Jun

13

VN1) It had always seemed to me that the big differential between the rate of interest on the high yield debt, leverage buyout loans and mortgages and the treasury bond rate was a silver lining to make all the assets owned by the banks quite profitable even in a recession. Say they were earning 10% nominal on those assets with a 10% default rate of 10%. That was still 9% , and much more than the 3% available on treasuries or the fed funds rate they needed to borrow at. But now, the treasury rate is creeping up to 5% , and the differential doesn't look that attractive.

I always look at simple things like that.

My favorite mantra for fixed income has been that when the Fed makes tightening noises, this is very bullish because it keeps the long term inflation rate down.

I believe that's worked for 30 years or so, but now the interaction with the staggering amounts of leverage on the banks balance sheets adds an additional layer of complexity.

still with stocks reeling again, no way can the Fed raise interest rates as this would precipitate more problems in the differential that would truly create a lack of profitability on the income side as well as a weak balance sheet.

One realizes this is simplistic reasoning and would appreciate feedback on how predictions and tests and profits might be considered.

2) When in the merger bus in the 70's , we ran into buyers saying all the time " Why should I pay more than book for a company like this as it cant earn a return on its assets any better than average, and its activities could be duplicated. Much now seems to be clear about the brokerages and related financial institutions . Its clear that the relatively high rates of return on equity that they made, were because of high leverage and there was a corresponding low return on assets. Now that the assets have to be reduced, one is left with a ratchet brining both the bas assets and the return figure down. The Wall Street Journal in an article on Lehman says. " until Leh can prove that it has a future and find a way to regain lost investor trust, there is no reason to see why the shares should tradve above ( adjusted discounted book). Or why a potential buyer if the firm decides it can't survive on its own should pay much more ".

That's exactly what the potential buyers of companies in industries that were selling below book in the 70's used to tell me. The situation exacerbated by higher interest rates, so interest rates must go down considerably so that the problem is solved.

One realizes that the stable door is being locked late here, and that's why I concentrate on the interest rate prediction. The stock market vigilantes must show the world that interest rates must come down soon. 

John Floyd adds:

I was recently invited to speak to the ECB in Frankfurt. Below are some of the key questions I raised for them as they address the challenges going forward. I also gave them an investment example from 2001 which I thought was fitting given the similarities are remarkable with the current situation, oil/food have been substituted for mad cows. Given the singularity of their mandate and the fixed system they operate in I think the challenges are formidable. Milton Friedman does a much better job than me at recognizing this, and for anyone interested I suggest you take a look at his writings on the topic.

What is striking about much of the central bank rhetoric and action over the past year or so, particularly the Fed, is the extreme swings in the views, incorrectly in many cases. Along with that the investment houses have been wagged by the prices in changing their views, i.e. the changes yesterday by some banks for Fed tightening shortly.

Given the dynamics of what is happening on the banks, credit, and real economy it seems unlikely the central banks will tighten to the extent priced by the markets (+100bp by the Fed in the next 6-8 months, etc.). As the ECB has done in recent days expect some backtracking from the Fed, especially if the USD and oil calm down a bit.

Some more quantitative testing of these ideas and the resultant trading opportunities is probably warranted.

Some Key Issues Presented to ECB last week

Macro Economic Picture How does the European economy withstand the multiple external shocks that it is being exposed to? For example, the large appreciation of the Euro, substantially higher oil and food prices, credit problems facing European banks, and a significantly weaker United States economy.

The challenge of the Euro area is that some countries need higher rates to slow inflation (France and Germany) while others might need lower rates to offset the effect of housing slowdowns (Ireland and Spain). How is the circle squared? What are the prospects of expanding the Euro area to new members?

FX Is there a competitive problem with a strong EUR, especially versus CNY? What are the chances of intervention and what would the outcome be?

Inflation Primary attention is given to keeping inflation below 2% target. Does a slower European economy bring inflation down from 3.5% to target? What sort of gap is needed between the product and labor market to achieve the goal?

Credit How does the credit crises affect European Banks? And how might it impact lending behavior? How large are the losses and why does the pace of recognition seem to be slower than in the US?

Lending Window Are there limits to the lending to banks in places like Spain with real problems because of declining housing and foreign borrowing?

2001 rate trade

In Q1 of 2001 the prevailing market view was that the ECB would continue to tighten monetary policy given inflation above the 2% target. One of the great concerns of the ECB was that wage pressure would intensify over the course of the year, thereby placing upward pressure on prices. The ECB was concerned that with unemployment around the level estimated to be full employment (8.3%) above trend growth (estimated at 2.5%) would lead to accelerating wages. In contrast, it was the fund's view that the most likely outcome would be below trend growth, and the increase in inflation was largely attributable to sharp increases in food and energy prices. Regarding growth, the reasons it was expected to lag were two-fold: first, the slowdown in the U.S. would be greater than commonly expected and exert a negative force on Europe, and second, surveys indicated that consumer and business confidence were falling across Europe suggesting a sharp deceleration in domestic activity. For example, the expectation sub-component of the IFO survey pointed to sub 1% growth over the year beginning in the fourth quarter of 2001. Importantly, growth in this range would cause the unemployment rate to rise above the full employment level, with the consequence that wages would withdraw, not add, to inflationary pressure. As this outcome became apparent, the ECB would become more confident that inflation would fall below target and ease monetary policy. In terms of inflation it was believed that food prices were event driven, due to foot and mouth disease, they were not part of an inflationary process. Energy prices were expected to go lower as global economic weakness would exert downward pressure on prices throughout the year.


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