Should CFOs be Economic Pundits?

Posted on April 24, 2008 by Felix

Kevin Kelleher, like me, listened to the Apple conference call yesterday. Both of us picked up on this exchange:

Mike Abramsky – RBC Capital Markets

And then final question, you haven’t said anything in your call about economic headwinds. It’s obviously something people are focusing on. It seems you are benefiting from resistance to some of those headwinds and also share gains. Any commentary you can offer in addition to the comments you’ve made that help us understand some of the kind of sustained drivers of that?

Peter Oppenheimer (Apple CFO)

We are going to leave economic commentary to others and we are focused on managing our business, which performed exceptionally well in the March quarter, and I credit it to just outstanding innovative products that drove amazing results.

I found Oppenheimer’s response to be quite refreshing. Often investors and economists interested in the big picture are interested in what CFOs have to say about the economy, because those CFOs see how their customers are really behaving on a day-to-day basis. But CFOs are not economists, and when they start talking in vague terms about generalized economic slowdowns, it always sounds a bit like they’re making excuses.

It’s not Oppenheimer’s job to prognosticate on the economy; if investors think that a recession will hurt Apple’s sales, then they should reflect that view in terms of where they’re willing to buy the stock, and of course the stock price is not something which CFOs should spend much if any time talking about.

Kelleher’s view, however, is different:

Analysts tried to wring more data from Apple C.F.O. Peter Oppenheimer on the conference call with little result beyond some prickly responses. When one asked a question common on earnings calls these days–any thoughts on the overall economy?–Apple executives sniffed that they’re not in the business of economic commentary.

Maybe, in economic times like this, good investor-relations protocol requires that CFOs pretend to be economists. But I’m still happy when they don’t.

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Do People Drive Less When There’s a Carbon Tax?

Posted on April 24, 2008 by Felix

Peter Zimonjic makes an important point today: that a carbon tax, in itself, and over the short-to-medium term, will have very little effect on gasoline consumption.

What Zimonjic doesn’t mention is that this is no reason not to implement a carbon tax. For one thing, a carbon tax affects non-gasoline sources of carbon emissions, and many of them can be reduced much more easily than gasoline consumption. And for another, high gas prices do actually bring down consumption in the long term: maybe not a lot, but a glance at Europe shows you a lot of people with much smaller cars, and downsizing one’s car is one of the best ways of increasing one’s fuel mileage. Obviously replacing gas-guzzlers with smaller models is a very long-term project.

Zimonjic also doesn’t mention that this is another reason in favor of a cap-and-trade system. If you want to be sure of reducing carbon emissions, the only way to do that is to cap them. A carbon tax, in the first instance, would probably be set too low to have much effect on anything.

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Condos With Embedded Puts

Posted on April 24, 2008 by Felix

People say that given the non-recourse nature of mortgages in states like California, homeowners don’t normally buy their houses so much as buy a call option to buy the house at the purchase price, along with a put option to put it to the bank at the face value of the mortgage. So if that’s the de facto situation, why not make it de jure?

In a move that speaks volumes about the glut in the condominium market, Lehman Brothers Holdings Inc. is promising some luxury-condo buyers their money back after three years of ownership.

The offer applies to some 200 condo units, priced between $480,000 and $2 million, in West Bay Club, a Lehman-owned resort community in Estero, Fla., near Naples on the Gulf of Mexico.

In an effort to jump-start sales in a skittish market, Lehman says that for every buyer until June 1, it will guarantee that the resort will either sell or buy back the residence at the "full cost of the purchase price three years after closing."

The gamble is that prices will recover during that time, and buyers will hold on to their condos.

I would love to know how this gets accounted for chez Lehman.

(Via Curbed)

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Extra Credit, Wednesday Edition

Posted on April 23, 2008 by Felix

Global CDO Issuance: CRASH !!!

International financial system was close to the brink – Credit Suisse ex-CEO

Weighing a McCain Economist: He looks like "the least fiscally conservative candidate still in the race".

The homeownership ideology: "Only an ideologue would view homeownership as an end in itself. One of the reasons that millions of families face foreclosure and/or the loss of their life savings is that the ideologues of homeownership continued to promote homeownership even when it was clear that buying a home would be financially detrimental."

Arson to avoid foreclosure?

Funkalimination: Inside the mind of Fred Wilson: "I am on jury duty the next couple days and really enjoying the time off."

Hard times ahead as porn goes soft? "Veterans of the porn trade are edgy about the downturn. A generation ago, they recall, when authorities cracked down on ‘Deep Throat’ and closed many of the porn palaces, the country promptly fell into a serious recession."

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Getting Empirical on Subprime Losses

Posted on April 23, 2008 by Felix

Tom Brown has a very interesting essay over at bankstocks.com, where he looks at 2006-vintage subprime mortgages and tries to come up with a cumulative loss rate for them. He makes the reasonable assumption that the ABX index represents subprime bonds more generally, and then looks at the ABX index on a bond-by-bond basis. It turns out that the numbers aren’t nearly as gruesome as you might think:

Of the $600 billion or so of subprime mortgages originated in 2006 (again, by the lights of what have gone on with ABX bonds), $282 billion have already been repaid, while realized losses have come to just . . . $12 billion.

Brown does a bit more mathematics and comes up with a cumulative loss rate of 12.8%, which is much lower than just about any of the estimates doing the rounds, and is also much lower than the loss rate priced into the ABX:

UBS, the only firm on the sell-side that’s analyzed the credit performance of the ABX bond by bond, uses loss estimate embedded in the price of the ABX itself and comes to an estimate of 18%.

Maybe now’s the time to start going long the ABX? The ABX-HE-AA 07-2 index, which I thought was a buy at 45, is now just 21. If Brown is right, it’s a screaming buy. But it has to be said that buying the ABX has been an astonishingly good way of losing money for the best part of a year now.

Posted in housing | Comments Off on Getting Empirical on Subprime Losses

The Semiotics of Stock Tickers

Posted on April 23, 2008 by Felix

Living in New York, one sees stock tickers quite often – crawling along the bottom of a TV screen, scrolling around a building in midtown, even crowning the burger flippers at the McDonalds at 160 Broadway. What are they for?

One theory has it that people find stock tickers genuinely and intrinsically useful. You can be watching TV or eating your burger, and find out that INTC is +1.10 on the day. Hey! Nice little datapoint! But really, I can’t quite get my mind around the idea that enough people really care about what a more-or-less random selection of individual stocks is doing on an intraday basis. And if New Yorkers cared, you might expect to see stock tickers in other financial centers, too – but they’re much rarer outside NYC.

So my theory is that the main purpose of a stock ticker is not to impart information, so much as to send a very New York kind of message. A stock ticker is up-to-the-minute! It’s for people who are on the ball! It’s for strivers and sophisticates! Someone watching a ticker has the opportunity to congratulate himself on being in the kind of place where people watch stock tickers, and that makes him feel good.

Then again, I might be entirely wrong about this, and there might be some functional purpose to stock tickers which people like myself who don’t even have television simply don’t understand. I’m not talking about customized tickers on one’s computer: I’m talking about the big public tickers which purport to have a large audience. Is there something I’m missing here? Is there actually a reason for their continued existence? Or are they just relics of a pre-internet age when people really couldn’t get stock prices any other way?

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Murdoch in Welcomed-by-the-Union Shocker

Posted on April 23, 2008 by Felix

This might be a first: has an acquisition by Rupert Murdoch ever before been welcomed by a newspaper’s unions?

“We’d appreciate anybody coming in here that has a newspaper background, that knows New York, whether it’s Zuckerman or Murdoch or anybody, to put this paper back on track,” said Dennis Grabhorn, president of Local 406 of the Graphic Communications Conference, the union that represents more than half of Newsday’s employees.

Note that Newsday is very profitable, by newspaper standards: it had ebitda of $80 million last year on $500 million of revenue. What does Grabhorn expect Murdoch to do which would benefit the union and improve profitability?

Posted in Media, publishing | Comments Off on Murdoch in Welcomed-by-the-Union Shocker

Can We Trust the TIPS Spread?

Posted on April 23, 2008 by Felix

Add Wolfgang Münchau to the list of inflation hawks. If the Fed ignores inflation while putting out more urgent fires in the financial markets, he says, "the US bond market would implode, the current account deficit would become impossible to finance, the dollar would collapse, inflation would rise even more and the Federal Reserve would have to raise interest rates to high single digits or higher".

Central banks have to be worried about inflation, he says, and they have to be worried about overall inflation, not just core inflation.

I expect that the biggest danger to global economic stability will be not the credit crisis, but the way we are overreacting to it. Both in the US, and increasingly in Europe as well, monetary policies are no longer consistent with price stability.

This is a debate that just won’t go away. But Münchau adds an interesting twist, saying that even the TIPS spread, which is my favored inflation indicator, has serious weaknesses as a measure of inflation expectations:

Financial market indicators do not show any strong evidence of a rise in long-term inflationary expectations. These indicators include the yield difference between Treasury inflation-protected securities and ordinary Treasuries and their respective European equivalents. In fact, some of these indicators have actually gone up a little. But more importantly, they are not really forward-looking. The yield difference tells us more about liquidity conditions in those markets than about future inflation.

I’m not sure I understand this. Unless liquidity conditions in TIPS are significantly different from liquidity conditions in Treasuries, how could "liquidity conditions" keep down the spread between the two? I’m always a bit suspicious when economic commentators have to resort to the slippery notion of "liquidity" to explain away something which doesn’t fit their thesis. If you know exactly what you’re talking about, there’s nearly always a clearer and more precise way of doing so.

(Via Knobel)

Update: SamiK, in the comment, points to a Cleveland Fed chart which actually attempts to quantify changing liquidity conditions in TIPS.

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How Economic Illiteracy Could Doom Gordon Brown

Posted on April 23, 2008 by Felix

Gordon Brown is arguably the most economically literate head of state in the world. Which is maybe why he felt comfortable tinkering with the UK’s income-tax system. But as John Kay says,

Tax is always more complicated than you think and the results come back to haunt you.

Brown’s political future could be in jeopardy here, and a large part of the reason is that people have difficulty understanding the difference between average and marginal tax rates. It’s a pitfall which faces many sophisticated politicians: they think they can communicate ideas which are clear to them but which are not clear to the general public. And most of the time they’re wrong.

Posted in Politics, taxes | Comments Off on How Economic Illiteracy Could Doom Gordon Brown

Is There a Need for NYbor?

Posted on April 23, 2008 by Felix

nyborAre European banks significantly riskier than American banks? Looking at RBS’s decision to raise $24 billion in new capital, it certainly seems that way: the move will take RBS’s tier-one capital from a normal-for-Europe 4.5% up to a normal-for-the-US 6%.

And so it’s maybe not surprising that US interbank borrowing rates are lower than European interbank borrowing rates. The spread at the moment is 4bp, which is significant enough, but Carrick Mollenkamp reports that it could widen further, to as much as 10bp, as Libor continues to widen out to reflect reality rather than wishful thinking.

The inevitable result is that some bright spark (Scott Peng of Citigroup, to be precise) has proposed a "NYbor" measure of US interbank rates. Which is a bit weird, given that the WSJ was able to run its accompanying chart in the first place: clearly someone is already measuring these things. So the idea is clearly that NYbor not be simply used as an indicator of transatlantic spreads – that’s something which already exists – but rather as a replacement for Libor. And that seems a little excessive to me.

Posted in banking, bonds and loans | Comments Off on Is There a Need for NYbor?

A Sensible Way of Buying Fixed-Income Risk

Posted on April 23, 2008 by Felix

In a world where the Charles Schwab YieldPlus fund has fallen more than 25% this year alone, statements that bond funds just aren’t risky enough are likely to be met with a hollow laugh from some quarters. But it’s true: bond funds just aren’t risky enough.

I’m not talking about the leveraged funds which helped to bring down Bear Stearns, I’m talking about the products available to retail investors. If you’re an individual, the options available to you in the equity space are very broad indeed, from index funds and 130/30 funds through to high-growth, high-risk technology funds. Then, if your risk profile from equities is too aggressive, the done thing is to buy a few bond funds as well, to add a bit of safety to your portfolio.

But equities are no longer the only place to seek high returns. Hedge funds and university endowments have been making lots of money elsewhere for decades, and in the wake of the credit crunch there’s a strong case to be made that the best returns over the next few years will be made in the fixed-income space, which looks as though it has overshot to the downside in many areas, rather than in the equity space, which mostly hasn’t.

What’s more, emerging-market local debt is a good way to play the foreign exchange market as well, if you’re sophisticated enough to be able to work out what happens when you layer credit risk and the legal risk of not having debt issued under New York or London law on top of foreign-exchange risk.

And most importantly, as the cash bond market pales in liquidity next to the CDS market, it’s increasingly important that managers understand and use effectively the full spectrum of derivatives instruments available to them.

And there’s the rub: a moderately risky, widely diversified bond fund is not the kind of thing which can be started up by a couple of guys with a Bloomberg. Fund managers like John Paulson do well because they do a deep dive into something like housing credit, see a mispricing, and make a big directional bet. That’s fine for a hedge fund, but it’s not something to offer to retail.

If you were to start up a bond fund with a hefty risk appetite, you’d need much more than some diligent credit analysts. You’d need a good grasp of global macroeconomics, an expertise in medium-term foreign-exchange movements, a strong legal team, a large set of derivatives experts, and, crucially, a rock-solid counterparty risk rating. If you had all that, however, you could venture into areas few mutual funds have ever dared enter, and launch a fund which, in the best case, could get equity-like returns even if and as the stock markets were going nowhere.

But who has all that? Well, the first and most obvious name is Pimco. And guess what:

Pimco, a unit of Allianz, plans to launch a fund, Pimco Fixed Income Unconstrained Fund, which can invest in derivative vehicles such as options, futures contracts or swap agreements, or in mortgage-backed or asset-backed securities.

More broadly, the fund can invest in fixed-income investments with durations ranging from three to eight years and in an unlimited number of securities denominated in foreign currencies, according to a filing Pimco has made with the Securities and Exchange Commission.

The fund may also invest as much as 50% of its assets in securities and instruments economically tied to emerging-market countries and may invest as much as 40% of its assets in junk bonds.

This move makes a lot of sense to me. I doubt the Unconstrained fund is ever going to be a true monster in terms of size: fixed-income investors by their very nature tend to be risk-averse animals. But this fund could attract risk capital into the fixed-income space to a degree rarely seen in the past, just as retail investors are looking for areas where someone with a long enough time horizon can try to pick up undervalued debt.

What’s more, the Unconstrained fund would also fit in to a strategy of moving Pimco more broadly into alternative investments and higher-risk activities.

The risk to Pimco, of course, is that the Unconstrained fund blows up and drags the reputation of the entire firm down with it. But the one word I don’t see in its mandate is "leverage" (although it’s trivially easy to simply embed leverage in derviatives if you’re so inclined). Given how nimbly Pimco has managed to navigate the current credit crunch, I’d say the firm has as good a claim as any to being able to say that it’s capable of avoiding disaster.

Posted in bonds and loans, personal finance | Comments Off on A Sensible Way of Buying Fixed-Income Risk

Extra Credit, Tuesday Edition

Posted on April 22, 2008 by Felix

Bear Raid? Let me tell you about bear raids: "In most cases the raids just aren’t that effective, and, like firing a medieval musket, a bear raid is more a danger to the perpetrator than the target."

RBS – bank or printing press?

W.S.J.: When Putsch Came to Shove: "Brauchli, in less than a year at the helm, has become a martyr to Rupert Murdoch’s ambition."

Is Chess The Biggest Spectator Sport In The World?

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How UBS Lost Money on Super-Senior Bonds

Posted on April 22, 2008 by Felix

Yesterday I speculated that the reason banks got stuck with so many toxic super-senior CDO tranches was that they were unable to sell the things. Turns out, not so much. Check out the UBS report on its subprime losses (pdf here):

Losses on the Super Senior positions contributed approximately three quarters of the CDO

desk’s total losses (or 50% of UBS’s total losses) as at 31 December 2007…

Of the total USD 50 bn Super Seniors held by UBS, UBS purchased USD 20.8 bn of these

Super Seniors from third parties.

UBS wasn’t just holding onto its own super-senior tranches, it bought more than $20 billion from other banks as well! And it had some inventive ideas when it came to hedging the credit risk on these instruments, too. Consider the largest bucket of super-senior tranches:

Amplified Mortgage Portfolio ("AMPS") Super Seniors: these were Super Senior

positions where the risk of loss was initially hedged through the purchase of protection

on a proportion of the nominal position (typically between 2% and 4% though

sometimes more). This level of hedging was based on statistical analyses of historical

price movements that indicated that such protection was sufficient to protect UBS from

any losses on the position. Much of the AMPS protection has now been exhausted,

leaving UBS exposed to write-downs on losses to the extent they exceed the protection

purchased. As at the end of 2007, losses on these trades contributed approximately

63% of total Super Senior losses.

I’ve read this quite a few times, now, and I still don’t understand what it means. I think it means that UBS took out insurance against the value of the security falling between 2% and 4%: "the purchase of protection" here refers to protection against market moves, and not to CDS protection against an event of default. But I’m not sure. In any case, it was clearly a license to print money for the mortgage desk:

A hedging methodology enabled the desk to buy

relatively low levels of market loss protection (generally 2 to 4% and sometimes more),

and the desk considered the position as fully hedged.

It’s the arbitrage that wasn’t. You buy a security yielding more than your internal cost of funds, and which has a zero risk weighting, you "fully hedge" it, and you get a positive carry. What’s not to love? At this point it’s easy to see how UBS ended up with $50 billion of these things.

One normally hopes that a human being somewhere in most banks would look at a $50 billion exposure based only on "statistical analyses of historical

price movements" and call a halt to what could be a very dangerous venture. Evidently no human at UBS did so.

(Via Campbell)

Posted in banking, bonds and loans | Comments Off on How UBS Lost Money on Super-Senior Bonds

American Apparel Responds to WSJ Takedown

Posted on April 22, 2008 by Felix

On April 12, the WSJ published a 2,600-word front-page article on American Apparel which painted it as fiscally out of control. Not long afterwards, one of those tiny and niggly corrections appeared:

American Apparel Inc.’s shares trade on the American Stock Exchange and not on the New York Stock Exchange as was incorrectly indicated in a graphic showing the company’s share price that ran with a version April 12 page-one article about the retailer.

But check out the letter from American Apparel corporate finance chief Adrian Kowalewski which just got sent to Dealbreaker.

Apparently the company was extremely upset with the WSJ article. Kowalewski has a long list of issues he has with the WSJ report, but prefaces them all with this:

Our lawyers are

currently pursuing this matter with News Corporation, so we have not yet

issued a public statement.

Um, I think a detailed 755-word response counts as a public statement, it seems like the cat is out of the bag. So far, of course, there’s no sign of any correction, so it seems that the WSJ is standing by its story. But at least now if you want American Apparel’s take on it, you can read it on a public blog rather than having to phone up Kowalewski directly.

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How the Futures Conundrum Causes Higher Food Prices

Posted on April 22, 2008 by Felix

On March 28, Diana Henriques examined the weird phenomenon of futures prices expiring well above cash prices in the agricultural-commodities market. Today, she returns to the same subject, from the point of view of farmers, who can be significantly damaged by it.

Historically, a farmer could lock in a price for his crop by selling it forward: he’d enter into a futures contract to sell his wheat, say, for $1 million. Come expiry, so long as his crop didn’t fail, it wouldn’t matter what the price of wheat was. If he ended up selling for $500,000, then he’d get another $500,000 in cash settlement of his futures contract, and if he sold for $1.5 million then he’d be the one paying $500,000 to settle the contract.

But now the difference between the cash and futures prices means the farmer can lose on both legs. If the futures price rises, he will need to come up with more cash to settle the contract, even if he can’t raise that kind of money by selling his crop in the cash market. This wouldn’t be a problem if the futures contracts had the option of physical delivery rather than cash settlement, but they don’t.

What’s more, as the price of the crop rises, the farmer’s broker will make a series of margin calls on him, because the value of the futures contract is moving against the farmer. It’s a hedge, that’s what’s meant to happen: as the price of the farmer’s crop goes up, then the value of the hedge goes down. But historically individual farmers didn’t have to worry about things like margin calls: they’d just contract to sell their crop to a grain elevator in advance, leaving large grain elevators to worry about the futures and options market. Now, however, grain elevators are ceasing to offer that service, buffetted as they have been by volatility in the derivatives markets.

The one sliver of hope in the article comes from AIG, which is offering to buy commodities and sell them back at a fixed price in six months. But that has a systemic downside:

Private deals like these do not provide pricing data to other farmers and to the rest of the food industry that has long relied on the Chicago Board of Trade as the best measure of supply and demand. If such bilateral contracts become more common, it will be harder for everyone in the industry to anticipate costs and potential profits — which could also push prices up.

This growing uncertainty about prices and hedging “just makes the market less efficient,” said Jeffrey Hainline, president of Advance Trading, an agricultural advisory and brokerage service in Bloomington, Ill. “And anything that makes these markets less efficient increases the cost of food.”

In economics, it’s often hard to disentangle causes and effects. If commodity-derivative volatility is causing high food prices, might there be some kind of mechanism working the other way too, so that higher global food prices are causing volatility and basis risk in Chicago? I’m still just as puzzled as I was last month, but I do suspect there’s some kind of explanation somewhere.

Posted in commodities, derivatives, food | Comments Off on How the Futures Conundrum Causes Higher Food Prices

Is There Still a Premium for Triple-A Debt?

Posted on April 22, 2008 by Felix

One of the themes running through Roger Lowenstein’s NYT magazine magnum opus on the ratings agencies is the idea that debt becomes more valuable when you slap a rating on it, and that the higher the rating, the greater the value that the ratings agency is adding.

From the investment bank’s point of view, the key to the deal was obtaining a triple-A rating — without which the deal wouldn’t be profitable…

Credit markets are not continuous; a bond that qualifies, though only by a hair, as investment grade is worth a lot more than one that just fails. As with a would-be immigrant traveling from Mexico, there is a huge incentive to get over the line.

I see two lines which matter: the line you cross when you become investment grade, and the line you cross when you become triple-A. In both cases the universe of potential investors increases, which means that price is likely to go up even if your fundamentals haven’t changed.

I’d love to see some empirical research on the amount that yields fall when you gain an investment-grade or triple-A credit rating, holding everything else equal. Is there some way of measuring that? I’d also love to see what’s happened to that ratings premium over the past year or so. Is it finally going away of its own accord?

Update: Also well worth reading is Aaron Lucchetti’s piece on the culture of Moody’s from April 11.

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Jingle Mail: How do you Value Home Equity?

Posted on April 22, 2008 by Felix

One of the biggest questions overhanging the housing market right now concerns the behavior of underwater mortgage borrowers. If the mortgage is non-recourse – and let’s assume for the moment that it is – does it always make sense for such a borrower to walk away from the house? If you listen to the likes of Nouriel Roubini, the answer seems to be yes – he expects as many as half such borrowers to walk away. But many other people, including myself, think that the incidence of "jingle mail" will be much, much lower.

The key concept in this debate is the idea of equity. If you’re in a "negative equity" situation, then on a purely economic level there is a strong case to be made for leaving your house and its associated mortgage. But how do you value equity? A blog entry by Buce got me thinking today: when people talk about "equity" in the context of residential housing, they’re actually talking about book value. And as any stock-market investor knows, there can be a world of difference between equity valuations and book value.

If your outstanding mortgage is larger than the value of your home, then you’re in a situation where liabilities (the mortgage) exceed assets (the house), and book value is negative. But it’s entirely possible for a company with negative book value still to have positive equity: look at General Motors, which is trading at $20 per share even as its book value is -$65.

If you sell your house, you’re essentially liquidating: you’re selling off the assets and paying off the liabilities, to the extent that they can be covered with the proceeds of the asset sale. But most companies are worth more than their book/liquidation value, and there’s no reason why home equity shouldn’t be thought of in the same way.

Buce points out that the equity can be valued as an out-of-the-money call option: it might not be worth much, but such options are generally worth something. And more generally, just as there’s value in operating a company as a going concern, there’s value in owning and living in your house, even if your mortgage payments are higher than they would be if you bought the house today.

Why do houses generally cost more to buy than they do to rent? Because there’s a speculative component to the price: buyers pay extra for the possibility that they might be able to make a large capital gain when they come to sell. Nowadays, of course, they’re likely to do the opposite, and force a discount to compensate for the possibility that they might have to suffer a large capital loss when they come to sell. But if you bought your home to live in it, and if you expected to make the mortgage payments you signed up for, and if you’re able to make those mortgage payments, then owning a house does still give you that possibility of future capital gains. And walking away will probably mean you can’t buy another house for at least two years, so you lose that option. (Theoretically, of course, you could buy your new house before you walk away from your old one, but I haven’t yet heard of anybody doing that.)

So where does that leave us? I suspect that prime fixed-rate mortgage borrowers are not going to walk away in significant numbers. Prime ARM borrowers expected to be able to refinance before their reset, and they might find that impossible if they’re underwater, so jingle mail is a possibility there, depending on whether the reset rate is significantly higher than their initial rate or not. Subprime ARM borrowers, of course, are already defaulting in record numbers. Which leaves just subprime fixed-rate borrowers: they’ll probably continue to make their payments unless or until they can’t.

But the willful jingle mail – can pay, won’t pay – I think is still going to be a very rare thing.

Posted in housing | Comments Off on Jingle Mail: How do you Value Home Equity?

Food is Made from Natural Gas

Posted on April 22, 2008 by Felix

Paul Scheckel:

Fertilizer production is second only to petroleum refining when it comes to industrial use of natural gas in the United States: 97 percent of the fertilizer applied to crops is manufactured from natural gas. With spiking energy costs, fertilizer manufacturers are opting to close their doors and instead sell their natural gas supplies.

The Haber-Bosch revolution, which produced vast amounts of cheap nitrogen to use as fertilizer to boost crop yields, feed the planet, and prove Malthus wong, was literally fuelled by natural gas. Given where oil prices are, natural gas is if anything undervalued. Yikes.

(Via Some Assembly Required)

Posted in commodities, food | 1 Comment

Murdoch Returns to his Mass-Market Roots

Posted on April 22, 2008 by Felix

Rupert Murdoch seems to be quietly nearing a deal to buy Newsday from Sam Zell for about $580 million. That’s almost exactly the same amount of money as he spent on buying MySpace – an investment which Gillian Wee weirdly says "has turned News Corp. into a toxic stock".

How can a $580 million investment in a profitable company do any visible harm at all to News Corp, a company with revenues of about $30 billion a year? It’s unlikely, but it is possible. In the case of Newsday, Murdoch could get dragged through a long and damaging antitrust investigation; in the case of MySpace, he could be the target of Concerned Parents or, worse, stock analysts who start mentally grouping him in with Barry Diller and other moguls desperately trying to remain relevant in the age of the internet.

But in reality both acquisitions look like very good deals for Murdoch. MySpace is already worth many times what Murdoch paid for it, while Newsday, when combined with the New York Post, will help provide economies of scale in the New York region. Those economies will be loaded on the back end, in things like printing and distribution, but they could also come in terms of content: as a commenter on Jeff Bercovici’s blog notes, it would make a lot of sense to start running Page Six in Newsday.

Indeed, both MySpace and Newsday play to Murdoch’s mass-market strengths, in contrast to the much more high-profile Wall Street Journal. Why is Marcus Brauchli leaving? Maybe, in part, it’s because he doesn’t have the sole authority he was promised: all Murdoch papers are ultimately run by Murdoch. But I suspect it’s more a function of the direction that Murdoch is taking the Journal – very much towards his mass-market comfort zone.

Right now two big headlines at the top of the WSJ.com home page are "Money Edge Could Sway Campaign" and "Loan Losses Pose Threat to Banks". Neither headline would be out of place in the pages of USA Today. They’re indicative of Murdoch’s broader strategy, which is increasingly coming into focus: to turn the WSJ into a general-interest newspaper with a first-rate business section attached. Its business readers won’t desert it because they can’t desert it, and it might pick up new readers along the way who until now have read their local broadsheet.

I have to admit that it’s not the strategy I thought Murdoch would take. Rather than try to appeal to a broader swathe of Americans, I saw Murdoch concentrating more on taking the WSJ international, appealing to the global business class. But if that ever does happen, it seems it won’t happen for a while: international coverage is still something of an afterthought in the WSJ.

Posted in Media, publishing | Comments Off on Murdoch Returns to his Mass-Market Roots

RBS: Getting Stronger by Raising Equity

Posted on April 22, 2008 by Felix

Even by this month’s outsize standards, the $24 billion that RBS is raising in new capital is an absolutely enormous sum. But it’s much more than a replenishment, it’s a significant augmentation:

"In the light of developments during March — including the severe and increasing deterioration in credit market conditions, the worsening economic outlook and the increased likelihood that credit markets could remain difficult for some time — the board has concluded that it is now appropriate for RBS to accelerate its plans to increase its capital ratios and to move to a higher target range to reflect the generally weakened business environment," the bank said in a statement…

The rights issue and disposals together are expected to bring Royal Bank of Scotland’s ratio of capital against risky assets, also known as the core tier 1 ratio, up to an estimated 6% at the end of June this year from 4.5% at the end of 2007. Regulation calls for core capital to cover 4% of risk-weighted assets.

CEO Fred Goodwin is giving himself a nice capital cushion here, allowing him to continue to take the kind of risks he loves – maybe even a well-timed acquisition, if something attractive comes along. But it’s also clear that buying ABN Amro at the top of the market does look, in hindsight, to have been extremely expensive. And Goodwin’s probably quite relieved at this point that he ended up losing LaSalle to Bank of America.

Given how expensive equity is these days, why is Goodwin still paying out a $4.5 billion dividend? Remember this is a rights issue, so it’s mostly just a case of giving to shareholders with one hand while taking back from them with the other. Maybe Goodwin got Goldman, Merrill, and UBS to charge him a very low fee for underwriting the issue, so he just wanted to make it as big as possible and get it all over and done with in one go.

Overall, this might not be great news for RBS shareholders in the short term – the stock opened down about 4% on the news – but it’s good news for the UK and even the global financial system in the medium term. Right now, it’s good to have too much capital, rather than just enough. Would that more institutions followed suit.

Posted in banking, stocks | Comments Off on RBS: Getting Stronger by Raising Equity

Extra Credit, Monday Edition

Posted on April 21, 2008 by Felix

Berkshire Hathaway Annual Meeting Crowdsourcing Experiment: Questions for Buffett and Munger.

The Difference Between WordPress and Facebook, As Usual Google Is The King Dog. How Big Is Google? Here’s Another Measure: "As best as I can tell, Google sells more advertising than any company in the world."

The Conference Room: How You Get Fired In Finance: "Subject: Hey, do you have a minute? Either come to my office or we can meet in a conference room." It’s all you need to know. You’re fired.

Credit cards a bright spot for BofA: People don’t seem to be defaulting on their credit cards, yet.

Clayton Christensen thinks we suffer from a medical symptom shortage: Justin Fox says that Christensen says that there’s new medical technology which could actually reduce healthcare costs. I’ll believe it when I see it.

Oil, Migrants and Santa Anna: A good backgrounder on the depths of feeling against any kind of oil privatization in Mexico.

Posted in remainders | Comments Off on Extra Credit, Monday Edition

How to Make Fake Profits in the CDO Game

Posted on April 21, 2008 by Felix

Gillian Tett has a good column on the super-senior game, in which she chastises banks for losing sums "larger than the gross domestic product of many countries" by entering into "a humongous, misplaced bet on a carry trade that was so simple that even a first-year economics student (or Financial Times journalist) could understand it". Super-senior tranches of CDOs, she explains, were zero risk weighted by dint of their triple-A credit rating, and the banks never stopped to ask why they yielded 10bp more than risk-free funds:

But, last August it became clear why this 10bp spread existed: namely, because these assets are not as liquid as government bonds in a crisis. Indeed, the prices of some tranches of debt have fallen by 30 per cent in recent months, to the shock of senior managers.

I don’t think that bonds fall by 30% just because they’re illiquid in a crisis: there was definitely a lot more credit risk buried in these tranches than the ratings agencies ever imagined.

But more to the point, there’s a strong case to be made that the super-senior tranches of CDOs were never worth what the banks booked them at, not even before the market crashed. Here’s the bit of the story that Tett only hints at when she talks of banks buying these instruments "simply to keep the CDO machine running".

Many banks, up until last summer, were making enormous sums of money buy packaging bonds into CDOs. They would buy up a bunch of debt, roll it all up into a CDO, and then slice it into tranches ranging from the super-senior all the way down to equity. The riskier the tranche, the higher the yield. And somehow, by the magic of securitization, the value of all a CDO’s different tranches, in aggregate, would be a little bit higher than the cost of all the bonds which went into it. And that difference was profit for the bank.

Except. When you slice up a CDO, you end up with a relatively small amount of relatively high-risk debt, and a very large amount of triple-A debt. The riskiest triple-A tranches could get sold off to yield-hungry investors who were only allowed to buy debt with a triple-A rating, but no one was interested in the "super-senior" tranches which yielded only 10bp over government bonds but which were more or less impossible to sell since there was never a market in them.

If the banks had sold the super-senior debt at a market yield – if they’d bumped up the coupons on the super-senior tranches to the point at which some investor would have been willing to buy them – then the magic profits of securitization would have been eradicated, and the efficient markets hypothesis would have held: you can’t make a pie bigger by slicing it laterally rather than radially.

But the bankers’ bonuses were all tied to the idea that you could make a pie bigger by slicing it laterally. And so they found the only buyer they could for the underpriced super-senior tranches: themselves.

Think about it this way. I buy the ingredients for an apple pie: apples, sugar, flour, that sort of thing. Add them all up, and they come to $10. I then cut the pie into four unequal slices. I sell one for $1, another for $3, and a third for $5. The fourth slice I price at $2, but I can’t find any takers.

Now in theory, if I could sell that fourth slice for $2, then I’d have a nice little business going. But I can’t, so instead I keep a hold of that fourth slice myself, telling everybody that it’s worth $2, and booking my $1 profit. Then, one day, the game stops, people start asking awkward questions about how much that slice is really worth, and it turns out that when I test the market, no one’s willing to pay even $1 for it, let alone $2. And that’s when I write down the value of my slice and take a big loss for the quarter.

But hey, at least I got nice big bonuses so long as the game was going.

(Via Setser and Kedrosky)

Posted in banking, bonds and loans | Comments Off on How to Make Fake Profits in the CDO Game

How Principles-Based Regulation is Like a Soccer Match

Posted on April 21, 2008 by Felix

Jim Surowiecki gives the best description of the difference between rules-based and principles-based regulation, and why a principles-based approach makes sense, that I’ve yet seen:

It’s something like the difference between football and soccer. Football, like most American sports, is heavily rule-bound. There’s an elaborate rulebook that sharply limits what players can and can’t do (down to where they have to stand on the field), and its dictates are followed with great care. Soccer is a more principles-based game. There are fewer rules, and the referee is given far more authority than officials in most American sports to interpret them and to shape game play and outcomes. For instance, a soccer referee keeps the game time, and at game’s end has the discretion to add as many or as few minutes of extra time as he deems necessary. There’s also less obsession with precision–players making a free kick or throw-in don’t have to pinpoint exactly where it should be taken from. As long as it’s in the general vicinity of the right spot, it’s O.K.

Wall Streeters must be soccer fans at heart, because they are huge supporters of the principles-based approach. That should, perhaps, make us skeptical: when the fox applauds ideas for henhouse security, watch out. Yet the European experience suggests that a principles-based system has real virtues. It can make life easier for honest corporations, since they have to spend less time complying with overly complex rules, and also thwart dishonest ones, since regulators can spend more time looking at the substance, rather than the minutiae, of corporate bad behavior. It has been argued that Enron might have found it harder to get away with its shenanigans under a principles-based system, since many of the company’s gambits, while following U.S. accounting rules, nonetheless violated fundamentals of financial reporting. More recently, bank regulators in Italy, following a principles-based strategy, succeeded in keeping big Italian banks from heavily investing in subprime derivatives, even though such investments wouldn’t have broken any laws.

One of the interesting things about the soccer-football comparison is that among the small group of people who like both sports, soccer is almost universally considered the better game. Both can be exciting, of course, and both can be very boring. But at its best, soccer has an elegance, fluidity, and beauty that (American) football can never approach. On the other hand, at their worst, soccer matches reach levels of disastrousness that are unheard-of in football.

Surowiecki’s main point is that there’s no point switching to principles-based regulation unless you have well-funded and independent regulators. To continue his analogy, a bad or biased ref can ruin a soccer match in the way that no bad ref can ruin a football match. Given the amount of regulatory capture which has occurred in the US, it makes sense to sequence things: first make sure your regulators are independent and well-funded, and then move them over to a principles-based approach. A principles-based regulator without any teeth is the worst of all possible worlds.

Posted in regulation | Comments Off on How Principles-Based Regulation is Like a Soccer Match

Why Stockbrokers Need Close Scrutiny

Posted on April 21, 2008 by Felix

Floyd Norris received an email today from a financial adviser who’s upset at the level of supervision in his industry. No, he doesn’t think there’s too little, he thinks there’s too much:

“As a financial adviser at a major Wall Street firm, I am amazed at the amount of resources spent to supervise our business practices. These firms spend crazy amounts of money policing our practices for things like mutual fund “B” share sales while a small amount of bankers and traders lost hundreds of billions of dollars on scam structured investments.”

Norris is sympathetic; I’m not. This kind of regulatory supervision does not exist to stop the bank making stupid decisions or to minimize losses to shareholders. Rather, it exists because financial advisers have a fiduciary duty to their clients. If you want to recklessly lose your own money, go right ahead. But don’t do that with your client’s money.

Stockbrokers occupy a peculiar niche between the buy side and the sell side. Their clients are investors, not issuers, but neither are stockbrokers buy-side fund managers. As such, they deserve extra scrutiny: stockbrokers’ profits generally come out of their clients’ pockets, even as the brokers have a legal responsibility not to fleece their clients. Because the brokers’ incentives aren’t really aligned with those of their clients, it makes sense to keep a very close eye on their behavior.

So far, retail investors have managed to navigate the credit crisis about as well as could be hoped. The ones invested in auction-rate securities aren’t happy, but the ones invested in a well-diversified set of stocks are doing much better than many much smarter investors. Insofar as scandalous activity has happened at banks, it happened far from the retail-facing arms. And I suspect that we have, at least in part, regulatory scrutiny to thank for that. So let’s not start saying that there’s too much of it.

Posted in regulation | Comments Off on Why Stockbrokers Need Close Scrutiny

How to Prevent Foreclosure, Ohio Style

Posted on April 21, 2008 by Felix

Ohio Attorney General Marc Dann has one of the best plans for reducing foreclosures that I’ve seen yet. It targets homeowners rather than lenders, it costs a known and not particularly large amount of money, and it has the potential to be extremely effective. Luke Mullins has the Q&A, in which Dann says that he thinks he can prevent "the vast majority" of foreclosures. How?

The state has enlisted more than 1,300 lawyers–from state agencies and the private sector–to help struggling homeowners avoid foreclosure by reaching agreements with lenders or, if need be, through litigation.

A good lawyer is a friend indeed to a homeowner facing foreclosure. Dann has already persuaded Ohio’s 10th District Court of Appeals that any bank foreclosing needs to have physical possession of the mortgage note, which often is not the case these days. And in general if the foreclosing bank knows it will face expert legal opposition, it’s going to be that much more likely to negotiate an alternative.

If this Ohio scheme proves effective, there’s no reason why it shouldn’t be rolled out nationwide. And the great thing about it is that even the lenders could end up winning in the end. Foreclosing is the lazy way out for a mortgage servicer: swamped by delinquencies, lenders know how to foreclose and have a tendency to do so even if there are better alternatives which take more time and more individualized attention. If the states staff up and make foreclosure more difficult, maybe the servicers will staff up too and make work-outs easier.

Posted in housing | Comments Off on How to Prevent Foreclosure, Ohio Style