possibly bad for the taxpayer. However, in saying that the govt. will turn a profit, Buffett & Gross have said that we need to pay close to the fire sale price, which will create more write-offs, which is bad for the companies but good for the taxpayers. PB continue to name-drop to build support without acknowledging that they are talking about different prices.

2. Is there a chance that a lot of the details of the plan are vague because PB don't intend to purchase many securities? There is a ton of cash sitting on the sidelines, waiting for the right spot to buy these distressed assets. Up until now, though, the prices they were willing to pay have been well below where anyone is willing to sell. Are PB thinking that if they do a transaction or two at above-market prices, private equity and hedge funds will see that a floor is in and start buying aggressively in order to not miss the move? There has been little reason to buy up until now - waiting got you a lower price. But this will go away once the floor is in. If a feeding frenzy ensues, will PB need to continue to participate? Probably not. So, are they counting on this as their savior - they don't need $700B or details and don't care about other pork added to the bill (executive pay, warrants, etc.) because they don't plan on spending much of that money?

3. One of the big scare tactics thus far has been that if this doesn't happen, the economy and stocks will go in the crapper. It is very, very often mentioned that this will have devastating effects on pension funds and 401(k) accounts and drastically hurt everyone. This is why we need the bailout, we are told. I'm sorry, but is the government (especially the Treasury & the Fed, though many members of Congress have said the same things) telling us that they are going to put a floor under the markets, because too big of a fall will hurt everyone's retirement? Is this something that is going to continue going forward? As Social Security becomes worthless, more and more retirement funds will find their ways into markets via 401(k)'s, pension funds, etc. So, knowing this, is there now a perpetual floor on equity and bond markets, to protect retirement accounts? Is it going to be a moving target, where markets will not be allowed to fall more than 35% or something like that? If so, isn't that a new moral hazard, making bubbles that much more likely? And how does this impact the likelihood of privatization of Social Security accounts? I've always been a fan, but this will direct more money to the markets and make a floor that much more important. It used to be that only the rich played in stocks, and retirement was handled by the govt., so if there were huge losses in stocks, it didn't have as great of an effect on the rest of the country. Looks like we've entered a whole new world. What are the implications of this? They are many, but I'd love to hear others thoughts.

So, those are my thoughts on the bill. I see that they are close. I'm not in love with the bill - it's a bailout, and we're going to have to overpay for assets if the companies are going to be helped. While fraught with issues, I do like the insurance contracts idea in principal - make sure the banks have a lot of skin in the game. If these assets have such a high intrinsic value, as Bernanke has suggested, why don't we structure something to allow banks to keep the assets on their balance sheets yet insulated from mark-to-market rules (creating a special HTM account for everyone) and give them long-term loans at Fed Funds (which is less than the current cost of new issuance but would turn a profit fairly quickly, once yields back up)? I think it's because Bernanke knows that he's selling a lie - that these assets are not worth very much but just doesn't want to admit it, because doing so forces greater write-downs and is not helpful to his current goal. So, we're being snowed. But something does have to be done. I just wish there was more honesty surrounding the whole deal.

30 yr <11bps from all-time lows

Maybe everyone else has been talking about this, but someone had to point it out to me today. (Thanks, B.) The attached says it all.

Fed funds - chart

Here is a chart of the future Fed Funds rate (looking at the rate, not the price) forward curve. There are 3 lines - Monday, y'day, and today. Look at the flattening we've seen this week, as the 10yr has moved from 3.85% to 3.55% (the bottom today) and the 2yr has moved from 2.40 to 2.08% (the low yield thus far today). I expect a little chance of a cut to continue to be priced in - Dec thru Feb are showing the smallest chance right now - expect that to continue.