Way behind . . .

Good show — first time I met Arianna Huffington, and we obviously disagree about Foreclosure, but she was very nice.

I’ll get the video posted as soon as it comes out.

Late getting back to the office from 30 Rock — I need a few minutes to catch up

~~~

Madoff Video

Housing Video


Wall Street’s Script: Should We Follow It?

Good Evening: Yet another afternoon rally after morning weakness allowed the major U.S. stock market averages to finish mixed today. Some earnings misses, along with some so-so economic data set the tone in the early going, but enough buyers showed up by day’s end to turn 1% losses into gains for both the NASDAQ and Russell 2000. That the markets remain resilient even as they are “overbought” shows how much the mood has changed since the turn back in March. With he S&P still looking like it wants to test resistance up at the 1000 level, it’s fair to ask just what forces are pushing stocks higher these days. Yesterday I showed how analysts and technicians were doing their part to get clients to invest at these levels, so today we’ll examine what market strategists, institutional investors, and individual investors are thinking. It is pretty clear that, except among individual investors, risk appetites have been rising at an impressive rate. To many on Wall Street (more than a few of whom had their glasses fogged when peering into 2007, 2008, and the first half of 2009), it’s time to pull out the post-recession script and invest accordingly.

U.S. stock index futures were flat during the wee hours this morning, only to sink with the rising sun. Europe, which had opened to the upside, started weakening after Deutsche Bank reported a disturbing rise in loan loss provisions. U.S. Steel, Coach, and Office Depot then reported disappointments of varying degrees, more than offsetting good news from Amgen and a few others. Index futures were pointing to losses of 1% or so when the Case-Shiller home price data was released 30 minutes prior to the open (see below). Home prices actually rose for the first time in 3 years (on a month over month basis — yoy declines are still in the high teens). This news helped to contain the early selling in New York, and the indexes rallied back to the unchanged mark almost as soon as trading commenced.

At 10 am edt, however, the Conference Board reported that its latest measure of consumer confidence ticked down for the second straight month. Posting 46.6 versus expectations closer to 50, this confidence figure inspired anything but. The averages retreated between 1% and 2% within the next 90 minutes, and the economically sensitive names (materials, miners, energy, etc.) swooned even more. And yet, yet again, the averages were able to grind their way back to unchanged by day’s end (though not so for the aforementioned cyclical companies). The NASDAQ’s 0.4% gain edged ahead of the Russell 2000, showing that managers are trying to capture alpha by adding beta, while the Dow Transports (- 1.3%) finished in the omega spot.

Treasurys were uniformly higher in the morning, only to also finish mixed at the bell. A poor 2 year note auction left yields on shorter maturities higher by 2 to 4 bps, though the long end held firm. An 8 basis point drop in the 30 year bond implied that more than one trader was compelled to reduce curve steepening positions. The dollar was mixed, but mostly finished higher, and the commodity traders were just as surprised as the curve traders. Hurt by falling energy and metals prices, the CRB index declined almost 1% today.

Market strategists are supposed to peer into the future and tell investors what they think lies ahead for the stock market. Mostly, they’re just bullish. The Great Recession and the bear stock market that began in 2007 gave them pause, and some of Wall Street’s finest became cautious. A couple of them were even bearish for a spell, but the rally off the March lows has many of them convinced that both economy will soon recover and that a new bull market is at hand. The London-based strategy team at Credit Suisse was indeed one of the teams that worried openly in 2008, and, like many others, they now view Mr. Market with favor.

In the attached “Market Focus: Shaping Up”, the CS team argues that a rally to S&P 1000 will likely NOT auger a resumption of the bear market. They think instead that risk assets are poised to climb a thick wall of worries back to “pre-Lehman levels” (above 1200). They cite, among other reasons, a “thundering herd of pessimists”. Since Bank of America-Merrill Lynch months ago dispensed with David Rosenberg and Rich Bernstein in favor of strategists more in keeping with the Merrill logo, I find the allusion puzzling. What’s also interesting is that the CS team seems to be ignoring their own “Risk Appetite Indexes”, which are nearing euphoria territory.

cs-risk-appetite-charts1

Herds of pessimists, thundering or cowering, are actually pretty hard to find among strategists these days. And, according to State Street’s Investor Confidence Index at least, so, too is it hard to find bearish behavior among the institutional investors they track. I’ve never really given their poll much attention, but at least it is not some bland (and therefore suspect) survey. No, the folks at State Street track actual positions in customer accounts. The following excerpt from today’s press release tells the whole story, but the sound bite take is: Investors are acquiring risk positions (read: equities) at the briskest pace since 2004. It wouldn’t be the first time since the turn of the Millennium that institutional investors spoke like bears but invested like bulls. In addition to CS’s “climbing a wall of worry” cliché, I’ll offer my own — “watch what they do, not what they say”.

“Developed through State Street Global Markets’ research partnership, State Street Associates, by Harvard University professor Ken Froot and State Street Associates Director Paul O’Connell, the State Street Investor Confidence Index measures investor confidence on a quantitative basis by analyzing the actual buying and selling patterns of institutional investors. The index is based on financial theory that assigns precise meaning to changes in investor risk appetite, or the willingness of investors to allocate their portfolios to equities. The more of their portfolio that institutional investors are willing to devote to equities, the greater their risk appetite or confidence.
“The index results strongly reflect increasing investor strategies designed with a view that the global recession will wane more rapidly than many had feared,” commented Froot. “Investors are now adding risk to their portfolios at an impressive rate, faster than we have seen in several years. In fact, this is the highest level the ICI Global index has reached since mid 2004. That is an impressive turnaround over last October, when the ICI Global reached its lowest-ever-recorded level of 82.1.” (source: State Street press release below)

So, if analysts, technicians, strategists, and institutional investors are positively disposed toward equities, who is left to turn bullish? Individual investors, that’s who. More bullish than any other group of investors at the top of the tech bubble in 2000, the 401K crowd has, like their retirement accounts, not fully recovered from what’s transpired since 2007. According to the latest poll by the American Association of Individual Investors (AAII — see below), bears still outnumber bulls among smaller investors. Closer to becoming part of the weekly jobless claims statistics than the average strategist or asset manager, individuals are understandably cautious, in spite of (perhaps because of?) all the bullish advice they are receiving from professionals these days. These poor souls, if one listens to the laments of financial advisors who can’t seem to get their clients to plunge into stocks, don’t understand history. They don’t understand that, according to the perceived wisdom on Wall Street, that stocks have already bottomed and the economy will soon follow. Next stop, Nirvana!

AAII Poll: Results as of July 23, 2009
This week’s survey results saw bullish sentiment rise to 37.60%, below its long-term average of 38.9%. Neutral sentiment fell to 20.00%, below the long-term average of 31.0%. And bearish sentiment fell to 42.40%, above the long-term average of 30.0%. (source: American Association of Individual Investors)

Bullish 37.60%
Neutral 20.00%
Bearish 42.40%

It’s possible the Quants, Strategists, Technicians, and asset managers have built an unassailable consensus this time , but I’ll throw my lot in with the little guy, anyway. With a broken credit bubble that followed a broken housing bubble that followed a broken stock bubble, how can Wall Street be so sure that our capital markets will now follow the script from previous, post-WWII recessions? Is it wrong that individual investors remember how Wall Street analysts and strategists trotted out this same, “stocks bottom 3 to 6 months prior to the bottom of a recession, so you’d better buy now!” rationale back when the economy bottomed in 2001, only to see stocks make much lower lows in 2002? The herd pushing equity products might be right for a spell, and the S&P might even take a peek above 1000. But this is no ordinary time we find ourselves in, and the tremendous forces of credit contraction and money printing are colliding to set fresh history with each passing day. How can anyone claim they know what the future holds in such an uncertain environment? We’re all actors without scripts these days.

– Jack McHugh

U.S. Stocks Drop on Disappointing Consumer Confidence, Earnings

U.S. Economy: Home Prices Rise, Consumer Confidence Declines

Investor Confidence Index Rises from 115.8 to 119.4 in July

market_focus_shaping_up


The Simple Math of Chinese Staggering growth

Chinese non-export economy grew 23% in June! Before you start googling for that number, let me warn you. You won’t find it. I’ve computed it using fifth grade math.

Here is what we know: exports constitute about 35% of the Chinese economy and they dropped over 20% in June, while the Chinese economy (GDP) grew 8%. So the “X” is the growth rate of 65% of Chinese non-export economy.

0.35 x (-20%) + 0.65 x (X%) = 8%. If you were to solve for X you get 23%.

Enough with math, let me put this number in perspective. Chinese non-export economy grew at 3 times the rate of their GDP. I only have two, very contradictory, explanations for this:

1) The Chinese government is lying through its teeth about its economic miracle growth. It has the incentives to interrogate economic data until it confesses to the party line numbers. This is very plausible, as for months, the Chinese government was showing positive GDP growth while its consumption of electricity was declining. Obviously this doesn’t make much sense. Also, China is not famous for production of intellectual type goods (i.e. software, creation of toxic financial products – that is our specialty) which scale a lot better and don’t require proportional electricity consumption to grow GDP. China makes stuff and to make stuff you need a lot of electricity. Also, even if the growth is completely driven by building high story buildings (even if they collapse), highways, schools - these activities still require a lot of electricity.

2) The numbers are real, the monetary base was up 28.5% in June (again if you can trust that number) and thus the quality of growth is horrible. I’ve discussed this scenario in great detail.

I hate to leave on open-ended note, but only time will tell what is actually going on in China.

P.S. I was not surprised to learn that Jeremy Grantham of GMO – a value investor for whom I have a tremendous respect is concerned about the future of Chinese economy as well.

Kindest Regards,

Vitaliy Katsenelson, CFA


Tuesday Clickage

Tuesday clickage — quite a few items from around the web:

Michael Lewis amusingly opinesBashing Goldman Sachs Is Simply a Game for Fools Its important to remember, the vampire squid doesn’t feed on human flesh. (Bloomberg)
Related to the above: We Fear What We Don’t Understand (Kid Dynamite’s World)

The Great Recession: A Downturn Sized Up:  What makes the current recession so bad? Other downturns have been more painful by some measures, but none since World War II has delivered so many severe blows to the economy at the same time. Already it is the longest. (WSJ)

Fed Has Few Fans, Poll Finds (CBS News)

Stock markets are rising even as the economy bombs - what’s going on? Ultimately, stock markets are driven by the outlook for corporate earnings. A number of US companies have surprised on the upside in their most recent results, though it is fair to say that quite a few others have disappointed. None the less, this renewed focus on the positive is in itself an encouraging sign. Stock market values are determined as much by sentiment as underlying realities. As such, they frequently get things hopelessly wrong. (Telegraph)

What does it mean when Insiders are selling (Marketwatch)

Floyd Norris writes: Politicians Accused of Meddling in Bank Rules: Accounting rules did not cause the financial crisis, and they still allow banks to overstate the value of their assets, an international group composed of current and former regulators and corporate officials said in a report to be released Tuesday. (NYT)

A CLOSER LOOK AT THOSE GREAT HOUSING FIGURES (NYPost)

A Fed Inflation Hawk Speaks: “I think we will probably have to begin raising rates sometime in the not-too-distant future,” Federal Reserve Bank of Philadelphia President Charles Plosser  (Fox Business)

U.S. Issues New Rules on Short-Selling (WSJ)

Why Don’t Lenders Renegotiate More HomeMortgages? Redefaults, Self-Cures, and Securitization Servicers have been reluctant to renegotiate mortgages since the foreclosure crisis started in 2007, having performed payment-reducing modifications on only about 3 percent of seriously delinquent loans (Boston Fed)

A Golden Age for Venture Capital (Dealbook)

In Battle, Hunches Prove to Be Valuable: High-tech gear, while helping to reduce casualties, remains a mere supplement to the most sensitive detection system of all — the human brain.  (NYT)

FINRA on Leveraged and Inverse ETFs (PDF)

Drowning Endowments Leave Tuition Money Stuck Underwater (Bloomberg)

Apple targets new player revolution (FT) Video (Bloomberg)

A Quest for Batteries to Alter the Energy Equation: R&D has to tweak the chemistry of devices and improve the manufacturing process, bolstering the batteries’ capabilities. Prices have to come down — a problem that is far more daunting when it comes to batteries for vehicles and the grid (NYT)

Was Moore’s Law Inevitable?

Frickin Hysterical: William Shatner reads Palin’s resignation speech, as poetry (Conan O’Brien)

• Finally, the Irrational Exuberance Matrix

Anything else clickworthy?


Blue Chip Bull, or Thoughtful Contrarian?

Good Evening: As they have so many times in recent weeks, U.S. stocks were able to overcome some early bumpiness to finish higher on the day. Some earnings disappointments were responsible for this morning’s profit taking, but stronger sales of new homes powered the home building and financial sectors enough to lift the averages into positive territory. It’s hard to give much weight to today’s action, since volume was so light, but the S&P 500 continues to trade as if it has a rendezvous with the 1000 level. The fundamental analysts, the technicians, and the cheerleaders on CNBC are all telling investors to get in now before the markets go even higher, so perhaps it makes sense to check back in with Jeremy Grantham to gain some perspective.

Stocks around the world were in the plus column heading into Monday morning’s trading in New York. Some lighter than expected earnings from the likes of Aetna and Corning, and, to a lesser extent, Verizon and Honeywell, worked to subvert the early upticks, however, and stocks opened on the shady side of unchanged. The averages went from red to green as soon as some surprisingly good new homes data were released 30 minutes into the day (see below). That rally faded when the incentives needed to achieve those sales were revealed, and stocks hit their lows for the day (down approximately 0.5%) some 45 minutes later.

But the housing news helped enough homebuilding and financial stocks to lift the tape back toward unchanged just before lunch, and the averages drifted slowly and unevenly higher from there. Trading was on the dull side throughout the session, though I will say breadth was firmly positive. By day’s end, the Dow Transports were up 1% to lead the way, while the NASDAQ lagged with only fractional gains. More than the housing data, it was in preparing for an onslaught of new supply that hurt Treasurys today. Yields were up between 4 and 9 basis points ahead of $115 billion worth of new paper this week. For its part, the dollar was weaker against all but the yen, but it wasn’t enough to ramp up the commodity pits. Helped by advances in both the grains and the metals, the CRB index squeezed out a gain of 0.2%.

Judging by the rest of the articles you see below, the bullish consensus is becoming more crowded by the day. On the fundamental side, equity analysts have been busily upping their earnings estimates for 2010, causing Bloomberg to posit that the S&P could rally another 26% from here. Since these are the same analysts who had to take erasers to their 2008/2009 estimates, let’s see if the technical analysts have anything to add to the outlook. Lo and behold, they’re bullish, too, saying the S&P 500 is now in “breakout” mode. This is the same crowd that missed the long term double top in the S&P back in October of 2007, and many of them also thought the October/November lows in 2008 were “THE bottom”. Still, with the fundamental and technical analysts both giving investors the “all clear” sign, seeing the last set of headlines on Bloomberg today made it seem as if even the bears had turned bullish.

Jeremy Grantham is commonly thought of as a pessimist, but it is a moniker that is better suited to headlines and Twitter than it is to the man himself. If Bloomberg is vying to become a sort of “Cliff’s Notes” for investors, then what they served up to readers about Mr. Grantham’s latest views does not pass muster. In reality, as well as in the piece you see attached, Mr. Grantham is not the Blue Chip bull the article suggests. He does have nice things to say about “U.S. Blue Chip stocks”, but his views are far more nuanced that a simple “up or down, bullish or bearish” connotation could ever hope to capture.

Mr. Grantham cares about value, first and foremost, and then relative value among sectors and asset classes. In such an uncertain world, Mr. Grantham maintains that the closest thing to certainty that can be found when investing is to take the other side of bubbles. In the late 1990’s, he shunned the zany prices for tech and telecom names, paying the price with some underperformance and some lost clients. A few years ago, he avoided exposure to real estate and finance, but GMO’s performance was helped by an overweight in emerging markets. When the averages were circling the drain back in March, Mr. Grantham gritted his teeth, bought stocks, and then wrote (virtually in real time) how hard it was to do so. Jeremy Grantham does not lack courage, even when he harbors doubts.

So what does this well regarded, long term value investor have to say about the choices arrayed before him in July of 2009? After a nearly 50% run in the indexes, Mr. Grantham bemoans the paucity of easy choices. He knows a broken bubbles in credit and real estate mean the economy is unlikely to roar back, but he is also mindful of the power of all the policy intervention by governments and central banks. He sees “the market” as being close to fairly priced, and he thinks a quick run to 1000 or higher in the S&P 500 is an even money proposition. If the S&P does pop another 5% to 10%, Mr. Grantham will once again batten down the hatches and await better opportunities. And while he likes “high quality” (low debt, P/E, and P/B ratios) blue chip stocks, he is not blindly wedded to the large cap Dow. He likes to emphasize quality and value, especially on a relative basis to lower quality names.

He also (still) favors emerging markets, though he is trying to reconcile his ardor for fast growing overseas economies with what he sees are growing imbalances in China. As an aside on market sentiment, Mr. Grantham notes that at a recent conference he attended, managers who were more concerned about underexposure in a rally outnumbered those worried about overexposure to a renewed decline by 10 to 1. All in all, he finds a “Boring Fair Price” type of market a tough environment in which to deliver outperformance to his clients. I agree. I also think that if silly labels must be affixed to money managers during the information age, maybe next time Bloomberg will be a little more precise when describing Jeremy Grantham to its readers. Rather than “blue chip bull”, they should call him a thoughtful contrarian.

– Jack McHugh

U.S. Stocks Rise as Gain in Home Sales Sends Banks, Builders Up
U.S. New-Home Sales Climb 11%, Most in Eight Years
Surging Profit Estimates Signal 26% Rally for S&P 500
S&P 500’s ‘Solid Breakout’ Points to Gains: Technical Analysis
Grantham Says U.S. ‘Blue Chips’ Are Cheapest Stocks
jeremy-granthams-quarterly-letter-july-2009


Monday Linkage

Monday linkage — some things from off the beaten path:

• Jeremy Grantham calls markets at a Boring Fair Price!, and he is Waiting for Markets to be Silly Again;  Since early March, the market has had the type of strong speculative rally that often follows extreme declines.

• After calling for a generational bottom in early March, Doug Kass now likes Cash (The Street.com)

Tenacious G: Inside Goldman Sachs, America’s most successful, cynical, envied, despised, and (in its view, anyway) misunderstood engine of capitalism (NY Mag)

• 10 Members Send Letter to Federal Reserve on Goldman Sachs Gambling with Government Money

Subprime Sequel: Mortgage fraud has doubled since 2007, according to the FBI—and the fraudsters include everyone from individuals fudging loan forms to thieves who steal millions from lenders and victims alike. The danger is with Mortgage fraud skyrocketing, the housing market won’t rebound if it’s tainted by sleaze. (Reader’s Digest)

UBS Bans Leveraged, Inverse ETFs (ETF Database)

Fear, Falling Demand Keep Loans: The total amount of loans held by 15 large U.S. banks shrank by 2.8% in the second quarter, and more than half of the loan volume in April and May came from refinancing mortgages and renewing credit to businesses, not new loans, an analysis by The Wall Street Journal shows. (MarketBeat)

Three months EHS in a row means what? Are EHS Improvement stretching three months something special? Was it in 2006 or 2007?  (themessthatgreenspanmade)

Earnings game: Don’t take the spin Because it’s let’s-play-beat-the-number season (i.e., when corporate earnings are reported), let’s look at what a game it is (Fleckenstein)

Real Yields Highest Since 1994 Aid Record Debt Sales: Treasuries are the cheapest relative to inflation since 1994 after consumer prices fell 1.4 percent in June from a year earlier. (Bloomberg)

Get ready for banking’s next headache: Though housing markets remain weak, analysts expect credit problems over the next year to center on $1.8 trillion worth of commercial real estate — mortgages on office and apartment buildings and shopping malls, as well as construction, development and industrial loans. (Fortune)

Distressing Gap: Ratio of Existing to New Home Sales: In many areas,  home builders cannot compete with distressed and REO sales, and this has pushed down New Home Sales (Calculated Risk)

Why Counting Money Can Make You Happier (Time)

The Associated Press discovers the Web (Funny!)

Anything else clickworthy?


Martin Mayer On Credit Default Swaps: Comments at AIER, June 25, 2009

Earlier this year, I had the privilege of participating in a discussion at American Institute for Economic Research on CDS with Martin Mayer, Walker Todd, David Michaels, Chief Financial Officer, AIER; Arthur Kimball-Stanley, a student at Boston College School of Law known for his research on CDS and insurance; Patricia McCoy of the University of Connecticut School of Law, and a number of other colleagues.

Below are Martin’s notes for the event where he makes some telling points about CDS, the nature of markets and life in general, which we published today with his permission.   You may read our comment on CDS, “White Swans and Credit Default Swaps,” in today’s issue of The Institutional Risk Analyst by clicking here.

On Credit Default Swaps: Comments at AIER, June 25, 2009

By Martin Mayer

Let me open with a large thought you can carry with you when you leave. Note how we are no longer being told that the chairman of the Federal Reserve is the second most powerful man in America. Why do you think that is true?

One of the truly awful moments of my time in this business was the early evening of December 9, 1982, an incident not in any of the histories but highly revelatory. What happened that evening was that Banco do Brasil failed at CHIPS (the Clearing House Interbank Payments System). Neither National City Bank nor Chemical, which represented Banco d Brasil in New York, was willing to pony up the $300-plus million the Brazilians couldn’t find. So they kept the window open until midnight, while the Fed worked its necromancy on its member banks and the money was found.

Subsequent examination revealed that after the Mexican collapse the previous summer, Banco do Brasil had found it increasingly difficult to roll over its loans, and had steadily switched a higher and higher share of its borrowings out of the conventional lending and borrowing market and into the overnight infrastructure market. For more than six months, the Brazilians had increased the size of its overnight position, until somebody at National City noticed and said, No more. The Treasurer of Chemical was an exceedingly able young man who went on to a great career at AIG, oddly enough. I went to see him to help my understanding of what had happened. Finally, he said, “You have to understand. They were paying an extra eighth.” A banker will turn himself absolutely inside out for what looks like a safe extra eighth of a point.

The change over the quarter century is that now he will probably do it for five basis points. Meanwhile, on a less cosmic scale, let us start with the thought that Wall Street gets in its worst trouble not by taking risks but by following false prophets who promise to make finance risk-free. The nomenclature and some of the equations change, but the truth is that there are only six scams, and each of these financial panics is rooted where the others were. What made the market break of 1987 so sharp and so deep was the widespread adoption of dynamic hedging, a mathematically proven plan to provide portfolio insurance by selling futures contracts on stock indexes if the stocks themselves fell hard.

Dumbest idea ever accepted by any substantial part of mankind, said Howard Stein, who then ran the Dreyfus fund. How could anybody believe that everybody could sell at the same time? It then took twenty years for the magnificently rewarded innovators of the new paradigm in banking to find an even dumber idea that everybody could safely and profitably hedge everybody else’s risks through credit default swaps.

We make bad policy in this country because we do not inquire about how we got to where we are. There are every few second acts in American finance. Not one in a thousand of the people now commenting on the future or regulation of the CDS knows where the instrument comes from. The truth is that the CDS is one of many of what I shall call GSIs - “Government Supported Instruments” — that would never have come into existence without dumb ideas from on high.

The Collateralized Debt Obligation or CDO, which came into existence in the late 1890s, is a single instrument expressing a garbage pail of loans and notes and bonds. It is all but impossible to value because it mixes together many disparate risks. Most people who think about it at all come to the conclusion that its not very useful for trading or for investing. In short, it is an excrescence that ought not to exist.

The CDO came about because Bill Seidman, when he was given control of the S&L workout in the late 1980s, wanted to sell whole banks rather than gather the tainted assets in FDIC control and auction them off in the usual FDIC procedure. Instead of taking, say, the real estate loans of six failed S&Ls and lumping them together as an offering on which real estate experts could paste a price, he wanted to take the entire portfolio of one or more failed thrifts and sell it off for what it would bring.

Note that this multiplied the amount of business Wall Street would get from the workout. The way you got people to bid on this sort of package was to give them the right to substitute other assets for assets in the package, or to guarantee the cash flow from the package. The idea that a bank could be rid of its bad stuff through the device of a bad bank was then picked up by Mike Milken, and carried through with Mellon Bank in Pittsburgh, where the operation was funded through junk bonds. I wrote a piece for Barrons about how intelligent all this was. I spoke with some of the brilliant kids Milken assigned to this project.

The damage these CDS instruments do has not yet been exhausted. The publicized stress tests to which the federal bank examiners recently subjected the 19 largest banks was not really a serious enterprise, because all these banks rely on swaps to protect them against their losses on the toxic legacies they accumulated under the gaze of these same examiners — and nobody knows whether or not these hedges will pay out if they are needed.

Swaps, after all, are bilateral contracts, and if the loser under the contract can’t pay, the fact that he has theoretically hedged his risk in a separate contract with a third party does not necessarily mean that the winner can collect. Hence the “systemic risk” when AIG or Lehman, signatories to tens of thousands of these contracts, blows up, leaving a paper litter of unimaginable dimensions. Sixteen years ago, I testified before the House Banking Committee to urge that it should be public policy to discourage over-the-counter derivatives contracts and encourage the use of exchange-traded instruments instead.

To assure that losers pay, exchange-traded contracts impose overnight deposits to meet margin requirements rather than collateral that may show up some day. The Treasury Department, after years of fighting on the other side, has now discovered the virtues of settling derivative contracts through clearing houses. But what Treasury Secretary Timothy Geithner has proposed will not do the trick, because it leaves the actual trading of these instruments in the hands of inter-dealer brokers who do not publish the prices at which they arrange the deals (and may not offer the same prices to all bidders). And because it does not show the way to meeting the legitimate needs that spawned this illegitimate market, the Geithner proposals invite evasion of the rules.

The legitimate need is for a place where traders can short bonds. Shares of stock scan be borrowed (fees for such borrowings are an important source of income for brokers) and delivered to buyers who don’ know that what they have bought is borrowed stock. Much publicity has been given to traders who abuse these rules, sell what they have not borrowed and then fail to deliver and suffer no significant punishment for their failure. The SEC had been and remains asleep at the switch when it comes to this issue. And even when stock cannot be borrowed, there is an options market offering puts in a trading context where open interest is public knowledge. No such institutions exist in the bond market.

It was the difficulty of shorting bonds that produced the T-bond contract at the Chicago Board of Trade thirty years ago, permitting participants in the fixed-income markets to protect themselves against interest-rate fluctuations. Interest-rate futures are a legitimate instrument because there is a generic interest-rate risk, expressed in the market-determined yield curve. It is easy to understand that traders once they have hedged interest-rate risks would seek to insure also against credit risks. But there is no such thing as a generic credit risk that can be traded. Like all instruments with a trigger option, they promote the illiquidity that drives markets out of the patterns the white swan people need.

Questions? Comments? info@institutionalriskanalytics.com


Instability and the cover rule

In the old days of equity derivatives, one of the main instruments was the covered warrant. This was a call option (usually - put warrants are uncommon) issued by a bank and traded as a security: it gave the holder the right but not the obligation to buy some number of underlying shares at a fixed price. This market still exists, and is reasonably active in some countries.

The term 'covered' come from the early regulatory framework. In order to prove to the exchange that the issuer of the warrant could meet their obligations, they had to keep some or all of the underlying. This position in the underlying was known as the cover: it ensured that if the warrant ended up in the money, the issuer could deliver shares to the warrant holders. (Obviously if a corporate issues warrants on itself, then there is no problem: an entity can always print more of its own shares. The issue arises when a bank issues warrants referencing shares in another corporation, often without that corporation's permission or support.)

The cover requirements were supposed to ensure that squeezes did not happen whereby the issuer was forced to pay higher and higher prices to buy shares against the warrants that they hold. This is an issue with less liquid underlyings, especially ones where most of the liquidity is controlled by a small number of parties. By forcing banks to buy the underlying before issueing the warrant, exchanges made market disruption much less likely.

There is definitely something that we can learn from this piece of market history. When derivatives traders are forced by regulation to have a matching position in the underlying, then:
  • There is a natural limit on the size of the market;
  • Both derivatives and underlying markets are more orderly; and
  • The issuer's risk is automatically limited.
When that is not the case, things can get a little crazy. Let's look at two examples.

The first is the CDS market. I am a supporter of this market, and I view many of those who wish to limit CDS trading as uninformed, hysterical or both. (People called Gillian who have a book to plug may well fall into this category.) However, there is one reasonable objection to CDS, and that is that it sometimes allows the tail (the derivatives market) to wag the dog (the underlying bond or loan market). I have no objection to letting people short credits, but doing so by CDS can provide more protection sellers than there are bonds, creating exactly the sort of squeeze post default that the cover requirements eliminated for warrants. The lack of a borrow market for corporate bonds is the real culprit here. Perhaps one solution would be to keep the CDS market as is, but to require that naked shorts pay a credit borrow fee to a holder of a deliverable instrument. This fee would be in exchange for the bond or loan holder agreeing not to buy protection on it or lend it to anyone else: the fee would automatically ensure that no more CDS protection was sold than there were bonds (or loans) extant which would at least make it more likely that the CDS settlement was orderly.

Second, the commodities market, specifically oil. This post was inspired by a fascinating article on the oil market from the Oil Drum (via FT alphaville). One part of the author's arguments is that the existence of an enormous market in financial contracts on oil has resulted in considerable price volatility - perhaps even price manipulation - which is in the interests neither of producers nor consumers of physical oil, but which benefits intermediaries such as the investment banks considerably. Certainly if one believed that this is true - and the evidence is impressive - then again the solution is obvious: require all derivatives positions to have a physical hedge. If you are short, then you have to own the underlying. If you are long, then you have to borrow the underlying. A given barrel of oil can act as the hedge for just one contract. And you can only use deliverable oil - stuff in tanks - not oil that is still in the ground.

Instability and the cover rule

In the old days of equity derivatives, one of the main instruments was the covered warrant. This was a call option (usually - put warrants are uncommon) issued by a bank and traded as a security: it gave the holder the right but not the obligation to buy some number of underlying shares at a fixed price. This market still exists, and is reasonably active in some countries.

The term 'covered' come from the early regulatory framework. In order to prove to the exchange that the issuer of the warrant could meet their obligations, they had to keep some or all of the underlying. This position in the underlying was known as the cover: it ensured that if the warrant ended up in the money, the issuer could deliver shares to the warrant holders. (Obviously if a corporate issues warrants on itself, then there is no problem: an entity can always print more of its own shares. The issue arises when a bank issues warrants referencing shares in another corporation, often without that corporation's permission or support.)

The cover requirements were supposed to ensure that squeezes did not happen whereby the issuer was forced to pay higher and higher prices to buy shares against the warrants that they hold. This is an issue with less liquid underlyings, especially ones where most of the liquidity is controlled by a small number of parties. By forcing banks to buy the underlying before issueing the warrant, exchanges made market disruption much less likely.

There is definitely something that we can learn from this piece of market history. When derivatives traders are forced by regulation to have a matching position in the underlying, then:
  • There is a natural limit on the size of the market;
  • Both derivatives and underlying markets are more orderly; and
  • The issuer's risk is automatically limited.
When that is not the case, things can get a little crazy. Let's look at two examples.

The first is the CDS market. I am a supporter of this market, and I view many of those who wish to limit CDS trading as uninformed, hysterical or both. (People called Gillian who have a book to plug may well fall into this category.) However, there is one reasonable objection to CDS, and that is that it sometimes allows the tail (the derivatives market) to wag the dog (the underlying bond or loan market). I have no objection to letting people short credits, but doing so by CDS can provide more protection sellers than there are bonds, creating exactly the sort of squeeze post default that the cover requirements eliminated for warrants. The lack of a borrow market for corporate bonds is the real culprit here. Perhaps one solution would be to keep the CDS market as is, but to require that naked shorts pay a credit borrow fee to a holder of a deliverable instrument. This fee would be in exchange for the bond or loan holder agreeing not to buy protection on it or lend it to anyone else: the fee would automatically ensure that no more CDS protection was sold than there were bonds (or loans) extant which would at least make it more likely that the CDS settlement was orderly.

Second, the commodities market, specifically oil. This post was inspired by a fascinating article on the oil market from the Oil Drum (via FT alphaville). One part of the author's arguments is that the existence of an enormous market in financial contracts on oil has resulted in considerable price volatility - perhaps even price manipulation - which is in the interests neither of producers nor consumers of physical oil, but which benefits intermediaries such as the investment banks considerably. Certainly if one believed that this is true - and the evidence is impressive - then again the solution is obvious: require all derivatives positions to have a physical hedge. If you are short, then you have to own the underlying. If you are long, then you have to borrow the underlying. A given barrel of oil can act as the hedge for just one contract. And you can only use deliverable oil - stuff in tanks - not oil that is still in the ground.

Introducing Algo

Given that I used to be a computer scientist, my knowledge of algorithmic trading, aka high frequency trading, is shamefully slight. Partly it's because the technology has improved vastly over the last five years: the algo guys used to be three or four nerds in the corner of a vast equity trading floor; now, everyone else is a small corner of their trading arena. If you are as behind on this story as me, you might find this article in the NYT helpful. It does at least make it clearer where the money comes from.

Is the Fed About to Lose On “Systemic Risk” Legislation?

It is really fascinating to see how much people underestimate the political staying power of technocrats such as FDIC Chairman Sheila Bair and SEC Chairman Mary Schapiro. I get the distinct feeling that some senior members of the media, analysts and the banking community, still don’t see the ladies as serious players. If you bother to look at the Players’ Roster of American politics, it is clear that the ladies are very much in the ascendancy in Washington, both in government and in the lobbyist community.

Consider the movement in terms of legislation on regulatory reform. The ebb and flow of the debate is headed very much in the direction of collective, shared authority for determining when a TBTF bank or, more specifically, a non-bank company such as AIG needs restructuring. This goes directly contrary to the Geithner proposal to give this function to the Fed. Bair’s comments here about why giving the sole authority to the Fed or any single agency is a bad approach are instructive:

“The macro-prudential oversight of system-wide risks requires the integration of insights from a number of different regulatory perspectives — banks, securities firms, holding companies, and perhaps others. Only through these differing perspectives can there be a holistic view of developing risks to our system. As a result, for this latter role, the FDIC supports the creation of a Council to oversee systemic risk issues, develop needed prudential policies and mitigate developing systemic risks. In addition, for systemic entities not already subject to a federal prudential supervisor, this Council should be empowered to require that they submit to such oversight, presumably as a financial holding company under the Federal Reserve — without subjecting them to the activities restrictions applicable to these companies.”

Click here to read the entire comment to the HFSC.

By making such decisions collective, inter-agency processes, the tendency at the Fed for cults of personality a la the “Greenspan doctrine” to guide decision making will be largely eliminated. Since each agency in the proposed council will have to document its decision process and maintain a public record of same, the Fed’s cultural tendency to bury such decisions and the people responsible will be at least partly thwarted.

The unilateral misuse of the resources of the FRBNY by Tim Geithner, for example, in the AIG rescue would be much more difficult in the future since the banks would have to subvert not just the Fed but a handful of other agencies that are far less secretive that the US central bank. At the very least this would be an expensive — if not impossible exercise. No doubt the folks from Goldman Sachs would rise to the challenge.

Notice too that as Chairman Bair was making here case to the Congress for a collective approach to systemic risk, Chairman Schapiro was laying down covering fire, agreeing with most of the basic points made by her counterpart at the FDIC. “Structured correctly, a credible resolution regime could force market participants to realize the full costs of their decisions and help reduce the ‘too big to fail dilemma,’” Schapiro said at a Senate Banking Committee hearing, Reuters reports.

And then we have Rep. Barney Frank, waving the bloody shirt on “naked derivatives” regarding reform of OTC derivatives just as the reform legislation is supposed to be a done deal: “The question of banning naked credit-default swaps is on the table,” Frank, a Massachusetts Democrat, said during an interview on Bloomberg Television today. The legislative proposal will be released next week, Frank said.

Hmm. Could it be that Barney’s reelection committee fund raising is below target? Maybe. Or is little Barney losing interest in reg reform since all the action is now over in the Senate?

What it all looks like to me is that the Frank proposal to give the Fed the entire world when it comes to “systemic risk” is fading. Part of my judgment is a personal assessment. For all of his bluster, Frank is really not so much smart on financial services issues as an obnoxious little child. Shifting to an “anti-derivative” position like banning naked CDS gets attention for Frank, who is every bit as affected by media envy as any national politician. Nobody would care about Frank’s personal quirks except that, well, he is chairman of the key House committee that has responsibility for financial services.

The key think to understand about Frank is that his proposals are not well considered and his colleagues and staff won’t bother to try an educate him because of his offensive personal behavior. I have watched Frank on Capitol Hill for two decades and he has always been rude and discourteous to both staff and other members, as well as careless in his research. If it sounds good with him saying it, Chairman Frank will make the proposal. That is why now, as Chairman, nobody on the staff bothers to tell Frank when his latest strokes of brilliance are off track. They just let him put out the press release and move onto the next pressing issue.

Here’s what one member told me: “If he actually were smart as reported, Barney would be looking to leverage this financial crisis into a Senate seat, where he could rave w/o danger of actually doing damage. Even as a junior Senator, Frank wouldn’t lack for attention, but he claims to dearly want to stay in the house.”

My guess is that Frank was just posturing on OTC yesterday on Bloomberg TV to remind the lobbyists to put something in the cup, but that his focus on regulatory reform is dimming as other, more attractive issues/playthings dangle in prospect.

Meanwhile, in the Senate, it is very clear from the statements of both Chris Dodd (D-CT) and Dick Shelby (R-AL) that the Fed as systemic risk regulator is DOA. With Sheila Bair and Mary Schapiro both making common cause in the name of collective responsibility, my bet is that the Congress is going to distance itself from the Geithner/Bernanke proposal and end up giving SEC and FDIC a share of authority when it comes to rescues and/or restructuring of systemically significant enterprises. The flow of opinion in the Senate has been moving away from the Fed for weeks.

In the event, score another point for Bair and Schapiro. If I could be Geithner one piece of advice, it would be “don’t mess with the ladies.”

Chris


Commercial vs Residential Real Estate

Historically, Commercial Real Estate lags Residential by about 2 years. Here is what the past 10 years look like:

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cre-vs-residential-prices

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Source:
The CRE disaster
Rolfe Winkler
Reuters, July 23rd, 2009
http://blogs.reuters.com/rolfe-winkler/2009/07/23/the-cre-disaster-comparing-with-residential/


Nobody Likes Missing Out on History

Good Evening; Unless you’ve been in a cave or in meetings all day, you know by now that U.S. stocks were kited to new highs today. And that’s really all you need to know. There was a batch of reasons given, from economic data to corporate earnings, but the biggest reason for today’s surge was the surge itself. In carrying to new highs for the year, rising stock prices forced shorts to cover and underexposed longs to feel uncomfortably overexposed to cash. As the day progressed, it almost seemed as if the “all clear” siren had sounded somewhere, indicating that the storm that knocked our economy and markets around for months was now over. With a swelling consensus that the bear market is now in hibernation, investors don’t want to miss out on the historic bull market that is sure to follow. Or so went today’s frenzied logic. As we shall later see, in both sports and investing, the desire to avoid missing out on history is a powerfully motivating force.

A raft of corporate earnings reports too numerous to mention came out during the past 24 hours, and they were mostly of the positive surprise variety. U.S. stock index futures were already trading higher due to these reports when some good news on jobless claims surfaced. New claims rose by a slightly less than expected 30K, but the bulls were especially heartened to see continuing claims drop for the second straight week. A 3.6% rise in existing home sales and a reduction in the backlog of unsold homes only reinforced the rationale for buying stocks today.

Opening higher, the major U.S. averages marched northward until they were all up more than 2% after 100 minutes of trading. The rest of the session was spent going sideways, but the rally really never suffered any setbacks today. By day’s end, the Dow (+2.1%) could brag the least, while the Russell 2000 and Dow Transports (both up 3.25%) vied for top honors. Predictably, the perceived parting of the storm clouds left Treasurys feeling unloved and unwanted. Yields rose 7 to 14 bps across the curve, and if recovery has indeed come (which, other than some welcome inventory rebuilding, I personally doubt), then Treasury yields are too skimpy to stay at these levels. Given the fast rises in stock and interest rates, the dollar probably should have rallied more than the modest amount it did today. But the uptick in the greenback didn’t hurt commodities, and most of them went up along with equities. The CRB index tacked on 1.75% to what has become an impressive run in recent weeks.

“Want two free tickets to this afternoon’s ballgame?” was the question posed to two of my colleagues as they returned from lunch this afternoon. Visions of a fun afternoon away from work watching the White Sox flashed before there eyes, but these team players decided to turn down this gift and return to the office. Little did they know that White Sox pitcher, Mark Buehrle, would soon become only the 16th pitcher in major league history to throw a perfect game (see below). Nor did these poor souls know that White Sox outfielder, Dewayne Wise, would heroically save the perfect game (and Buehrle’s no-hit shutout) by leaping above the left field wall to snatch a home run away from Tampa’s Gabe Kapler in the ninth inning. The circus catch only added to the sense of history made in Chicago today.

My colleagues were kicking themselves when they heard the news, just as under-invested kicked themselves when they saw today’s rocket launch in equities. The NASDAQ has been the focus of the run since the March lows, as managers use the beta-heavy names in that index as a way to play catch up ball. The NAS is now up a cool 54% in just over four months, prompting some to wonder if they, like those who passed up on the free Sox tickets this afternoon, are missing out on history in the making. Of course, the NASDAQ has been up 50% or more in roughly six months time on three other occasions during the past ten years. From August of 1999 to March of 2000, the NAS rose a stunning 110%. From September of 2001 to January of 2002, the tech-laden index rose just more than 50%, just as it did from March of 2003 to September of that same year. The sharp-eyed among you will note that devastating losses followed these quick gains in both 2000 and 2002, while the 2003 rally was followed by two years of sideways action.

The 2007-2009 bear stock market has been the worst almost any manager has ever lived through, and no one wants their son to ask them, “Daddy, why didn’t you buy stocks at the bottom like Chester’s Dad?” They don’t want the boss (or clients) asking them the question, either. This rally may thus keep running, despite its overbought condition and some setbacks along the way (one of which might start tomorrow after MSFT’s earnings miss tonight). I could easily see others feeling compelled to participate before the S&P 500 returns to 4 digit territory. As with sports, it’s the same with investing: It’s how our decisions might look in retrospect that causes fearful decision making in the present. My friends would have loved to attend the Sox game, especially for free, but they worried what the man in the corner office might think if they couldn’t be found. Like those who watch over other people’s money, they managed away from potential pain and found a different form of it. Let’s hope the same doesn’t happen to those who feel like they have to chase the rally on Wall Street.

– Jack McHugh

U.S. Stocks Rally, Dow Tops 9,000 for First Time Since January
Mark Buehrle Throws First Perfect Game in Five Years


Not many stocks powering the rally

Although the U.S. equity market has had an impressive run since the July 7th lows, what many investors might find less-than-reassuring is how narrow the advance has been.

In the Nasdaq-100 index, for example, one stock, Apple, accounts for nearly one-fifth of the 11-percent gain. It has also pulled much more than its already hefty weight in the index. Otherwise, just nine stocks are responsible for more than half the move in the technology-laden bellwether.

While that doesn’t mean the rally can’t carry on, it’s another reason to be cautious on reading too much into the advance we’ve seen so far.

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Symbol Name 7/7/2009 Close 7/22/2009 Close Net Change in Points Net Change in % % of Overall Move in NDX % Weight in NDX Cumulative % of Overall Move
NDX Nasdaq 100 Stock Indx 1404.78 1565.00 160.22 11.41%
AAPL Apple Inc 135.40 156.74 21.34 15.76% 18.35% 13.97% 18.35%
QCOM Qualcomm Inc 43.68 48.45 4.77 10.92% 6.58% 6.83% 24.93%
MSFT Microsoft Corp 22.53 24.80 2.27 10.08% 4.81% 5.36%
CSCO Cisco Systems Inc 18.24 21.45 3.21 17.60% 4.57% 3.16%
INTC Intel Corp 16.25 19.14 2.89 17.78% 3.91% 2.65%
GOOG Google Inc-Cl A 396.63 427.69 31.06 7.83% 3.15% 4.44%
SBUX Starbucks Corp 12.97 17.39 4.42 34.08% 3.13% 1.23%
RIMM Research In Motion 66.36 73.50 7.14 10.76% 2.80% 2.93%
AMZN Amazon.Com Inc 75.63 88.79 13.16 17.40% 2.59% 1.80% 49.88%

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ndxbyconstituent


CIT = Capitalism In Transition

Good Evening: U.S. stocks finished mixed for a second straight day on Wednesday, as positive earnings from Apple fought lingering credit concerns to a virtual draw. The NASDAQ did manage to advance, however, extending its streak of positive closes to eleven. The rest of the capital markets didn’t stray too far from unchanged, either, with bonds and the dollar modestly lower, and commodities flat. Financial stocks were initially quite heavy, but most of them staged comebacks as the day progressed. CIT was not among them, though, as word of the potentially onerous terms of a proposed private financing were leaked to the press. The media clucked quite a bit about the money bondholders stood to make on this deal, but when I last checked, that’s how capitalism is supposed to work

With another light day on the economic release calendar (mortgage purchase applications crept higher), investors once again focused on earnings. Apple announced last night that it had — surprise! — easily surpassed estimates. AAPL’s stock dutifully jumped in after hours trading. After listening to the conference call, investors then decided there wasn’t a whole lot in the company’s results that applied to the rest of the tape. U.S. stock index futures thus retreated when the bourses in Europe traded lower this morning. Morgan Stanley and Wells Fargo contributed to this sinking feeling when they reported less than stellar earnings (see below). Morgan Stanley’s results were hurt by the repayment of TARP capital and rising prices for its debt securities, while Wells Fargo was hurt by a large spike in delinquencies on mortgages and other types of loans. If the economy is truly healing, someone forgot to send the memo to WFC’s borrowers.

The net of the above news flow was a 0.5% drop in the major averages at the start of Wednesday’s trading. Stocks wasted little time, however, in vaulting back above unchanged, a level they then criss-crossed until lunchtime. Apple’s strength, as well as the aforementioned comebacks in the shares of MS and WFC, helped push the indexes higher in the early afternoon. The S&P 500, for example, was up more than 10% from its July 8 low at one point this afternoon before some late profit taking set in. The major averages eased back toward unchanged and then finished mixed. Treasurys were down ahead of the next refunding announcement, with yields rising between 2 and 7 bps. The dollar was off a few tenths of one percent, while commodities as a group treaded water. Emblematic of today’s action were the metals, since a decline in metals considered base was offset by a rally in those deemed precious. The CRB inched a fraction higher.

Earlier today, a headline on Bloomberg (since retracted) plaintively claimed that PIMCO and some other money managers stood to book an immediate, $100 million gain on their offer to help CIT through its current rough patch. A couple of other media outlets picked up on the story, also playing up the “quick buck” angle. Representative of the complaints about the terms offered to CIT by the free market — and not taxpayers — are the following two paragraphs, also courtesy of Bloomberg:

“CIT, the 101-year-old commercial lender struggling to retire $1 billion of debt maturing next month, agreed to pay a 5 percent fee to the creditors and annual interest of at least 13 percent. On top of that, the New York-based company pledged assets worth more than five times the amount of the loan as collateral.
“The terms are egregious,” said Dwayne Moyers, the chief investment officer at Fort Worth, Texas-based SMH Capital Advisors, which oversees $1.4 billion, including more than $70 million of CIT bonds. “They ripped the faces off everyone with these terms.” (source: Bloomberg article below)

Whoa, hold on there a second, Tex. Your pretense of outrage is silly. Why didn’t you, Mr. Moyers, offer to fund CIT on the same terms? Rather than disparaging private providers of capital, the media, investors, and, yes, other bond buyers, should be cheering the return of capitalism to our capital markets. This is how markets are supposed to work: Investors take risk (in this case, the bankruptcy of CIT), and they are rewarded for doing so. It’s that simple, though these lessons were forgotten during the credit bubble, when huge risks were sought without much thought — or reward. Predictably, losses and crisis ensued. It’s high time investors rediscovered the art of demanding return for the assumption of risk.

Getting the government out of the lending business should be celebrated, not scorned. Have we taxpayers been cheated out of an opportunity to make fabulous returns in CIT via yet another TARP “investment”? Of course not (the government employees at Treasury would never think of cutting such a sweet deal). This transition back to capitalism from the statism of bailouts will be bumpy, as Morgan Stanley’s earnings today will attest. Why even GE is trying to stop issuing FDIC-backed debt (see below). CIT may or may not live long enough to pay back everything it owes to its creditors, but it’s nice to see them trying to stand on their own two feet instead of settling for a TARP I.V. drip in the emergency ward at Treasury.

Ideally, the deal offered by PIMCO, Oaktree, Baupost, and others may actually act as a clarion call to other sources of capital. Reading about these terms will probably cause them to rub their eyes, and subsequently open their wallets. High prospective returns have a way of doing that to proper capitalists (as opposed to the bailout-seeking, crybaby capitalists). Again, the trip back from government sponsored finance will be neither quick nor easy. But here’s hoping that the “egregious” terms offered to CIT will some day be looked back upon as one of the turning point moments as our markets move away from their current reliance on government funding. Let CIT stand for “Capitalism In Transition”.

– Jack McHugh

U.S. Markets Wrap: Stocks Mixed; Bonds Drop Before Debt Sales
Morgan Stanley Loss Misses Estimates on Debt Costs
GE Capital Wins Approval of Plan to Exit FDIC Program
CIT Hit With Interest Rate More Than 25 Times Libor


Bernanke Campaigns for Reappointment

Good Evening: Stocks were poised to correct their recent gains today, but a late rally extended the winning streak for both the Dow and NASDAQ to seven straight. The earnings news was deemed positive by market participants, though the bottom line “beats” came even as top line revenue estimates fell short. Cost cutting can always flatter the profit figures in the short run, but mass layoffs, deferred capital expenditures, and jiggered tax rates are not what creates either prosperity or long term wealth. Perhaps business executives are taking these actions in the hope the Fed’s aggressive monetary policies can restart the economy, save their careers, and prevent their stock options from expiring worthless, but Mr. Bernanke himself is fighting for his job these days.

With no economic releases on tap today, our index futures markets relied upon earnings releases to guide trading prior to the open in New York. Caterpillar, Texas Instruments, DuPont, UnitedHealth, and Freeport-McMoran all reported positive surprises to one degree or another, though most required financial gymnastics to achieve these “beats”. For all but FCX, revenues came in on the light side. Such a divergence between revenue and profits will be hard to sustain, but who knows? IBM has been managing to pull off this same trick for years, and investors have rarely put the stock in the penalty box for it.

CIT has certainly been penalized of late, though, and today brought word the company’s privately funded recap is in doubt (see below). Reported as a virtual certainty only yesterday, the deal looked less than done today. Fresh concerns about CIT helped cause the stock market to retrace its opening gains of 0.5% or so. CAT helped the Dow remain aloft, but the rest of the tape fell in for a bit of profit taking. Most of the major averages were down some 1% at mid day when stocks began to recover. Acting as if few investors wanted to be short ahead of Apple’s earnings release this evening, the whole tape healed by the time the closing bell rang.

The Dow’s 0.75% gain led the way, while the Dow Transports lagged with a loss of equal measure. Treasurys were on the strong side, with yields falling between 6 and 12 bps. The yield on the benchmark 10 year note is now once again below 3.5%. The dollar was on the lethargic side, with smallish early losses giving way to smallish gains later in the day. Commodities followed stocks to the downside early on, but, unlike equities, they never really recovered. Pulled down by losses in the grain complex, the CRB index gave back 0.5% on Tuesday.

The 2010 campaign season kicked off today, and I’m not referring to the folks in Congress who constantly seem to be running for office. No, the race for high office I refer to is the one for the Chairmanship of the Federal Reserve System. Ben Bernanke may occupy the corner office in the Eccles building right now, but others covet his job. Perhaps sensing the brewing competition, Chairman Bernanke fired off a pre-emptive salvo in the press prior to his semi-annual testimony on monetary policy before Congress today (see below). He wanted to reassure long bond investors that, cross his heart, the Fed would tighten policy at the “appropriate time”. Not content that politicians can read, the Chairman then trudged to the Hill and took to the microphone. He tried to strike a balance between caution (downside risks remain) and optimism (tentative signs of recovery). He even tried to claim his share of credit for the receding financial crisis.

“Aggressive policy actions taken around the world last fall may well have averted the collapse of the global financial system,” he said. “Many of the improvements in financial conditions can be traced, in part, to policy actions taken by the Federal Reserve.” (source: Bernanke testimony before Congress)

Unmentioned, of course, was the Fed’s role (mostly under Greenspan) in fostering the credit bubble that later froze the credit markets, but Mr. Bernanke was not shy in saying the Fed’s monetary blowtorches were responsible for the thaw now under way. For this professorial man to strut, even a little, in front of elected officials and the media must mean he feels his job is on the line. As a Bush appointee, Bernanke knows he represents anything but the type of change promised by the Obama administration.

Bernanke knows who wants the keys to his office, too. One is Janet Yellen, and another is Larry Summers. I have no great love for Mr. Bernanke, but it’s probably fair to say that his tenure at the Fed has been marked more by trying to clean up messes than it has been marred by creating them. Neither of his main contenders can make such a claim; if anything, they’ve been part of the problem. Summers would be an especially poor choice, since he would be viewed as politicizing the Fed. Knowing that Bernanke would be on the Hill today, for example, Summers took the airwaves in a thinly veiled attempt to stay relevant (see below).

As the junior member of the famous troika on the late ’90’s Time Magazine cover, “The Committee to Save the World”, Summers is the only one of the three not (as yet) to have scorn heaped upon him. Greenspan has been unmasked as a disgrace, and Citigroup shareholders silently curse Rubin for his poor stewardship. I guess Summers wants his friend, President Obama, to give him a shot at redemption after some of his policies as Treasury Secretary under Clinton came a cropper during the credit crackup. Summers would be anything but “change we can believe in”, but his appointment would have some redeeming value. It would allow him to join the other “Committee to Save the World” members in validating the Time Magazine cover jinx. What happened to Greenspan, Rubin, and, to some extent, Summers after that cover came out is a fitting reminder that when someone tells you they want to save the world, just politely turn them down. History is littered with examples of well meaning people who did a lot of damage to the world in the name of saving it.

– Jack McHugh

U.S. Stocks Advance on Caterpillar Earnings, Bernanke Remarks
CIT Expects Loss of $1.5 Billion, May Seek Bankruptcy
The Fed’s Exit Strategy, by Ben Bernanke
Summers Urges Banks to Lend More, Says Growth Pace ‘in Doubt’


Tuesday Linkage

Tuesday linkage  — something for everyone:

•  Bernanke Disarms Lawmakers With Garage Meetings, Credit Repairs (Bloomberg) see also Bernanke Heads to Congress Battling Calls to Tame the Fed (WSJ)

Are Manufacturers Also Too Big to Fail? (NYT)

At N.Y. Fed, Blending In Is Part of the Job: Some Fear Wall Street Too Heavily Influences The Financial Enforcer  (Washington Post)

Why Japan Isn’t Rising (Newsweek)

Distressed Assets Market and FDIC Closures (Real Property Alpha)

Morgan Stanley’s Albatross: Real Estate (WSJ)

Bailout Overseer Says Banks Misused TARP Funds (Washington Post)• Is Something Wrong with Certain Kinds of Trading? (Cassandra Does Tokyo)

Patternicity: Finding Meaningful Patterns in Meaningless Noise (Scientific American)

Yahoo to Launch New Homepage (WSJ)

10 Worst Evolutionary Designs (Wired)

Why did I miss — anything linkworthy?


Off to Vancouver

agor-symposium

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I am on my way to the Agora Financial Investment Symposium, where I will be one of the keynote speakers (along with Boom Doom and Gloom’s Marc Faber, BIll Bonner and Addison Wiggins.

I will be doing both a keynote speech Wednesday morning, and a Bailout Nation discussion later that day.

If you are in the Vancouver area, swing by and say hello!