Archive for the ‘Fixed Income’ Category
During my days at Capital Group, we had an opportunity to bring Paul Harrison in to give a presentation at an internal research conference. This was prior to the crisis when people were still feeling good and were still confident that the Fed had conquered the business cycle. They even called it the Great Moderation.1
Paul was great. I truly enjoyed his presentation and he was very gracious with his time afterward putting up with my questions. I remember he was examining the term structure of credit spreads and the information that can be extracted from it. His presentation and subsequent question and answer session had a lasting impression on the way I look at fixed income markets.
However, one thing about it always seemed odd to me. Paul was the head of the Capital Markets Section at the Federal Reserve. That wouldn’t be so odd in itself, but what I found odd about it was that they actually managed a risky fixed income portfolio. Why was the Federal Reserve managing a portfolio of corporate bonds? Talk about conflict of interest. Not to mention the potential for insider information.
Soon afterward, Paul left the Fed to work at a big investment bank and I left Capital. I hadn’t put much thought into it since then, but the “odd” feelings came rushing back when I read the following article from Zero Hedge:
Please go have a look.
Although quantitative easing is quite a different animal than the fixed income portfolio at the Capital Markets Section, the market risk is the same. The mark to market losses the Fed is now exposed to are astronomical. The sad thing is, I have very little confidence they even understand those risks. Bernanke is quite confident he can raise rates, but that is exactly the thing he should fear most. What is going to happen to yields in the US when they get their wishes and China floats the RMB (which I expect them to do within 4 years)?
It is difficult to inflate your way out of debt obligations when the Fed is the largest holder of US treasuries. When the RMB floats, China will take a hit on their USD holdings, but that will be hedged to a large extent by their improved purchasing power, which will only accelerate their evolution to a consumer economy. The US will once again increase manufacturing as promised but at the huge cost of quality of life as prices of all imports skyrocket.
Be careful what you wish for. It is sad for me to watch my country deteriorate like this at the hands of Bernanke and Geithner. History books will not be kind to either of them.
1: You dont hear that term very often anymore. I remember debating colleagues about the concept and told them when history books were written they’d look at the period of the Great Moderation as the most irresponsible period of monetary policy in history, but that is another story.
When I left my first job in asset management back in July, I had 5 weeks to sit around and read blogs and listen to streaming Bloomberg TV all day (I know I’m a nerd) before starting the new gig. Mind you, this was during the early stages of the snowballing credit crisis. One thing I found is that the quality of analysis that can be found on blogs is surprisingly good and timely. For veterans, that is probably not news, but it was eye opening for me.
Another example of a fantastic markets blog is a relatively new one I recently stumbled upon. I’ve already added it to my blogroll and subscribed to the feed and am looking forward to following it with keen interest. I like it so much so far, I wanted to specifically point it out to anyone who hasn’t seen it yet:
Welcome to the blogosphere and thanks for the fantastic commentary!
Whenever I read about “subprime contagion”, I feel frustrated. When you get the flu, does the runny nose cause the muscle aches? No. Just because the runny nose came first doesn’t mean the flu can be described as “runny nose contagion”. The subprime mess was just the first symptom to appear in the bursting of a general credit bubble. The corporate high yield market saw very similar aggressive loan covenants. Commercial real estate. Emerging markets. You name it. We’ve been in the midst of a general fixed-income bubble since our friends at the Fed decided to keep rates far too low for far too long.
Think about this. Back in 2005, we were worried about the CDS market reaching $17 TRILLION notional. That is a HUGE number. But the notional amount is not indicative of overall exposure because of hedging, right?
If you want to see a perfect hedge, visit a Zen garden.
What is that number today? More like $45 TRILLION. That is insane. An entire new insurance industry has basically assumed that corporate defaults do not exist anymore. Not only that, a “hedge” can turn into naked exposure at the flip of a switch, i.e. what happens when the entity you bought insurance from no longer exists?
When I get a chance, I hope to start posting some more mathematical analysis of what’s going on (since that’s what I’m good at). For example, a primer on Leverage Mathematics 101 (which is partially complete) followed by Hedge Mathematics 101 would be a good start. In risk management, “hedging” basically means “let’s buy(sell) some similar securities so that we have more capital to buy other stuff.” In other words, hedging allows you to leverage yourself more.
Here is an article that may help spread the word, i.e. it’s not about subprime:
However, I would go even further. The truth is the current mess is not even about mortgages. Here is the word we should all be thinking about, “Fixed Income Bubble”.
[From RRP:]First of all, best wishes to your daughter on her birthday. One of the benefits of living in Southern California is close proximity to Disneyland.
Thanks dude. We had a blast. There must have been a “Goth” convention nearby or something because 10% of the people in the park looked like they were straight out of deathrock concert or something. An interesting contrast to Cinderella
Sorry if I misinterpreted your comments, but things like
“you should do it here, in the phorum instead of running to your blog”
“If you weren’t so self congratulatory on all of your “calls” about the market”
“you’re coming across, to me at least, as a dilettante who has never taken a risk position in his life”
“this is not some random trash bin on the internet where anyone can say whatever pops into their head and not have to defend it”
“The problem I have with second guessers is that they generally are the last to the party and the first to point out how shitty it is”
do not seem very conducive to a decent conversation. Not only is it grossly inaccurate, but I think we can all do without sheah like that. I really hope that it stops, but if you want to continue, please do so on the blog so that it does not pollute this phorum. I’m more than happy to answer there. It’s not running to the blog. It’s more like trying to filter sheah like that from here.
Like I said in my <tj>, I’m happy to answer to comments here, but just consider that others may not be interested in our tete a tete and think about taking it elsewhere (you know where).
Anyway, so here’s your comment:
Dude, what started me on this thread was some throw away comment you made about Bernanke at least not being as bad as Greenspan. I asked you to elaborate, you responded about how Greenspan would have cut the rate 1% already. My response was to post data that shows the fed reaction in 1998, which I felt to be mos t similar to this crisis; 3 cuts starting 2 months after the onset of the crisis. You countered that 2001 was the best comp to this market, now I didn’t agree with you on that, and I told you why 1998 felt more like this than 2001. If you want to believe that I’m just saying you’re a n00b and should shut up, your perogative. What I’m really meaning to say is that you’re totally lacking perspective in most of your views. Perspective that comes with experience. It is showing plainly.
When you lack direct perspective, the best you can do is to pay attention to others who have perspective. I didn’t post a link to the source of some of my thoughts because I’ve been accused of posting links simply to suport my arguments. WTP. In grad school, I called that citing references, but I guess that doesn’t fly in the real world of old timers.
kr picked up on it. No surprise. I was referring to Roubini’s latest stuff. Sure he is a certified bear and has been for a long time. In fact, he’s so gloomy even I had to unsubscribe from his RSS feed because I couldn’t handle it any more. Just because he’s gloomy doesn’t mean you shouldn’t pay attention to him once in a while though. He is a super sharp guy and hearing him speak on BBG TV did impress me. He is certainly not a whack job.
That is a fantastic article and I agree with him wholeheartedly. When you held up 1998 as a comparison, I was immediately skeptical because it’s in direct contrast to someone else that I think knows his stuff better than either of us.
It really sucks when you compare me to these “second guessers” or those “late to the party”. Have a look at what I wrote here:
I was concerned (for good reason) about credit markets going back to no later than December last year. It wasn’t until the following March-April that I actually had my models built to give some empirical support. I started trying to make a case and practically begged my research directors to let me work with the high yield analysts, but was shot down because of other high-priority projects going on. When Bear Stearns’ HFs imploded things were obvious.
Now, I know I’ve said that at least twice now and some are definitely sick of hearing it, but PLEASE do not think I’m being self congratulatory. I said some things which irritated some people who were probably losing money and then started seeing some baseless judgements coming down on me. I think I’m entitled to stand up and try to set the record straight without these straw man jabs.
There are MANY valid reasons to criticize me, but “self congratulatory”, “second guesser” and certainly “dilettante who has never taken a risk position in his life” are not among them. You yourself named a particularly strong counter example. Yeah, I am %$#%ing scared about my career decision. I left a cushy place working with fantastic people. I had my own plush office with a great view and my own phriggin secretary for Cartan’s sake, but I had my reasons. Now I couldn’t find a post-it note to save my life, but I’ve got a good title with a good company with a significantly better mark to market. We’ll see how I pull through, but one thing I know about myself is that I’m a survivor. I’ve come a long ways from the days of being practically homeless, living in the physics study room and surviving off microwaved potatoes.
Anyway, I hope you are somewhat satisfied with my previous post regarding some of the differences between today and 1998 (which were borrowed heavily from Roubini… no apologies for that). It’s not like subprime mortgages are such a huge part of the markets (they obviously are not) and we’re seeing “contagion”. It’s more like a bunch of sand castles of lax credit standard be swallowed one by one in a rising tide of risk premium. Subprime was the first such sand castle to go. High yield is probably next.
The “I warned you” comment was certainly tongue in cheek, but what happened? The market did shut down, right? It’s good you got those two deals out in July, but where are they trading now? In my opinion, the CDO market is history. Existing (tranched) deals will probably need to be unpackaged into the more vanilla (untranched) structured products from which they were born. Is there any precedent for that? Has a CMO ever gotten deconstructed into its constituent assets? [Not a rhetorical question. I’d like to know.]
Anyway. Wild times. I may be out of a job sooner than you know, but even if that were to happen, I would still think I made the right decision to leave my previous place.
The interesting discussion continues over on Nuclear Phynance. Here is my latest:
My opinion on CDS has nothing to do with what is going on in subprime. In my opinion, subprime is just the first “zit” appearing on the face of a pubescent teen’s face who has been eating nothing but junk food for the past 10 years and is about to have a massive breakout.
I’ve heard economists blabber about how strong corporate balance sheets are as they have decreased leverage since 2000-2001, but these same economists have absolutely no clue about CDOs and other avenues for off balance sheet implied leverage. In my opinion, the only thing holding default rates down was the availability of easy credit, not some increased sense of corporate responsibility. I think we will find that most corporations are more highly leveraged than balance sheets would suggest. Now that spreads are widening with a return of risk premium (plus some for good measure), the availability of easy credit, especially in high yield, is quickly disappearing.
A logical next step following reduced easy credit is going to be increased default rates. This I think is going to severely test the CDS market (again nothing to do with subprime), especially when a default occurs on a company whose outstanding CDS protection exceeds the outstanding cash debt by factors of 10 or more. Even if the CDS is not settled physically, the cash needs to come from somewhere. Where will that be? What happens when the person you bought protection from defaults?
Regarding treasuries, close to 50% of all outstanding US government debt is held outside the US.
David Walker, the US comptroller general, indicated that the huge holdings of American government debt by countries such as China, Saudi Arabia and Libya could leave a powerful financial weapon in the hands of countries that may be hostile to US corporate and diplomatic interests.
Mr Walker told The Times that foreign investors have more control over the US economy than Americans, leaving the country in a state that was “financially imprudent”.
He said: “More and more of our debt is held by foreign countries – some of which are our allies and some are not.”
Mr Walker, who heads the Government agency that is responsible for auditing the national accounts and is also the arm of Congress that scrutinis-es spending by the Administration, said that the US has been forced to rely on foreign investors more because Americans are saving so little.
Don’t get me wrong though, I’m not all gloom and doom. There are certainly investment opportunities galore even if what I am preaching does occur. For example, oil is going no where but up. Food prices are going no where but up. Gold is going nowhere but up. Call me crazy, but I think land, i.e. physical land, not necessarily structured paper, is going to go up.
My favorite blogger, Barry Ritholtz over at The Big Picture, has some great comments on Countrywide’s conference call earlier today.
My inaugural post, “The End is Near“, seems to be not too far from the mark 😉
My premonition that high yield bond spread would widen by 200 bps seems to be not so crazy either.
Here’s the article:
High yield spreads measure the difference between the yield on high yield corporate bonds (junk bonds) and US Treasuries. Traditionally, the size of the spread has been inversely correlated to the level of risk aversion among investors. When spreads are low, investors are paying little attention to risk, while high spreads indicate investors are more sensitive to risk.
As we noted last week, spreads in the junk bond market have been widening since the start of June. On June 1st, the spread bottomed at 241 basis points. Since then however, the spread has widened by over 100 basis points to 344, which represents an increase of 43%. Below we highlight the Merrill Lynch High Yield Corporate Bond Spread since 1997 and highlight other spikes in the index.
Remember, I’m an optimist 🙂
I’m halfway through
and will give a review when I’m done. So far, it is awesome. I’m also a big fan of Panzner’s Financial Armageddon blog. This morning, he points to a very interesting article in the Times Online.