March 17, 2008
The Fed Can Provide Liquidity, But Not Solvency
With the Carlyle Group (one of the world's largest private equity groups) and Bear Stearns (one of the world's longest existing investment banks) suddenly plunging into chaos last week, investors should be braced for more trouble. What we observed last week is clearly a liquidity problem - the solvency problems are only beginning.
I've long argued that the Fed is irrelevant when it comes to day-to-day open market operations; that bank reserves are a shallow, stagnant $40 billion pool of funds uncorrelated with the volume of bank lending; that investors are deluded about Fed liquidity because they count the continuous rollover of short-term "repurchase agreements" as if they represent new money; and that the Federal Funds rate largely follows, not leads, market-determined interest rates.
But I've also emphasized that the Fed has a legitimate and essential role as a "lender of the last resort" during banking crises and other financial panics. In my view, the recent interventions by the Federal Reserve - $100 billion in "Term Lending" financing and another $200 billion "Securities Lending Facility" - are, in fact, large interventions. But investors should fully understand that these only address short-term liquidity problems, not solvency problems. In other words, they make it easier for various financial institutions to carry on their day-to-day transactions for a while. But they do not lower the probability of continued major losses on defaulting mortgages.
Think of it this way. A liquidity crisis is when you write a check for more than the amount in your checking account. You suddenly realize that you need to sell a big securities position to cover it, but selling everything at once might only get you "fire sale" prices. In this case, you need a loan for a few weeks to give you time to work out of your securities position. Without that short-term "liquidity," the check might bounce even though you really do have the assets to pay it off. In contrast, a solvency crisis is when the only asset you have to cover that check is an IOU from your Uncle Ernie, who keeps promising "I'll pay you every dime as soon as I win it back on the ponies."
This distinction between liquidity and solvency is badly reported and widely misunderstood. A few economists, particularly Nouriel Roubini, have emphasized the difference, but by and large, the phrase "Fed intervention" is heard by investors as "Fed bailout." The essential fact is that the Fed's provision of short-term (generally 28-day) liquidity does not represent a "bailout," and the Fed is emphatically not taking the default risk of the mortgage market onto itself.
To see this, keep in mind that the Fed works through "primary dealers" - generally large U.S. banks that are members of the Federal Reserve system. When the Fed enters a repurchase agreement, or other type of "lending facility," it provides a certain amount of short-term funds to those dealers, in return for collateral in the form of Treasury securities, and more recently, investment-grade (cough) mortgage securities. But this is the important part - the dealers agree to "repurchase" those securities back from the Fed at the original price, plus interest.
As a result, even if the mortgage securities used as collateral go into default while they are in the hands of the Fed, the primary dealer still has to repurchase them from the Fed after 28 days, at the original price plus interest. The Fed does not take on the risk of default for the collateral, since it will get paid back as long as the member bank makes good. Instead, the only risk that the Fed takes on is the possibility that the primary dealer itself - a major U.S. bank - will go bankrupt during the 28-day period that the Fed holds the collateral. While the risk of a major bank failure has increased in recent months, the vast majority of the securities briefly held by the Fed will remain the problem of the institutions that owned them in the first place.
Having plunged from a 52-week high of over $159 a share, Bear Stearns agreed over the weekend to be bought out by J.P. Morgan for the equivalent of (I'm not making this up) $2 a share. Now, I've been looking for a lot of trouble amidst financials, but that even I didn't expect. There will probably be further blowups and losses in the coming quarters, and more than a few entities will probably not survive in their present form - being liquidated or acquired by stronger institutions. I still think the concern from certain corners about anything more than a deep recession is overstated, but I'm not sure whether the Fed has retained enough credibility to forestall more blowups, and I remain concerned that the market hasn't even considered the potential losses in credit default swaps. The single largest trader in the CDS market is, perhaps ironically, J.P. Morgan.
The reason the Fed is taking on "private label" mortgage-backed securities (rather than just government agency ones) as collateral is because these are increasingly difficult to sell on the open market without taking a huge "fire-sale" discount. Again, the Fed is not assuming the risk of loss on these securities - unless its primary dealers actually go bankrupt too. Instead, it is providing a bit more time for sellers to find willing buyers in these securities.
That's not to say that this effort will necessarily help. When Ben Bernanke took on the role of Chairman, I suggested it would be best to "underestimate the ability of monetary policy to improve the economy, and overestimate its capacity to do damage." The first two laws of economics might be the law of demand and the law of supply, but immediately in third place is the law of unintended consequences.
As the Financial Times noted on Saturday, the co-founder of the Carlyle Group, David Rubenstein learned this after last-minute talks with the banks last week: "The Fed intervention was designed to help, but it had the reverse effect of what you would expect. People in the banks said, 'Because of this Fed move, the collateral is now worth more, so let's seize it and sell some of it immediately'."
The situation is bad enough that the Fed cut the Discount Rate by a quarter-percent over the weekend. Undoubtedly, the Fed will try to "help" even more this week with another cut in the Federal Funds rate, which will relevant given the market's anxiety, but only because of its impact on market psychology. It's difficult to envision a situation in which somebody won't be very unhappy.
Though the very latest monthly figure on consumer price inflation wasn't bad (year-over-year rate is running at 4.12% as of the February numbers), the Fed still has perceptions about the U.S. dollar to deal with, and to the extent that the FOMC tries to boost confidence in the equity market with a cut of more than 50 basis points (investors are begging for a 100 point fix), it will most likely destabilize the confidence of the currency markets, where the U.S. dollar has already plunged to fresh lows.
But don't be too hard on Bernanke. The lending binge of recent years (both in the mortgage and private equity markets), coupled with enormous growth in the Federal debt, has left the Fed in a no-win situation. Bernanke's problem is that he came into his role as Chairman believing too strongly in the ability of the Fed to affect the real economy.
With regard to the economy, the ECRI notes that its Weekly Leading Index is in recession territory. The ECRI coincident index has just started to turn down in earnest, and is still a good distance from where cyclical economic downturns have typically ended. As Bill Hester noted last week, it is typical for new unemployment claims to surge near the beginning of recessions. We should not be surprised if the weekly claims figures soar quickly above 400,000 in the weeks ahead.
On the inflation and commodities front, I've noted that the main downside risk for commodities is likely to emerge after the year-over-year CPI inflation rate falls below 10-year Treasury bond yields. We are not at that point, so my impression is that further weakness in the dollar will help to sustain commodity prices despite growing evidence of a recession (which we view as baked-in-the-cake). Still, it is again important to emphasize that commodity prices are cyclical, and there is no reason to believe that this has changed despite demand from China and other developing countries. We may observe higher levels of commodity prices in the years ahead, but cyclicality - the tendency for commodities to experience parabolic advances followed by precipitous drops - is likely to remain a feature of these markets.
To address the flurry of questions about whether my December 17 comments are still applicable, my impression is that we are indeed following a disturbing pattern given increasing volatility at short intervals, a clean break to fresh lows on Monday, a short-lived 400+ point Dow rally on Tuesday, and destabilizing news late in the week. The '29 and '87 crashes did start about the same amount (roughly 14%) below the prior highs, but they also occurred more quickly after the market top, and the Fed wasn't aggressively easing yet (whether that's a distinction without a difference, I don't know). Clearly the Fed is concerned about downside risks, prompting a surprise 25 basis cut in the Discount Rate on Sunday, just two days before their regular meeting. You only cut on a Sunday if you're trying to avert all-out panic on Monday, so I'm not convinced this was a particularly good signal for the Fed to be sending.
In any event, I make it a point to avoid predictions and scenarios. We don't require them. It's reasonable to allow for much deeper losses, but investors shouldn't rely on them. The Strategic Growth Fund is fully hedged, and has a "staggered strike" position to strengthen our defense against market losses. I still believe that more committed buying interest is likely to await a full 20% loss on the S&P 500 (below about 1250) and clear evidence of recession, but we're not "bottom-pickers," market forecasters, or short-term timers. We align our investment positions with the prevailing condition of valuations and market action.
For all I know, we could be removing a portion of our hedges a few weeks from now in response to lower prices. Or we could be taking a somewhat more constructive position in response to higher prices if we get a significant improvement in market internals. Maybe the market will rally and prompt us to raise our put option strikes to tighten our hedges. Maybe the market will crash. I don't know. There isn't a successful investor who does, because nobody achieves long-term success that way. Good investors may change their investment exposure substantially over the course of a market cycle, but they don't imagine they can forecast short-term outcomes. Good investors put themselves in the position of being able to respond instead of being forced to react. We'll take our evidence as it arrives. For now, we remain defensive.
As of last week, the Market Climate in stocks was characterized by unfavorable valuations and unfavorable market action. We're braced for trouble, with a "staggered strike" hedge that gives us some additional defense against market weakness. As usual, the Fund's returns can be positive or negative, presently depending largely on the how the stocks owned by the Fund perform relative to the indices we use to hedge.
In bonds, we continue to observe a periodic flight-to-safety at all maturities in Treasuries, but this should be viewed as speculative pressure, not investment merit. On an investment basis, the prevailing yields-to-maturity are by definition not at a level that can provide compelling long-term total returns for investors. In the Strategic Total Return Fund, we are in the unusual position of being invested primarily in Treasury bills, with about 15% of assets in precious metals shares. This, of course, isn't the sort of position that we would expect to hold for a significant period of time, but at present, it is exactly the sort of position that I hope will let our shareholders sleep at night.
We'll continue to look for good opportunities to establish investment positions in response to new evidence. For now, given the growing panic in the markets, we're all for a good night's rest.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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