Inflationary Implications of the Yuan/Dollar Currency Realignment

In my final Macroeconomics lecture given in May 2009 (I was on sabbatical this year) I predicted that this global debt crisis will be "solved" by a substantial inflation beginning in three to five years.

Now that a year has passed I can restate that I believe that we will see a few years of double-digit inflation within, now, two to four years. Some of the reasons I stated can be found by looking at the final few slides of that presentation, found here.

The European austerity programs that are now emerging in countries like Greece and Spain and will eventually be necessary in most other European nations, won't work. In the short run they will make the recession worse and are politically unpopular.

In the United States our annual budget deficits are so huge (around $2 trillion) and the prospects for reducing them so bleak, especially politically, that we collectively refuse to address the issue at any level. Essentially we are Portugal without a plan and without any recognition that we need a plan (or more accurately, without admitting that no plan is possible). In fact it appears this year that federal budget reconciliation, which normally takes place about now and is required by law will not even be attempted for the first time in our history.

The Chinese Contribution

The decision announced by the People's Bank of China over the weekend to effectively appreciate the Yuan relative to the Dollar will help contribute to the first leg of this inflationary impulse.

(The PCB press release actually said "... the People´s Bank of China has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility," but that clearly implies allowing the Yuan to appreciate manageably against the Dollar. In effect they are returning to the managed currency policies of the years indicated on the graph).

The recent history of the exchange rate is shown in the graph and is currently at 6.8275 Yuan to the Dollar.

Although it is yet unclear when and to what degree the Chinese government allow the exchange rate to drift, it is going lower on net. The PCB has made it clear that if the Dollar strengthens substantially as it recently did versus the Euro, then the Yuan may be temporarily devalued relative to the Dollar (but appreciated relative to the Euro), but none of this makes sense unless the exchange rate above falls.

This implies of course that the Dollar cost of goods and services manufactured in China and sold in the United States will rise. For example, if the Dollar devalues from its current level to, say, 6.00, that would be a devaluation of about 14%, and although collapsing margins could absorb some of this, prices of imported goods from China would likely rise by at least double digits.

The Size of the Chinese Trade

How important is the Chinese trade?

In 2009 in we imported $297 billion worth of merchandise goods alone (while exporting only $70 billion), down from $339 billion in 2008 but recovering in 2010. That only nets to 2% of GDP but is a much higher percentage of discretionary outlays by lower income consumers (the WalMart shoppers).

By itself it is not enough to turn a period of price stability into a galloping inflation but it will probably be remembered as one of the early catalysts.

In an earlier blog I suggested, without much evidence, that some speculation in the United States, including the creeping bull market that ended a few weeks back, was partly financed by a new Chinese carry trade. I still believed that happened. This currency realignment would damage any such carry trade and makes its continuation unlikely. Although the Chinese carry trade is initiated with U.S. Dollars (the first step does not require the conversion of Yuan to Dollars), the Yuan-value of the proceeds of such trade plunges as the currency plunges. Therefore, if I am right about the presence of a Chinese carry trade during the creeping bull market, it's removal now is bearish for the U.S. equity market.

Trading Treasury Rates with ETFs - Part 2

In Trading Treasury Rates Part 1 I established a good reason for devising ways to trade U.S. Treasury interest rates without using the futures markets. In that article I offered two candidate ETFs, the iShares Barclays 20+ Year Treasury Bond Fund (TLT) and the Proshares Ultrashort 20+ Year Treasury Fund (TBT).

TLT is a long bond fund - it's value rises when the market value of long-term U.S. Treasury securities (USTS) rise (which happens when their market yields fall).

TBT in contrast is a short fund which does the opposite - it's value rises when the market value of long-term USTS falls. Further, unlike TLT, TBT is a leveraged fund and it is also a delta fund. A delta fund is designed to track the change in the value of an underlying security (rather than track the long-run value of the fund over time) day by day, percent by percent. If the fund is 2X short-leveraged like TBT, if on any given day TLT were to rise by X%, then TBT should fall by about 2X%.

The benchmark for both funds is the Barclays Capital 20+ Year U.S. Treasury Index, which is discussed in the next part of this series. TLT tries to follow the index exactly. TBT attempts to track two times (2X) the inverse of the daily change in this index each day.

Criteria for Choosing the ETFs

Now let me justify these two choices.

Of the many ETF candidates that we might choose, the following criteria should be satisfied

1. The ETF must be liquid, which implies that it should have high daily volume, especially when compared to peers.
2. If the strategy requires options, as our does, then a full range of put and call options must be available for the ETF, and the options that are near the money in near-term months must have both adequate open interest and daily volume.
3. The ETF should track well - meaning that if it promises to track an underlying index or other stated value, it should have a track record of doing that with a high degree of accuracy (the criteria would vary from one context to another, but in this context for a straight tracking ETF like TLT it should be above 95% and for a delta ETF it should be above 90%).

There are more than a dozen ETFs that track U.S. Treasury securities of various maturities. Candidates can be found in online searches at dedicated sites or in the Online Wall Street Journal Market Data section.

Daily Volume

Figure 2.1 U.S. Treasury Security Exchange Traded Funds (ETFs) shows a selection of mid- to long-term funds for both longs and shorts. A quick glance shows that only TLT and TBT have the necessary liquidity, as measured by average daily volume, to qualify for the first criterion above. The daily volume eclipses that of the other ETFs. The Proshares TBF may seem like a better candidate than TBT for short trades because it is not leveraged, but at 238,000 shares a day and no listed options it must be ruled out (N means no options, I means illiquid - inadequate open interest and/or daily volume).

Adequate Options

In Part 1 when describing general strategy I stated that if we were to use options for our strategy, we would use only puts and calls on TLT. If not using options then TBT provides a direct short opportunity but if options are required then puts on TLT are more suitable than calls on TBT.

Although the argument won't be supported with data here, because delta ETFs don't track with anywhere near the integrity of a straight tracking ETF like TLT, options on delta ETFs compound the error in tracking integrity. In a word, they are too volatile.

Even the TLT options barely qualify for serious trading. They tend to be liquid with adequate open interest and daily volume only right around the money. Also there is almost always a minimum spread between best bid and best ask of five cents and it is often higher. This is a large negative, because on many of the equity index ETFs this spread is seldom more than a penny.

Figure 2.1 Near-the-Money TLT Options shows the daily volume and open interest on TLT for May 20, 2010. As can be seen both volume and open interest is adequate for small trades (say 30 contracts or so) but not really for large trades. Although not shown here, it should be noted that volume and open interest on TBT options are at least as high as TLT and in volatile markets sometimes higher.

The Tracking Record

Traditional ETFs that track a known index over the long-run, like TLT, normally have a good tracking record (at above 95%) if they are popular and liquid.

Delta ETFs, which attempt to track only the change in the target day-by-day, sometimes with leverage like 2X for TBT, don't have such a good track record. If the Delta ETF has any sizeable error on the day-by-day target, that error can accumulate over time to where the long-term performance of the target has little correlation to the long-term performance of the ETF that tracks it.

This is partly because of how these ETFs are collateralized, which is discussed in the next part.

The criteria for measuring how well an ETF tracks its target, in this case the Barclay's Capital 20+ Year U.S. Treasury Index, compares the daily Net Asset Value (NAV) of the fund to that of the underlying index. ETF fact sheets and prospectuses can always be found on their parent web sites with a simple search and the fund performance relative to the target they track can be found in either or both.[1] If untrusting, a researcher with some spare time can use regression analysis to see how they track.

TLT tracks very closely, with less than 2% error because (a) iShares collateralizes TLT by simply buying the same securities as are used in the index in the same proportions, and (b) the stock is popular and liquid enough for the daily trading price to actually track the true Net Asset Value (NAV) of the holdings.

It turns out that even though TBT is a delta ETF and is collateralized with derivatives called Treasury Swaps, because it is also liquid, in the first quarter of 2010 only on a few occasions did it track with more than a 3% error. For short term trades this is completely adequate, although because this is a delta ETF, its usefulness as a long-term short hedge (or hedge against rising interest rates) is still questionable.

NEXT: Collateralization and pricing conventions for these two ETFs.

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[1] In this case see the ProShares UltraShort 20+ Year Treasury Fact Sheet and Barclays 20+ Year Treasury Bond Fund (TLT) and once on that page, link from Related Links and Documents to the "Tracking Error Chart."

Trading Treasury Rates with ETFs - Part 1

Suppose you wanted to trade interest rates on long-term U.S. Treasury Securities, either as a hedge or a speculative position.[1]

For example, suppose you believe, as do I, that inflation will emerge as a serious problem in the next few years because of our debt excesses. If that happens, interest rates will rise on bonds in general, including U.S. Treasury notes and bonds and, for those bonds already issued before the inflation, their market values will plunge, causing large capital losses for holders. Also the stock market typically performs poorly during periods of high inflation. Therefore a trader with fixed income investments and equities might desire a strong hedge against inflation and rising interest rates.

The futures markets offer a huge selection of hedges against interest rate movements. But not all traders like to trade futures because they dislike the implied leverage and relatively high cash requirements for trading futures, or they simply feel uncomfortable in that arena.

Exchange Traded Funds (ETFs) now offer equity traders, including those operating on a very small scale with limited budgets, a full range of strategies for playing interest rates of different markets, from U.S. Treasury Securities (USTS) to commercial junk bonds, of all maturities, from less than one year to thirty years.

This series of articles will discuss trading with interest rate strategies for long-term USTS primarily using two common and liquid ETFs, iShares Barclays 20+ Year Treasury Bond Fund (TLT) and the Proshares Ultrashort 20+ Year Treasury Fund (TBT) and put and call options for TLT.

The General Strategy

Generally the strategy will be quite simple: (1) If you think that interest rates will fall on long-term USTS then you will buy TLT or buy calls on TLT or (2) if you think interest rates will rise on long-term USTS then you will buy TBT or buy puts on TLT. (I could have included options on TBT in this mix but didn't for reasons discussed in a later article).

The general strategy is easy to explain, but once we consider questions about the proper size of trades, trade timing, and the relationship between interest rate activity on long-term USTS and the market price of USTS and, hence, these two ETFs then the specific strategy becomes much more complicated.

So we will explore this in steps. The remainder of this article is dedicated to describing and understanding the mathematical relationship between the market yields and market values of USTS.

Future articles in this series will explain (1) the TLT and TBT ETFs and how they are structured and why they are suitable, (2) how TLT is securitized and how that affects TLT's price, (3) how TLT puts and calls respond to TLT volatility and interest rate volatility, and (4) the development of trading models that make use of all of this information.

The Relationship Between Interest Rates and Market Values of USTS.

For all yield-bearing (interest paying) financial assets (YBFAs) traded in the secondary markets after their original issue, including U.S. Treasury Securities of all durations, their market values move in opposite direction of their market yields.

For example, consider a 30-year bond originally issued with a par value of 100 paying a coupon rate (original issue rate) of 4% of par annually. If 10 years later newly-issued 20-year bonds were yielding 6% at par, then the 30-year bond with only 20 years remaining in its life would have to also yield 6% to remain competitive. Because the coupon rate is a fixed constant throughout the life of a bond, the only way the old bond can raise its yield is through a reduction of its market value below par. The bond would fall to a value below par and in this case would in fact fall to a value of $77.60.

Where did I get that number?

The relationship between a bond's market value and its market yield is mathematical. Figure 1 Simple Bond Valuation Formula shows that mathematical relationship, and provided the solution for our bond problem above.[2]

Figure 2 Possible Values for 30-year Bond taken from a slide used in a lecture to explain this relationship, shows all of the possible values that this 10-year-old 30-year-bond would assume given a range of possible yields offered by newly issued competitive 20-year bonds. As can be seen in the ranges shown, the old bond can trade as high as 155 (when the new market yield is 1%) and as low as 34 (when the market yield is 14%).

It should be easy to see that in an environment of volatile interest rates a long-term bond like this example can have the same degree of price volatility as some stocks. More important, in an inflationary environment, if long-term bond yields rise to reflect the inflation, then long-term bonds will suffer serious capital losses.

Consider a real example. As we will see, one of the USTS assets used the collateralize TLT is a 30-year Treasury bond that mature on November 15, 2039, has a coupon yield of 4.38%, but on April 30, 2010 had a market yield of 4.53%, slightly higher, and therefore was trading at a discount price of 97.52. Suppose that by November 15, 2013 that because of double-digit inflation this bond had a market yield of 12%. In that case this bond would be trading for 39.84!

So in an emerging inflationary environment, you would want to be short in this bond, or short in something that tracks this bond.

NEXT: The tracking stocks (ETFs) and their options that we will use to do this.

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[1] If the reader is unfamiliar with the types of U.S. Treasury Securities available on the secondary market, review The Market for U.S. Treasury Securities.

[2] For the curious reader, this mathematical relationship and why it exists is explored in much greater detail in the document Bond and Note Valuation and Related Interest Rate Formulas. The formula shown in Figure 1 is derived in this document and more complicated bond formulas are also developed and explained.

The New Chinese Carry Trade

The old Japanese carry trade, many a speculator’s bankroll in the glory days between 2003 and 2007, is dead, buried, and gone, a casualty of the crisis.

But I believe that it has now been replaced, on a much larger scale, having much more of an impact, helping fuel yet another asset value spec frenzy on a scale that is more dangerous than the last.

Our regulatory authorities are, of course, oblivious.

This new carry trade I will call the Chinese Carry Trade, although it may be more accurate to call it the overseas-trading-partner carry trade.

I should warn that below I am not going to make an iron-clad empirical case. Most of the evidence that I have pulled together is indirect. This will be the first of two or more posts, this one laying out the theory, later posts offering some of the evidence and more detailed support.

The Old Japanese Carry Trade

In the old Japanese carry trade, speculators with connections would borrow copious amounts of money from Japanese banks, short term (on essentially commercial paper terms), at very low interest rates (below 1%), exchange yen for the dollar, invest or lend in the U.S. at higher returns with typically longer duration, which required that short-term Japanese loans be rolled over.

Obviously speculators tapping into the Japanese carry trade faced exchange rate risk. But the Yen rose on net between 2003 and 2007. From January 2005 until June 2007, probably the hottest period for the Japanese carry trade, the Yen rose from about 103 to nearly 125, adding leverage to the gains already made on interest rate spreads.

A simple example: borrow a billion yen at 0.5%, at an exchange rate of 100, convert to 10 million dollars, lend at 4.5% for a year, convert the 10.45 million dollars at a new exchange rate of 120, receive 1.254 billion yen, pay interest charges of 5 million yen, leaving a profit of 249 million yen, a return of 25% on the borrowed money and an astronomical rate of return on the much narrower equity base used to secure the loan.

Independent of the crisis, the Japanese carry trade was doomed once the dollar began to plunge from its June 2007 high to its current level of around 95. Any interest rate spread profits would be wiped out by exchange rate losses.

Sterile Dollars in China

The China carry trade works a little differently. First, dollar-denominated financial assets flow to China in exchange for merchandise flowing this way, a consequence of our massive merchandise trade deficit with China

See the chart labeled Merchandise (Goods) Trade Deficit with China, which shows our merchandise (goods) trade deficit with China for the last 10 years. In recent years we have been running a merchandise deficit of around $250 billion annually. (We ran a services surplus with China of about $7 billion in 2009, trivial when compared to goods).

Most of those bookkeeping-entry dollars, initially in the hands of Chinese manufacturers and merchandisers, are swapped at banks and ultimately the People’s (PBC) Bank of China for the renminbi at the current fixed exchange rate of 6.83. Dollars in China in some form or another now exceed $2 trillion.

For much of it, at some point, the PBC converts the sterile dollars to low-yield U.S. Treasury Securities by indirectly participating in U.S. Treasury auctions.

But not all of it ends up held as U.S. Treasury Securities. Without doubt some of it stays in dollar bookkeeping-entry form (as a dollar-denominated bank debit in China or elsewhere) whereupon it can be leant to … well, anyone who has sufficient connections and business interests and who want to borrow dollars for whatever reason they want to borrow them.

That might include Chinese speculators, both in China and overseas, who would use this funding to buy U.S. residential real estate or stocks, either in the U.S. market or any other market that accepts dollars.

If this is happening, note that there is no exchange rate risk because the originating loans can be paid back in dollars (unlike the Japanese carry trade, where the loans had to be paid back in Yen).

The Connection to Stock Market Bull-Creep

I think this is happening, and I think that the phenomenon, in addition to funding much of the foreclosure real estate sold through auctions, is creating a steady demand flow for U.S. stocks and is contributing to the current bull-creep. (I do not believe that this is the only reason for the bull-creep).

But am I right? Is this happening? If so the evidence is all indirect and not very compelling. I admit that. For one thing the Bank of China is not very opaque. Their public data are not very good and I don’t believe all of it.

But I will continue to investigate this and will relay what I discover.

Do any of you agree with me? Have you seen any evidence of this? For those of you with China connections, do you know of any specific transactions that fit the scenario described above? If so I would sure like to hear about it, either in comments or by email.

(Not) Picking Peaks and Troughs

Today (Wednessday, September 2, 2009), I completed the rebalance of three of the four portfolios that I manage, as I said I would do in my last blog. I decided to complete this before Labor Day because I did not want to go into a three-day weekend without this task completed.

I am now approximately 30/70 equities/treasuries in these three portfolios (the fourth portfolio is a smaller spec portfolio that I am starting to churn a lot).

It was very pleasing to lock in the capital gains that I have picked up in the last six months.

I still think the market will soften now for reasons stated in my last blog and I haven’t changed my mind about any of that.

But it doesn’t really matter to me.

Good swing investors know that they can’t precisely pick peaks and troughs (no one can do that). You have to be content to be in what I have called in lectures “fuzzy vicinities.” Somewhere down near the river when you buy, at least in the foothills when you sell. You don’t have to be at the base of the falls when you buy nor tip-toeing on the peak when you sell. Such vanity if you think you can do this.

In fact, turning point anxiety screws up immature and inexperienced traders, even of they really have a flair for market conditions. How many times have I seen young traders take a 40% short-term gain then, rather than celebrate such sterling performance, grieve over the fact that the stock continues to rise. The lamentations are endless and vexing: “I could have made 50%! 60!” Then they buy back in and you know the rest.

When this happens I always say, “Are you so vain that, for a stock that has been rising for months, you think that you can pick the turning point to the day?? Because if you don’t think you are that good because you know no one is that good, then logically the stock will continue to rise for awhile after you have sold it, so just live with it!”

The reason is essentially the same if you sell a stock after it has peaked and has come down. If you end up netting 40%, of what relevance is it that, had you sold it on the day it peaked (because you are such a mastermind that you knew it was the peak?!?) you would have netted 45%?

That kind of thinking is the sign of an muddle-headed immature trader.

Why do you think it is called uncertainty?

Selling stocks at DJIA 9780.

If and when the DJIA hits 9780 I am going to start selling equities on a fairly large scale. If the DJIA does not hit 9780 by September 6, I will sell equities anyway.

My current portfolio composition is 60% equities and 40% fixed income. I plan to rebalance to about 30% equities and 70% fixed income.

Am I predicting a turning point at 9780, or an end to the summer rally?

Not really. I do think the market will fall back quite a bit sometime in the fall, but it is difficult to pick market turning points and I am not all that confident about that forecast.

Instead, feeling that the market has had quite a run and because I rebalanced into equities in November of 2008 (below 8000) and March 2009 (below 7000) I am locking in profits, which are considerable, from those purchases. (Most of the funds involved are in retirement accounts, so there are no tax consequences).

I really don’t care if there is a turning point. If I am wrong and there is no decline, my 30% equity stake will still allow modest gains. If I am right and there is a decline, my 70% stake in fixed income will allow me to rebalance right back into equities after the decline.

Meanwhile I’ll sleep better with a 30/70 portfolio.

The fixed income part of my portfolio currently consists entirely of U.S. Treasury mutual funds, including some TIPs and money market bills, but includes nothing with a maturity of greater than 5 five years (except for the TIPs). I do think interest rates will rise and might rise sharply and with little warning, which would provoke sizeable capital losses in longer-term Treasuries.

I think the market will turn down for a lot of reasons:

1. The earnings growth implied by the recent market rally are simply not there and won’t be there any time soon. Although businesses have succeeded at cutting costs, stabilizing their earnings somewhat, consumer demand will be tepid for years to come. It’s partly the wealth effect – consumer perceptions of their own wealth has plunged because of the destruction of home equity and investment account values. High levels of debt continue to be a problem. A very high percentage of U.S. households are in serious financial trouble. Job losses continue and employment will not stabilize for months.

2. Rallys from large market drops usually have setbacks at some point. For example, in the dot com crash, between January 14, 2000 and September 20, 2001 (an interval that included the 911 attacks), the DJIA declined from 11,723 to 8,236 (see the graph). Then there was a strong rally until the next March 12, a period of about six months, that lifted the DJIA 30% to 10,633. Then the real collapse happened, pulling the market down over the next nine months to its low of 7,423. History doesn’t always repeat itself, but for larger cycles, most of the early recoveries have relapses.

3. I have warned in my classes that the kind of volatility that we have witnessed in commodities, and not just oil, will be ubiquitous in all financial markets for years to come. It is easier than ever to speculate (witness the explosion of ETFs and ETNs including leveraged shorts and commodity ETFs and ETNs) and there is much more of it, and traders these days are myopic, fickle and suffer sentiment swings with a single Reuter’s release. High volatility implies momentum moves in both market directions, up and down.

So why 9780? It is not a magic number or a precise forecast. I simply must have a cardinal strategy to force myself to make a planned move. Otherwise I procrastinate or use the excuse of uncertainty to not take action. If 9780 gets here I’m selling, no matter what the immediate news or moment of excitement.

After all. I bought most of this stock when the DJIA was in the high sixes to high sevens, using a strategy in two steps exactly like this. So I will be taking nice profits and that is sufficient for me.

Will the Asset Purchase Plan (the Bailout) Work?

The Paulson Asset Purchase Program is a done deal. It’s final form will likely be approved on Thursday, September 25, 2008, the final day of this session of Congress. Some details of the plan must be negotiated, and Congress is generating a lot of heat because their constituents are furious, but an acceptance of the core plan is an absolute certainty.

The events leading up to the crisis that made this program necessary are described in the post below this so will not be repeated here.

Whether this plan will work, or the degree to which it will work effectively, is still subject to question and will continue to be long after the law is passed.

The plan will certainly avert a near-term continuation of the grave credit liquidity crisis that occurred last week, and that by itself is a strong positive. That crisis was as serious as is being described to Congress yesterday and today in hearings on this bill. A destructive global financial collapse was imminent on Wednesday of last week..

As the details of the plan are being debated in Congress, one serious tradeoff with both political and economic dimensions has emerged and is driving the debate on the final configuration of the plan.

The two parties in the tradeoff are the banks and other financial institutions who now own the bad debt versus taxpayers. These financial institutions will hereafter be called “banks,” but keep in mind that commercial banks in the United States hold only about $2 trillion worth of the approximately $10 trillions of U.S. mortgages outstanding. The rest is held by Fannie Mae and Freddie Mac, investment banks, foreign banks, and other players who are not commercial banks.

As will be explained below the outcome of the tradeoff will be set by a single, simple array of variables – the prices set for the assets that will be purchased by the government because of this plan. That same issue, pricing, will also determine the long-run effectiveness of this program and, to some extent, the probability of the crisis revisiting in another form in the future.

The Political Dimensions of this Plan

The timing of the crisis and hence the articulation of this plan is unfortunate. This has emerged just six weeks before a presidential election and only a few days before  Congress is scheduled to adjourn (they don’t convene again until January, 2009). The Congressmen who are shaping this plan in cooperation with Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson are gravely concerned about the outrage that they are hearing from their constituencies. All members of The House are standing for election as are one-third of the Senators. They know that if the final version of the plan is perceived as an expensive taxpayer bailout of recklessly irresponsible banks, including foreign banks, the political cost will be high.

This political reality is clearly influencing the emerging details of this plan. Various attachments are being added to the plan, such as a vaguely defined component that promises to “help” homeowners with these troubled mortgages and a punitive provision that limits severance packages (“golden parachutes”) for fired bank executives.

Congress will almost certainly insist that the purchase plan be rolled out in installments over time, providing more interim oversight.

These secondary issues will not be addressed in this post.

More important, as be seen yesterday and today on the televised hearings on this bill, this political reality is firmly impacting the allowable methods for pricing the troubled assets that are purchased by the new federal agency. 

As will be shown below, whether this turns out to be an expensive taxpayer-funded bailout of this banks will be determined almost entirely by the prices set for the purchased assets.

The Essential Features of the Asset Purchase Program

The new law will authorize the creation of a chartered federal (government-owned) corporation similar to the Resolution Trust Corporation created during the Savings and Loan Bailout. For the sake of reference this corporation will be called the Asset Purchase Corporation (APC).

The APC will be given the right to directly or indirectly (through the U.S. Treasury) issue up to $700 billion of debt instruments, which will almost certainly be a mix of bills, notes, and bonds similar in maturity to those issued by the U.S. Treasury presently. It is possible that the U.S. Treasury will sell a mix of conventional Treasury bills, notes and bonds and release the proceeds to the APC.

The APC will then use the proceeds to buy the Collaterized Mortgage Obligations (CMOs) from the banks who now own them, on a voluntary basis. The CMOs will thereafter be owned by the APC (i.e. the U.S. Government) who will be entitled to all cash principal and interest payments from the active mortgages in the pool, but will also absorb the default loss from the same pool of mortgages. The banks will be permanently rid of these troubled assets and will gain some cash to improve their liquidity. More important, they won’t have to continue the quarterly “mark to market” required by the Sarbanes-Oxley Act of these troubling assets nor will they have to keep drawing heavily from the interbank lending market to continue their operations (the two provisions that provoked this crisis).

From these details is should be apparent that the final cost to taxpayers will be nowhere near the $700 billion funding authorization. The money will be used to acquire assets which have value and promise considerable future cashflow to the APC. The cost to taxpayers (in the form of debt service and debt redemption of course) will largely be determined by (1) the interest costs of the securities issued by the APC and (2) the spread between the cost of buying these assets and the present discounted value of the principal and interest payments of the performing mortgages in the CMO portfolios.

The value of the latter, however, cannot now be determined with any confidence. That value will largely be determined by future mortgage default rates and no one is sure of what those will be,  Statistically it is a random variable with a very wide and changing dispersion. In fact, its dispersion may become a function of the outcome of this bill.

Given this, the cost to taxpayers is indeterminate right now. It could be zero or even slightly profitable (not likely). But no present estimate, unless it has a very wide range, is now credible.

The outcome will also depend on how these CMOs are priced when they are purchased.

Pricing

This crisis emerged largely because banks are now required under the Sarbanes-Oxley Act to declare any reassessment of the value of their assets in their quartely earnings statements. In the jargon of the financial media, they are required to “mark to market” the value of their assets. This writeoff reduces shareholder equity and in the case of commercial banks lowers their capital reserves.

Because default rates are high and rising on the mortgages in the low-quality CMOs owned by these banks, these banks have been required to recalculate again and again the value of their CMO portfolios relative to their original notional value and then make those revaluations public. Not only does this depress stock market values and reduce capital reserves for banks, it also makes it harder for banks to borrow in the interbank lending market and other sources for short-term funds.

When Lehman Brothers failed, part of that failure was due to the fact that they had marked to market their CMOs to only 39% of their value. In effect, that would mean that a CMO originally valued at $10 billion would thereafter be perceived to have a value of less than $4 billion.

Because these markets are now illiquid these marked-to-market values are the closest approximations to the true value of these portfolios. They are what economists call “shadow prices.” But they may be biased prices and they may not accurately reflect the true long-run value of these CMO portfolios.

From this discussion it should be clear that the “price” of any CMO being referred to here is a percentage of the original notional value of the CMO.

To say that the dispute is over pricing of these CMOs, the reference is the percent of original notional value that the APC will pay for the purchase of these assets. Should they pay 40% or 60% or 52%?

Each CMO will have a different price because each CMO has a different risk profile and default history.

That begs the question about how the price should be set. Generally, the lower the price the less the benefit to the bank but the higher the price the higher the likely cost to taxpayers. 

If the CMOs are priced at a level close to the level recently implied by marking them to market, the purchases will not help banks very much, if at all. For one thing they would effectively converted a accounting loss not yet realized (and a loss from which there may be some recovery in the future) into a permanent realized loss. If the bank is crippled at present mark-to-market values, it will remain crippled after the sale if the price is close to that same value.

But if the current mark-to-market value is a reasonably good estimate of the true discounted cashflow value of the CMO, any price above that will entail taxpayer cost, and the higher the price, the higher the cost.

Clearly, the pricing mechanism is a critical component of this asset purchase plan.

Proposals for Auction

Because of the pricing issue, in his testimony before Congress on Tuesday, FRS Chairman Ben Bernanke suggested that some of the assets can be acquired through a reverse auction.

In a reverse auction the selling bank would begin the process by tendering an “offer” to that market. Effectively the bank might say, “We are willing to sell this at a price of 80%.” Ideally that would trigger a bid from an interested buyer at a lower price, like 60%. In a liquid and orderly market offer and bid should converge until a price is settled and the purchase would proceed at that price.

Selling through a Dutch Auction is also a possibly (a procedure too complicated to describe here).

But neither procedure would work for a project of this size undertaken so quickly. Such markets work only if there are a lot of players and there is confidence in the market. Since most banks are precluded from the bid side (if they could buy these they don’t need help) and they would normally be a large part of this market, buyers with adequate capital to participate are restricted to sovereign investment funds and large hedge funds and a handful of large private and corporate buyes. They might dabble but would never shoulder the entire risk. Far more important, the program implies that only the U.S. government would be on the bid side.

Auctions don’t work between two players.

Because of that Bernanke is actually proposing a “trial” or sample market, where this would be done (offered to the private markets) for a small subset of these CMOs, resulting in a shadow price that can be applied to the remainder of the CMOs.

That won’t work either. The liquidity issue still exists for even a small sub-set of auctions. Far more important, if the small auction results in a shadow price that would be applied to later purchases of CMOs, there is a huge incentive for the private players impacted by the pricing to game that auction, even if results in a CMO purchase that is anticipated to produce a loss. For example, if a $1 billion auction is meant to establish a price for a $100 billion CMO purchase, far better that the price be 76% than 52%, even if it produces a $200 million loss on auctioned CMO.

The price issue is therefore completely unresolved.

 

[To be continued, either by amending this post or in new posts].