On the new Geithner's new TARP program, let's take a discounted asset as an example. The below example is based on the assumption the FDIC backed debt is priced to short term rates (cheap .25% fed funds will do). The bidding price of these assets will quickly fall as the interest rate of FDIC backed debt goes up, of course.
Let's say we have a currently performing and underwater, but yet to default alt-A or subprime loan, but already marked down by the bank (to 60c on the dollar). Currently it is yielding likely around 5-6%. Of course, there is no acceptable market for the loan to the bank.
If I am a hedge fund investor, to buy it at par (100c), I only need to put down 7.5 cents on the dollar. The TARP fund matches it. Private market capital provides the other 85 cents, which the FDIC provides a put to the bond investor for. We are essentially transferring risk from the bank to the FDIC.
The 15c investment shared by the hedge/pension fund and TARP are entitled to the 5-6% annual cash flows. Split evenly, if that loan performs for just three years, all of the investment risk assumed by the TARP/hedge fund is recovered entirely. After that, cash flows are pure riskless profit. Cashflow will determine the price, but anything with decent cashflow will likely go for par or above. That would give the owner of this new loan (and thus leveraged collateral, if there is any) incentive to keep the house producing income at any expense: renting it out, lowering interest rates, etc. After that initial payoff period, the FDIC's assumed risk on the portion of the loan they are insuring skyrockets. In the end, whatever the FDIC loses, the Fed will print to offset.
Without knowing the specifics of what level of consent the FDIC has on what they insure, or on the terms of the FDIC-backed debt that will be issued, the hairy details are impossible to determine.
But on back of the envelope, any substantially enough cashflowing loan that is trading far below par should mean par recapitalization for banks. In the end, the level of FDIC loss is determined by where the real estate markets are when the assets being insured generally fail. That will determine the amount of Fed money printed going forward. This seems like a perfect plan to make the FDIC (effectively the Fed) the bad bank.
Monday, March 23, 2009
Deferred Fed Money Printing
Thursday, March 19, 2009
Good Times, Great Opportunities
Yesterday, the Fed announced they will be creating money to purchase $300B of treasury debt, an additional $750B of agency MBS, and another $100B of agency debt. The message is clear: the Fed will fill the government debt funding gap, targeting long interest rates lower. 2 to 10 year notes will be the first victims of interest rate assault.
There are long term worries that when inflation does come, the Fed will be in a difficult position, unable to unwind its asset portfolio, as most of it will be held in agency MBS and other somewhat obscure debt (read: illiquid versus treasuries). An investor looking for protection has an easy choice to make, despite it being a relatively consensus view: buy assets that will hold value as global money supplies skyrocket.
Precious metals are the most obvious choice. Amongst most liquid choices (versus relatively illiquid Rhodium, which is another great opportunity) that possess best relative value is silver, which is nearly 40% off last year's peak price (whereas gold is less than 10% discounted). The monetary quality of gold and silver in particular will attract demand, and should move up merely as expectations of global currency supplies continue to increase, regardless of underlying real global economic activity. Since much of silver production is a byproduct of recently decreased base metal mining, the supply fundamentals are relatively supportive, at least to offset decreased industrial consumption.
There is quite a bit of interest in capturing an expected reflation amongst commodity related bets. Oil and natural gas benefit in the long run as supply destruction accelerates. In addition to ramping up of money supplies, look no further than statistics like decreased drill rig counts pointing to higher prices in the imminent future. Shale gas wells, the source of so much new supply keeping rigs busy, generally experience completely diminished production within 2-5 years. Any rebound in the demand side will amplify price recovery. The caveat to the bullish argument comes with the fact that the drill rates can be ramped up quickly, and inventories are at record highs.
Versus North American natural gas, crude oil price increases are more fundamentally dependent on demand revival. As OPEC has cut several million barrels per day, the market now has faith that overhead supply exists in the ground. Until that recently lost demand strongly trends back, even with increased global money supply, I believe crude is less likely to become an object of speculation.
Base metals such as copper will need genuine recovery of economic activity, just as crude. Correlation between energy and base metals should be very high for the next year or two because of this.
To bet on the most meaningful recovery of banks, we need asset price recovery. Increased credit will eventually help this happen. The more the markets see Fed lending at low rates is here to stay, and not merely a 6 month fix, the more the decreased cost of capital will drive the fundamental multiple of all real estate assets up. Time to let these policies soak in will be curative in itself. But it will lead to a paradox: the minute we see believable recovery in prices, there will be (or perhaps there already is) anticipation that Fed funding stops. This should coincide with mark-ups of bank assets and intuitively more aggressive bank initiated lending as banks no longer need to hoard capital. Excess liquidity of these massive proportions (banks currently hold 603B of excess reserve balances) lent into the economy will drive interest rate spreads down while likely moving price levels up. These falling risk spreads could meaningfully offset the lack of Fed credit lines and money printing in a future healthier economic environment.
Now this last paragraph must be the Fed's goal, otherwise it would not be embarking on these policies. One could postulate their way out might be to simply guide base money growth down to target lower inflation rates for an arbitrary period of time (to simply enable population and productivity increases to catch up with the recent spike in money supply). This would probably guide the softest landing, but could make a for a rocky decade of rapidly increasing prices.
In nominal terms, the results of this policy will be anything but 'slow growth' that is projected by so many analysts that cannot help but impose low multiple mood-driven analysis on views of future recovery. Just as easily as this market fell apart from 1200 S&P, we could melt up just as quickly. Changing expectations will lift multiples rapidly, all while actual nominal GDP will have no place to go but up, just as velocity (economic activity) returns to normal trend growth. This means healthier tax receipts to fund current US government debt growth. A higher price level this time around will see higher wages. It really is a different paradigm from the consensus view.
This said, I'm betting with the Fed, long BAC and XLF, picking on some US Steel (anticipating actual economic recovery), and am bullish precious metals. Long treasuries must be reiterated as a viable position. When Japan embarked on quantitative easing earlier in the decade, long maturity bond markets ramped towards bubbly price levels. Even now, Japanese 30 year bonds are under 2%. With the US 30 year at 3.61% post-announcement, I see no more obvious opportunity. To me, just as before the Fed announcement, the market is a bit in denial. Options and futures expiration may be playing some role in the recent somewhat muted price action. The Fed will keep buying more, expanding these programs outward, and because of this, it is reasonable to target a 1.5-2% 30 year. Just as Pimco has been so aggressively pushing, buy what you know the government is committed to buying.
Wednesday, March 11, 2009
Wednesday, March 04, 2009
Bottom Watch
Even the Grizzly Short fund manager, up 74%, says buy stocks because “These comparisons people make with the Great Depression are totally out of touch with reality, and pretty stupid.”
Divergences to mark a bottom?
The S&P is flirting with new bear market lows, but many other prices are nowhere near those levels. Here is a list.
USDJPY: Hanging around 99.50. Bottomed right below 87.50 in mid-December, and was definitely highly correlated to the global unwind, falling with it. Note this has helped the dollar index break out above previous mid November highs (87.79). The weak JPY helps Japan when propensity to consume (rather than save) is high enough. We'll see if this is a meaningful weakening.
Copper: Again bottomed mid-December around 40c lower. At 1.67/pound, new recent 'bull market' highs for the respective resource.
Crude: Front month contango is narrowest in a long time, at 1.80. Price bottomed around 32.50 on one of the recent front month expiration liquidations. Treading water a bit higher at 44.10 at the moment.
NASDAQ: Just barely held on above November lows.
VIX: Hit 52 yesterday when amid new S&P lows, while previous peak was 89.53.
10/30 year treasuries: The standard measure of fear, although one could argue supply here as a giant factor. Yields near 3.0% and 3.6% versus mid december lows of 2.0% and 2.52%.
Gold and silver, argued as a destination of fear money, has lost steam through the latest market fall as well. As you see, decoupling infers a meaningful deleveraging has occurred. Time will tell if these divergences have any predictive value.
Tuesday, March 03, 2009
GDP Perspective
The last time the S&P was in the 680s (as the futures are trading right now), the nominal GDP was 7.86T (September 1996).
Right now, nominal GDP is almost double at 14.2T. If you chop off 10% from peak nominal GDP of q3 2008 of 14.4T, we end up with 12.9T as the trough. 20% off = 11.5T. Still quite a far way from 7.86T, especially considering you only need 10% to formally dip into a "lowercase" depression. The Great Depression peak to trough witnessed a 45% decline in GDP. An equal fall in GDP (Great Depression "2"), would result in nominal GDP at 7.76T, right about where we see the S&P has already found its way to.
If the GDP shrunk almost 45% from here, we'd have a fairly valued S&P at these prices. I'd like to think size of GDP somehow correlates to long term residual earnings power of the market.
