Economic Musings

May 16, 2013

JPM CIO swings, hits home run on UK RMBS

The embattled CIO unit at JP Morgan which was rocked hard last year by major losses from the “London Whale” saga hasn’t missed on all of their trades. A close look at their holdings in their $360bil plus available for sale (AFS) portfolio reveals pretty substantial bets on UK & Dutch RMBS.

As of year end 2012, JPM held over $70bil in non-US non-agency MBS bonds. This is a sizable stake in the European structured products markets, something that Reuters reported on earlier last year. “Indeed, the CIO almost single-handedly resuscitated European RMBS market in 2009, buying huge chunks of new issues and providing repo agreements on others. As one fixed-income head said, when selling European structured finance, the JP Morgan CIO was “your first call, your second call, your third call and your fourth call.”>

With the dramatic rally in all spread products, non-agency MBS bonds have been big winners, and JP Morgan looks to have began to trim their position during Q1 2013. Their 10-Q provides confirmation of this on Page 37 noting, “Securities decreased largely due to repositioning of the CIO AFS portfolio, which resulted in lower levels of non-U.S. residential mortgage-backed securities (“MBS”)”. Given the ZIRP environment and pressure on bank NIM’s, activity in the bank’s investment portfolio will continue to play a big role going forward. $684bil or 29% of the bank’s total assets are in cash, AFS securities, or secured financing as of 12/31.

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March 19, 2013

Was a stealth tax in Cyprus the better idea?

The idea that the deposits of the average person in Cyprus (in addition to corporations, and Russian organized crime) could be confiscated via a levy has caused a great deal of fear in the financial markets. For instance, to people in the United States it almost seems unfathomable that you could wake up to have JP Morgan/Wells Fargo/Any Local Bank take 7-10% of your deposits.

Yesterday in the Financial Times, James Mackintosh showed a chart of the deposit rates for both Cypriot and German banks. The difference was easy to see, as deposit rates (less than 1 year) in Cyprus have averaged over 4% for the last three years while German deposit rates have hovered around 1-1.5%. As Mackintosh points out, over a three year horizon, a depositor in Cyprus would have earned roughly 13%, or ~10% over an equivalent German account. This difference, as he points out, is ~10% or nearly the exact amount that was originally proposed as the levy on deposits over 100k euros.

Better Idea?

I’m clearly out of my element to discuss bank specifics in Europe (let alone Cyprus!) but I will carry on anyways. US banks are all assessed fees (I’m simplifying the specifics) for FDIC insurance based on the amount of non-interest bearing deposits. So banks in aggregate pay out fees to “fund” FDIC insurance. Ultimately these costs are borne by the depositors as the bank incurs the cost of the insurance.

Instead of a publicly proposed/mandated tax/levy on deposits in Cypriot banks, could the EU/ECB not have accepted a “payment plan” from these banks? The banks could lower the deposit rates (Let’s say from 4% to 1%) and pay the difference as “ECB tax”. The cost of funds would remain the same for the Cypriot banks (all else equal), while the costs would still be borne by the depositors. This would be more like a “stealth tax” as the depositors would not feel this as much, and theoretically confidence would remain in the system.

Now there are obviously valid arguments to this. Would depositors keep their money in these banks at substantially lower interest rates? Isn’t this the return that is needed to entice depositors? How would you assign the tax rates among banks? I agree that this is no slam dunk, but you wonder if the same end game could have been achieved through lower deposit rates and the banks paying the difference in lieu of the levy. Thoughts? Am I crazy?

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December 3, 2012

Pondering Fixed Income in 2013

I recently had a chance to speak with Loomis Sayles’ Matthew Eagan who is co-manager of the famous Loomis Sayles Bond Fund led by Dan Fuss. We covered a number of topics ranging from the Fed, Europe, High Yield, Hedging Tail Risk, and many others. You won’t want to miss it as he’s a very bright PM. It should be posted Wednesday or Thursday on the CFA’s Inside Investor blog found here.
I was honored to participate in Reuters 2013 Investment Summit last week in New York. In Katya Wachtel’s article titled “Chasing yield, investors favor credit again in 2013” I join in the conversation. Chasing yield is no doubt a continuing theme heading into 2013 as institutional investors far and wide are finding a diminishing set of opportunities available. You are starting to see non-agency MBS become almost “too popular” as every HF is suddenly an expert! Everyone thinks its a great play on a housing recover and an “easy way” to earn 4-6% returns. The low hanging fruit has been picked! Funds such as DoubleLine, Ellington, and Elliot have apparently moved more towards CMBS & CLOs versus incremental non-agency investments.
Heading into next year, I’d have to think that the majority of the run in high yield is over. HY spreads and yields are down 111bps and 131bps respectively. Defaults, which have run under 2% (and likely will next year too) really have no room to improve. At the same time you have very positive factors supporting the market. The boom has caused a flood of refinancings, thus debt maturing in the next few years has been dramatically reduced. HY becomes negatively convex as prices rise, so I anticipate little price appreciation, but rather just the “clipping of coupons” for investors which isn’t a terrible thing.
I’d prefer leveraged loans to HY: According to JPM, high yield absolute yields less leveraged loan yields are at only 57bps as of mid-November. Traditionally this spread is a fair degree higher given that loans are higher in the capital structure. As concern about interest rate risk grows, I think the retail sponsorship of leveraged loans will continue to grow as investors seek floating rate alternatives; and LL’s provide that. This along with growing CLO demand could boost LL’s next year. The average investor can gain exposure to LL’s through various mutual funds or a closed end fund such as $VTA.
UST Rate Explosion Unlikely: Sure UST rates could rise. Or they could fall. My prediction for 2013 is that it’s unlikely we see a dramatic rise in UST yields. Overall, there is still a dramatic lack of risk in the financial system. Everyone’s waiting for the next crisis, and in my opinion, that’s not what bubbles look like. While base money continues to explode through the Fed’s QE programs, broad money supply has been kept in check through a lack of bank lending. More or less, the money multiplier is negative at the margin. I find it unlikely we see a large rise in yields without a strong lending led recovery.
Agency Derivatives: Yes, this sounds like somewhat of an obscure asset class but that’s a good thing. The natural pool of buyers for securities such as IO’s, Inverse IO’s, etc is small and as a result option adjusted spreads are extremely attractive. You really can’t buy these on your own, but you can get exposure through closed end funds such as $DBL and $PDI.
Mortgage REITs: No way I was getting through this post without mentioning mortgage REITs. I mentioned at the Reuters summit that I thought mREITs (particularly pure GSE mREITs) would be poor investments going forward. Leveraging a bond that yields 1.5%-2% (same bonds the Fed is buying via QE) over 8x is not a great business proposition. As the Fed keeps their foot down via QE-infinity, prepayments will continue to accelerate causing margin pressures at the mREITs. At the same time prepayments accelerate, they will be forced to redeploy this cash back into lower yielding bonds. This is a bad formula and dividends will be cut more than investors realize. I can’t tell you when, but you’ll see names like AGNC, NLY and others trade a lot lower next year. If you remember, I was actually a HUGE mREIT bull last year into the first half of 2012. Here was my post on Two Harbors written last July. The massive price appreciation in Agency MBS fueled large gains in mREITs, but I think this party is largely over. MBS prices may tread water, but margins are in trouble and that equals lower dividends and subsequently lower share prices.

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(Notes: 2)

December 3, 2012

Ex-Morningstar Analyst Confirms What We Already Know: Analysis is Lacking

One of my favorite blog pieces that I have written was undoubtedly “Is DBLTX misunderstood? Is the fund victim of faulty analysis & biased research?” No, it wasn’t fun pointing out mistakes made by various individuals. Rather, the enjoyment was found in setting the record clear on an investment management start-up (DoubleLine) that was being unfairly scrutinized by faulty and shallow analysis.

Earlier today a friend forwarded by an article written by a former Morningstar analyst named John Coumarianos who worked at Morningstar for six years. His conclusion was hardly shocking as it lined up nearly exactly with what I had written last December.

Gundlach accuses Morningstar of not understanding his approach to fixed income, and it’s a good bet that Morningstar’s analysts aren’t capable of analyzing a mortgage-backed security to the point of understanding which cash flows are owed to which tranche of a debt security Gundlach might own, what the FICO scores of the underlying borrowers are, what the loan-to-value characteristics of the security or tranch are, etc…Morningstar’s response conveyed by Don Phillips is that it’s “reprehensible” for Gundlach to demand that senior fixed income fund analyst Eric Jacobson be fired for misunderstanding the fund.

There’s an old saying in the bond market: “There are no bad bonds, only bad prices.” That means that some or all of the non-agency mortgages Gundlach owns may be excellent investments purchased at the right price, but it’s not clear that Morningstar knows how to judge the price Gundlach paid versus underlying or intrinsic value of a mortgage-backed security. Certainly Moody’s and S&P couldn’t perform that task adequately prior to the implosion of AAA-rated subprime CDOs. Morningstar, having achieved a largely unblemished reputation for protecting and assisting the individual investor and many advisors who, in turn, serve individual investors, may have to rethink its enterprise if it can’t analyze mutual funds on a security level basis. It’s not as clear that Gundlach’s request is reprehensible as it is that Morningstar is holding itself out as delivering analysis that isn’t worthy of the name.

The team at Morningstar is human, and I am by no means stating that any sort of mistakes are unacceptable. Unfortunately, in the line of business that Morningstar is in, they are perceived to be a trusted source of mutual fund analysis. My analysis from last December clearly showed that Morningstar missed the mark with respect to DoubleLine, and the post from the former Morningstar analyst only appears to confirm this thesis.

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November 8, 2012

The day after Halloween

Halloween was a fun time in our household this year, our four year old was finally old enough to have fun, dress up, and eat a lot of candy! As is probably typical in other offices throughout the country, many of my colleagues brought in leftover Halloween candy and the office collectively made ourselves sick on chocolate.

By the second day the large bowls had largely been picked through and only the least desirable snacks remained. Reese’s Cups & Snickers were long gone. As I stood over the bowl I began to try and convince myself that the remaining “bad snacks” could still be good.

Although it’s a stretch of a comparison, the same type of feeling is now present in the fixed income markets. The low hanging fruit has been picked. Years of income have been pulled forward through rapid capital appreciation. Yields and spreads have come in substantially. We are no longer in the early innings where easy money was made across the credit universe in high yield, non-agency MBS, IG Corps, levered loans, and so on. The relentless buying of Agency MBS has pushed investors into spread products and thus richened almost all areas of the bond market. Smart money has adapted and is now forced to become more selective. A good example is Ellington Financial (run by Mike Vranos) which said the following in their earnings release today:

In the third quarter, the market for non-Agency MBS rallied significantly. As home prices continue to stabilize (and are even trending higher in many regions), and as mortgage default rates continue to decline, investor demand for non-Agency RMBS has continued to increase. Meanwhile, alternatives for higher yielding investments in those other fixed income sectors where investors typically search for higher yields, such as Agency RMBS and investment grade corporate bonds, have become more limited, thereby further increasing the demand for non-Agency MBS. With interest rates currently at historically low levels, many financial institutions (such as pension funds and insurance companies) are finding that they will be unable to fund their long term liabilities without increasing their allocations to higher-yielding asset classes; we believe that this state of affairs will continue to provide support for the non-Agency MBS sector.

Later on Ellington discusses how they became less constructive on non-agency MBS and have found great opportunities within CMBS. Vranos isn’t the only renowned MBS manager to recently take a liking to CMBS. As I discussed in a recent post over at Inside Investing, DoubleLine’s Jeffrey Gundlach has also made a move into CMBS.

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October 23, 2012

“The incredible mispricing of risk”

Earlier this week I published a piece on the CFA Institute’s Inside Investing section titled: Mortgage REITs: Does Doubling the Leverage Make Them a Good Investment? The post was my response to UBS launching an ETN that provides 2x leverage on a basket of already heavily levered mortgage REITs “mREITs”.

In short, I believe it’s a dangerous product as many investors in the underlying REITs have little idea how 10%+ yields are being generated. Moreover, they don’t understand the scenarios that could lead to a significant decline in share prices. To paraphrase the great Howard Marks, “…do not confuse adding leverage to an existing investment with increasing return…if you take a 10% return in a security and lever it up 4x and after financing costs generate 15-20% returns, you haven’t increased your returns, you’ve just increased your leverage and significantly increased your risk, but you’ve also got a 20-25% downside threat”. I think this thinking certainly applies to mortgage REITs today.

A bigger threat is upon us

Last week Annaly Capital’s CEO Wellington Denahan-Norris (who this week replaced the late Michael Farrell who tragically passed away), said some very interesting comments to Bloomberg on the state of the risk markets. After discussing the impact of the Fed buying Agency MBS she said:

“It’s not just at the mortgage REITs where the returns in this market are being put under assault, It’s the general global landscape where you have an incredible mispricing of risk that’s being delivered at the hands of academics at the central banks of the world.”

I could not have said it better myself. I am firmly in the camp that both credit and duration is being dramatically mispriced due to the actions of the Fed. They’ve created a reckless chase for yield that is being driven not so much by greed, but rather by needs based investing. The yield piñata has burst and participants far and wide are scurrying to accumulate what they can across all sectors of the fixed income markets: IG corporates, CMBS, Non-Agency MBS, High Yield, Levered Loans, Munis, and others.

While equity focused investors don’t see the direct impacts of the Fed’s purchases, the spillover is pronounced in fixed income and is causing imbalances far and wide. When I read the article about UBS’ new 2x leverage mREIT product, I couldn’t help but think that we are starting to see signs of these policies backfiring as the chase for yield has reached a more than unhealthy level.

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(Notes: 3)

October 17, 2012

Annaly’s Michael Farrell Downplays the USA’s Currency Sovereignty

If you’re a regular reader of financial journalism (including blogs such as this) you’ve frequently encountered the argument that the United States is in no way comparable to a country like Greece. This argument, which I generally agree with, states that US is a sovereign currency issuer while Greece does not have control over their currency as they are part of an union. Greece can’t just print their way out of a debt crisis unlike a country who controls their own currency like the US.

Tonight I was reading a commentary (a few months old) by Annaly’s CEO Michael Farrell that goes back to the Civil War time frame and makes an interesting argument that fiscal union alone isn’t everything.

Much has been made about the contrast between the fiscal union in the United States and the lack of one in Europe, but recall that in 1861, eleven southern states decided to dissolve their economic and political ties with the United States of America, leaving the Union with twenty members and five border states.

Thus another lesson of the Civil War is that fiscal union alone is no solution if an economy is facing a drastic change in fiscal circumstances and steep growth in debts and deficits. Today the United States has a unique, historical opportunity to lead the world out of the current mess. But it is my concern that our political system is so polarized that we will be unable to seize the moment and capitalize on it for the benefit of all Americans.

Second Quarter 2012: Fiscal Union, Civil War

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(Notes: 2)

October 8, 2012

Will bonds be “burnt to a crisp”?

That was the question that Bill Gross asked in his latest monthly outlook. For now that’s likely much more of a fear tactic, but as investors we must always understand the risk/return characteristics of our investments.

In my latest for the CFA, I perform some very elementary bond math on the 10yr treasury showing the risk/return for various movements in interest rates. I then look at the holdings of the barclays aggregate index, which many bond funds are based upon, to give investors an idea of what they may be holding.

It’s getting tougher and tougher now to be invested in the fixed income markets. Previously attractive risk/return asset classes such as non-agency MBS, high yield and others do not have nearly the “margin of safety” they had even nine months ago. Central bank balance sheet expansion has changed the economics of the fixed income markets. Everything has rallied and we need to constantly re-assess the attractiveness of such investments.

The premise of his article is that the United States needs to get its fiscal house in order or else the Fed will be stuck printing money to pay the debt deficiencies. Strangely, Gross asserts that the United States will resemble Greece if deficits are not conquered.

That is nonsense because the United States is a currency issuer and can never run out of dollars. Greece, in contrast, is a currency user and cannot issue euros at will. But in any case, investors are coming to the conclusion that economic problems cannot be solved by monetary policy alone. In this, Gross is correct; the United States’ and other countries’ decisions on fiscal policy will be the key determinants of future economic performance.

I am thoroughly convinced that, in the interim, fixed-income asset prices will be largely driven by central bank policy. My earlier post on QE went through the mechanics of QE3 and how it has affected various fixed-income classes. Understanding the capital flows caused by the Fed’s balance sheet expansion is important but not essential to understanding the full fixed-income universe.

Fixed-Income Strategy: Are Bonds Poised to Be “Burnt to a Crisp”?

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September 18, 2012

The QE Aftermath: What it Means and How it’s (not) Different

The latest in my recent posts for the CFA Institute. I think overall I am more bullish on the actual economic impact that QE has had via the refinancing channel (it’s very material), but maybe more skeptical on how perilous of a hole the Fed is digging itself into by buying so much of the Agency MBS market. I obviously think the ramifications and understanding of QE are crucial in the day and age in which we live. I’ll post an excerpt below and read the full version on the CFA’s website. Thanks!

ther risky asset classes as the prices of these bonds rise (yields fall). To put the purchases in perspective, it’s important to understand the monthly production of agency MBS.

At the moment, about $125 billion of agency MBS (mortgages backed by Fannie Mae and Freddie Mac) are produced each month. Through Operation Twist and the reinvestment of previous rounds of QE, the Fed is already purchasing ~$30 billion of bonds per month.

Add in the $40 billion per month that was just announced for the third round of QE (QE3), and the Fed is purchasing ~$70 billion of the ~$125 billion that is produced each month. Purchasing nearly 60% of the gross issuance of MBS obviously has a major impact on the market and forces investors into other asset classes.

The data support the clear benefits that QE has had and will continue to have in certain segments of the economy. Nevertheless, unemployment is persistently high, inflation is relatively tame, and wage growth is anemic. How much will this iteration of QE really be different from QE rounds in the past?

Nomura’s Richard Koo, creator of the balance sheet recession theory, pointed out that monetary policy has lost its effectiveness when the private sector is deleveraging (or minimizing debt), despite near zero interest rates. More and more signs of this deleveraging are appearing in the U.S. economy. While major corporations shrewdly lock in long-term debt at record low rates, average Americans are reducing their mortgage terms. Instead of cutting their term in half and keeping the same monthly payment, they could be investing and spending the savings. Although I’m not saying people should be doing this, the psychology of decision making in the United States promotes deleveraging in many respects.

The QE Aftermath: What it Means and How it’s (not) Different

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August 27, 2012

Non-Directional Fixed Income Strategies

The below article is my third contribution for the CFA Institute’s new Inside Investing blog. They are making a strong entry into the blog world, and I’m more than happy to write for such a respectable organization. In the coming weeks I plan to dig into the various funds that I discuss below in greater detail including specific bond holdings.

Despite historically low interest rates and the risk of future rate increases, there are ways to make money in the fixed-income market.

Many investors today wonder whether the “ship has sailed” on investing in bonds. Apart from missing the rally, a number of prominent investors have been vocal about their decision to be short U.S. Treasuries over the last few years. These bond bears are quick to point out that the asset class is in a 30-year bull market and that absolute rate levels leave little room to fall.

The objective here is not to point out short-term market fluctuations but, rather, to highlight the typical fears that reluctant bond investors face. It is not practical to time or predict interest rate movements, but it’s helpful for investors to understand that the success of various fixed income strategies isn’t necessarily predicated on continued falling rates.

A handful of actively managed bond funds have shown significant relative outperformance in the face of a multitude of interest rate outcomes. Certain strategies and combinations of assets can perform well without needing rates to fall further.