The Big Picture | Fixed Income/Interest Rates

Inflation Index Bonds Now Paying 0%

Thursday, May 01, 2008 | 05:00 PM

in Fixed Income/Interest Rates | Inflation

Have you noticed what the interest rate TIPs now pay?

How about Zero?

Thanks to a flight to safety, the fixed rate on the newest issue of Series I inflation-indexed savings bonds has for the first time fallen to zero.

Heres' the Treasury Department press release:

I Bond Earnings Rate 4.84%, Fixed Rate 0.00%

The earnings rate for Series I Savings Bonds is a combination of a fixed rate, which applies for the life of the bond, and the semiannual inflation rate. The 4.84% earnings rate for I bonds bought from May through October 2008 will apply for their first six months after issue. The earnings rate combines a 0.00% fixed rate of return with the 4.84% annualized rate of inflation as measured by the Consumer Price Index for all Urban Consumers (CPI-U). The fixed rate applies for the 30-year life of I bonds purchased during this six-month period. The CPI-U increased from 208.490 to 213.528 from September 2007 through March 2008, a six-month increase of 2.42%.

Bloomberg observed:

"Financial market turmoil has caused the fixed rate on the newest issue of Series I inflation-indexed savings bonds to fall to zero for the first time, according to the U.S. Treasury's Bureau of Public Debt. Investors still get a return on the investment as long as consumer prices rise, because the government pays additional interest in lockstep with inflation.

The fixed rate's decline to zero reflects the decline in returns in money markets in the aftermath of the credit collapse, said Kim Treat, a spokesman for the bureau in Washington. The government promotes the savings bonds as "low- risk'' investments for individuals that protects them against inflation.

The so-called earnings rate on the bonds issued between May and October, which is tied to the rate of inflation, is 4.84 percent, the bureau said in a press release. The fixed rate, on top of the compensation for rising consumer prices, is officially 0.00 percent, down from 1.2 percent when the Series I was last issued, in November.

That means investors get no returns on their investments other than compensation for inflation. The fixed rate has never fallen so low since inflation-indexed savings bonds were introduced in the 1990s, Treat said."

All things considered, that's rather astonishing . . .

Sources:
Series EE To Earn 1.40% Fixed Rate, When Bought From May Through October 2008
Treasury Direct, May 1, 2008
http://www.savingsbonds.gov/news/pressroom/pressroom_comeeandi0508.htm

U.S. Offers 0% for First Time on Inflation-Linked Savings Bonds
Vincent Del Giudice
Bloomberg, May 1 2008
http://www.bloomberg.com/apps/news?pid=20601213&sid=adVhzxy3ygcM&

Report on UBS' $37 Billion Writedown

Saturday, April 26, 2008 | 07:06 AM

Kids, we have some fascinating reading in store for you this weekend.

The "conservative" Swiss banking giant UBS -- and I put that in quotes for obvious reasons -- wrote down a previously unimaginable $37 Billion dollars. Their shareholders were (ahem/cough) quite perturbed. So the nice folks at UBS, with an assist from KPMG, put together a 50 page report detailing the hows and whys UBS took such a humungo hit.

For what you would expect to be a dry report, it is absolutely compelling reading. It explains much more than the subprime fiasco. The report implies that management didn't really understand what the hell they were getting into with their purchases of Warburg/Dillon Read Capital Management. This unit eventually became UBS' internal hedge fund (it has since been shut down).

I wonder if management ever truly understands the nuts and bolts of these large acquisitions. We will find out if JPM knew what they were ~~getting into~~ getting the Fed into with the Bear Stearns (BSC) acquisition.

The report includes an indictment of the firm's compensation packages. The current structure -- big salaries and bigger bonuses -- encourages the riskiest and most short term of strategies. Prudence, risk management, and long term thinking were not money makers for employees. When the time came for the company to take its writedowns, many of these bad actors were long since gone. Go on, take the money and run.

You may not be surprised to learn that external consultants were involved and recommended "streamlining of risk processes." I don't know if these unnamed consultants were McKinsey & Co., but the whole description has a faint Enron-like smell to it.

A few other questions arise from the report:

Why do very risky strategies seem to end up in Fixed Income ?

How did Risk Control fail so badly?

Why was there an "Absence of risk management" and "Incomplete risk control methodologies" ?

Who created these compensation system ?

Again, this is just the tip of the iceberg in terms of asking what went wrong.

I wonder if this the inevitable banking equivalent of the Minsky moment. Perhaps these megabanks are simply too big, too unwieldy to be appropriately managed as hedge funds, rather than sleepy conservative banking institutions. The perverse incentives encourage reckless behavior.

Fascinating stuff . . .

Sources:

Shareholder Report on UBS's Write-Downs
18 April 2008
http://www.ubs.com/1/e/investors/agm.html

UBS ShareholderReport.pdf (download)

Related:

A good name sliced, diced and traded
John Gapper
FT, April 24 2008 03:00 | Last updated: April 24 2008 03:00
http://www.ft.com/cms/s/0/51099762-1198-11dd-a93b-0000779fd2ac.html

How UBS came undone
Roderick Boyd
Fortune, APRIL 23, 2008: 4:38 PM
http://money.cnn.com/2008/04/23/news/companies/ubs_deflates.fortune/

Too many risks, too few controls, says UBS report on write-downs
David Gow in Brussels
The Guardian, Tuesday April 22 2008
http://www.guardian.co.uk/business/2008/apr/22/ubs.europeanbanks

Bagehot's Lessons for the Fed

Friday, April 25, 2008 | 09:25 AM

in Credit | Economy | Federal Reserve | Fixed Income/Interest Rates | Inflation

Apropos to our earlier criticism of the US Central Bank is this piece by Stanford prof Ronald McKinnon, titled Bagehot's Lessons for the Fed.

In today's WSJ, McKinnon writes:

"By slashing interest rates too much in 2007-2008, the Fed has accentuated the foreign drain and thus made the alleviation of the domestic drain more difficult. Yet, despite this mistake, Bagehot would approve of other actions the Fed has taken to deal with the domestic drain by unblocking specific impacted domestic markets. These include (1) swapping Treasury bonds for less safe private bonds, (2) opening its discount window to shaky borrowers, and (3) maybe even rescuing Bear Sterns. He would also approve of the relaxation of capital constraints on Fannie Mae, Freddy Mac and so on, for mortgage lending. Yet these measures will be insufficient if the foreign drain continues.

To repeat Bagehot's Rule: "very large (domestic) loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain." The Fed, and the U.S. government more generally, have so far got it only half right."

The entire piece is worth a read . . .

Sources:
Bagehot's Lessons for the Fed
RONALD MCKINNON
WSJ, April 25, 2008
http://online.wsj.com/article/SB120908336730343529.html

Will the Fed Pause After the Next Cut?

Friday, April 25, 2008 | 12:30 AM

in Economy | Federal Reserve | Fixed Income/Interest Rates | Inflation

Greg Ip of the WSJ:

Source:
Fed Weighs Pause After Next Rate Cut
Inflation Worries Loom as Economy Continues to Stall
GREG IP
WSJ, April 24, 2008; Page A1
http://online.wsj.com/article/SB120899756185139975.html

Could the US Lose its Triple AAA Credit Rating?

Tuesday, April 15, 2008 | 12:30 PM

in Credit | Fixed Income/Interest Rates | Politics

That's the issue raised by a S&P report on government-sponsored enterprises (GSEs) -- Fannie Mae (FNM), Freddie Mac (FRE) & Sallie Mae (SLM)

The performance of government-sponsored enterprises like Fannie Mae and Freddie Mac could have a direct impact on the national economy and, more importantly, U.S. credit standing.

So-called GSEs enjoy implicit government guarantees and could cause the U.S. to lose its sterling triple-A rating if the government were forced to come to their rescue, Standard & Poor's said in a report Monday.

"Even though...credit damage from GSEs is unlikely, the greater risk to the U.S. lies with them than with broker-dealers," the report noted. . . . While this credit crunch has hurt financial markets, S&P notes that it hasn't threatened the standing of the nation's credit quality upon which U.S. Treasurys and debt priced off this government debt depend. But should a protracted recession cause Fannie and Freddie to buckle, the U.S. rating would be in danger.

To be blunt, I don't think Standard & Poor has the stones. Their original ratings on RMBS/CDOs shows they are a pay-for-play institution, and their cowardly refusal to downgrade the ~~mono~~ duolines is further proof of their cowardice.

They wouldn't/couldn't downgrade Treasuries, as it would cost the U.S. government so much more in financing costs as to cause a depression -- estimates are for between 1-1.5 trillion dollars.

Source:
Fannie, Freddie Could Hurt U.S. Credit
PRABHA NATARAJAN
April 15, 2008; Page C2
http://online.wsj.com/article/SB120818189112412691.html

S&P Report on Subprime Write-downs

Thursday, March 20, 2008 | 11:30 AM

in Credit | Fixed Income/Interest Rates

While there is plenty of blame to go around in the entire banking debacle, let's not forget who the key enablers were: The rating agencies. Their business model is a modern form of payola, with bond underwriters as customer #9. This allowed them to slap triple AAA ratings on the paper held by firms such as Bear Stearns.

When you consider just what a criminally negligent job they have done in covering nearly everything, from sub-prime infected RMBS to all manner of derivatives, to the duolines themselves, it is really beyond comprehension.

Last week, we heard from S&P, who opined the end was in sight for the sub-prime write downs. Are these guys really the best messenger for this?

(I may have to change the name of this blog to The Big Schandenfreude)

Which leads to this advert, circa 2005. Its a classic:

If anyone can scare up the full report, send it to me @ Yahoo . . .

See also:
States and Cities Start Rebelling on Bond Ratings
JULIE CRESWELL and VIKAS BAJAJ
NYT, March 3, 2008
http://www.nytimes.com/2008/03/03/business/03bond.html

AAA Paper? 92.5% Are Not

Tuesday, March 11, 2008 | 12:41 PM

in Credit | Derivatives | Fixed Income/Interest Rates

That headline is a bit of an exaggeration.

So what is the quality of the collateral willing to be accepted by the new Term Securities Lending Facility (TSLF)? As we noted earlier, much of this paper is junk.

Consider this recent survey of triple A (AAA) paper, at risk of losing their AAA rating in the ABX Indexes, via Bloomberg:

Click thru for interactive chart

Source: Bloomberg

Who Are the Socialists: FOMC vs ECB ?

Thursday, March 06, 2008 | 01:16 PM

in Federal Reserve | Fixed Income/Interest Rates

Today's chart porn is off of the most interesting article I read in today's NYTimes: In Europe, Central Banking Is Different.

Note that Central Banks in Europe left rates unchanged today.

The full article describes how the ECB focuses on reducing inflation. However, there is a laundry list of factors the ECB pretty much ignores:

-Eliminating the normal business cycle;

-Preventing a recession regardless of costs;

-Allowing the currency to be debased.

Further, the ECB doesn't seem to care where their equity markets are.

Two Different Approaches to Central Banking

The entire article is fascinating . . .

Source:
In Europe, Central Banking Is Different
CARTER DOUGHERTY
NYT, March 6, 2008
http://www.nytimes.com/2008/03/06/business/worldbusiness/06euro.html

Declining Home Prices, Rising Mortgage Rates

Wednesday, February 27, 2008 | 06:23 AM

in Credit | Federal Reserve | Fixed Income/Interest Rates | Inflation | Real Estate

courtesy of WSJ

The Fed's effort to bail out the credit crisis and Housing crash has run into an odd problem: Despite cutting rates 225 basis points since September, mortgage rates have actually gone up:

"The Fed's efforts so far to soften the blow of the housing slump with lower interest rates appear to be having a muted effect. Since September, the Fed has reduced its target for short-term interest rates by 2.25 percentage points to 3%. But some mortgage rates are actually rising, and those that are falling haven't fallen that much.

The average interest rate on a standard 30-year fixed-rate mortgage was 6.38% yesterday, little changed from September but up from 5.61% in late January, according to HSH Associates, a mortgage-data publisher in Pompton Plains, N.J. Interest rates on so-called jumbo mortgages -- those larger than $417,000 -- were at 7.35%, also close to their September levels.

Rates on adjustable mortgages have come down, but not by as much as the Fed has cut the rates it influences. A three-year ARM, for instance, carried a 5.43% interest rate yesterday, down from 6.29% in mid-September. Still, lower short-term rates should help millions of homeowners who took out ARMs with low teaser rates that are set to jump higher.

There are two reasons mortgage rates haven't responded more to the Fed's rate cuts. One is that long-term Treasury yields, which are the benchmark for most mortgage rates, have risen recently, perhaps because of increased concern about inflation as the prices of oil and other commodities soar. The other is that the spread between mortgage rates and Treasury rates has widened as investors and banks become increasingly reluctant to make home loans."

We closed on our current home March 2007. 30 year, prime, conforming mortgage. Rate: 6.125%. And, we keep getting refi offers from Chase and Citibank -- for 6.25 - 6.50%. (No thanks!)

Well, the Fed may not have impacted the mortgage arena much, but at least (as forewarned), they have had a significant impact on prices: rampant inflation . . .

UPDATE: February 28, 2008 9:42am

Bank Rate notes:

Bankrate: Fixed Mortgage Rates at 4-Month High

With the Federal Reserve expected to cut interest rates again at their meeting in March, rates for things like adjustable rate mortgages that are tied to short- term benchmarks have been moving lower. But concerns about inflation and continued turmoil in credit markets has pushed long-term interest rates, and especially fixed mortgage rates, higher.

Previously:
Screaming Hot Producer Prices http://bigpicture.typepad.com/comments/2008/02/screaming-hot-p.html
>
Source:
Decline in Home Prices Accelerates
Fed's Efforts Have Only Muted Effect On Mortgage Rates
KELLY EVANS, SERENA NG and RUTH SIMON
WSJ, February 27, 2008; Page A1
http://online.wsj.com/article/SB120403496764693703.html

Quote of the Day: Liquidity Trap

Thursday, February 14, 2008 | 11:30 AM

in Economy | Federal Reserve | Fixed Income/Interest Rates | Real Estate

Is the Fed out of bullets? I wonder:

"When an asset like real estate becomes overvalued, even if you drop interest rates to zero, you can't force consumers to borrow more, because they've already borrowed too much. Nor can you force lenders to lend, because they're already puking on 'bad paper.' It's called a liquidity trap."

-Bob Campbell, San Diego Real Estate Timing
via Fleck

>
Even more proof ? Consider this article, variations of which have been in the media the past few days: Fed Interest-Rate Cuts Fail to Lower Borrowing Costs:

"The Federal Reserve's interest-rate cuts last month have failed to lower borrowing costs for many companies and households, increasing the chance of further reductions from the central bank.

Companies are paying more to borrow now than before the Fed reduced its benchmark rate by 1.25 percentage point over nine days in January, based on data compiled by Merrill Lynch & Co. Rates on so-called jumbo mortgages, those above $417,000, have increased in the past month, making it tougher to sell properties and risking further price declines."

Bill King noted a similar story on ABC News:

"[Monday] night, the lead story on ABC evening news (World News) was ‘though the Fed has cut interest rates sharply in recent weeks, banks and credit card companies are hiking rates on consumers.’

Chase, Bank One and Bank of American were cited. The ABC News reporter said banks are hiking consumer interest rates and fees to cover losses on their crappy paper.

Yes, it’s that blatant and transparent.

>
Lovely. We get all of the wonderful inflationary effects of rate cuts -- but none of the economic benefits.

Can you say "The Fed is pushing on a string?"
(Very good children. I knew you could)

Sources:

Housing mess too big for a quick fix
Bill Fleckenstein
Contrarian Chronicles2/11/2008 12:01 AM ET
http://tinyurl.com/yqabfs

Fed Interest-Rate Cuts Fail to Lower Borrowing Costs
Scott Lanman
Bloomberg, Feb. 13, 2008
http://www.bloomberg.com/apps/news?pid=20601087&sid=a_c9_tQiZOLo&

Housing and Monetary Policy

Thursday, February 14, 2008 | 09:15 AM

in Currency | Federal Reserve | Fixed Income/Interest Rates | Real Estate

Interesting academic work on Housing Prices, Monetary Policy, and Subprime issues from Stanford's John B. Taylor. Incidentally, if you recognize the name Taylor -- as in Taylor rule -- they are one and the same person.

Here's the abstract:

Housing and Monetary Policy

Since the mid-1980s, monetary policy has contributed to a great moderation of the housing cycle by responding more proactively to inflation and thereby reducing the boom bust cycle. However, during the period from 2002 to 2005, the short term interest rate path deviated significantly from what this two decade experience would suggest is appropriate. A counter-factual simulation with a simple model of the housing market shows that this deviation may have been a cause of the boom and bust in housing starts and inflation in the last two years. Moreover, a significant time series correlation between housing price inflation and delinquency rates suggests that the poor credit assessments on subprime mortgages may also have been caused by this deviation.

That's the academic overview. I found Taylor's charts to be quite revealing:

>
For those of you who want to get into the details, Taylor's academic paper (10 pages) is rather readable for an academic work.

Sources:
Housing and Monetary Policy
John B. Taylor
Stanford University, September 2007
http://tinyurl.com/26vznb

Housing and Monetary Policy
John B. Taylor
NBER Working Paper No. 13682
December 2007
JEL No. E22,E43,E52
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1077808

John B. Taylor Home Page
Mary and Robert Raymond Professor of Economics at Stanford University
Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution
http://www.stanford.edu/~johntayl/

Taylor Rules
Athanasios Orphanides
Board of Governors of the Federal Reserve System, January 2007 http://www.federalreserve.gov/Pubs/FEDS/2007/200718/200718pap.pdf

The Taylor Rule and the Transformation of Monetary Policy
Pier Francesco Asso, George A. Kahn, and Robert Leeson
Federal Reserve Bank of Kansas City, Research Division, December 2007
http://www.kansascityfed.org/Publicat/Reswkpap/RWP07-11.htm

Builders: No Soup for You! Come Back One Year!

Wednesday, February 13, 2008 | 12:47 PM

in Fixed Income/Interest Rates | Politics | Real Estate

What is funnier than this, I cannot imagine. My sides ache from reading it. (Dear Lord, please make it stop!)

To wit:

"The lobbying group representing homebuilders is cutting off contributions to federal congressional campaigns, saying lawmakers and the Bush administration have not done enough to stabilize the housing market.

The National Association of Home Builders said Tuesday its political action committee has decided to stop making contributions to candidates for Congress "until further notice."

Since 1990, the trade group has given nearly $20 million to federal candidates, with 35 percent going to Democrats and 65 percent to Republicans, according to the Center for Responsive Politics.

Lawmakers and the Bush administration, "have not adequately addressed the underlying economic issues that would help to stabilize the housing sector and keep the economy moving forward," the trade group's president, Brian Catalde said in a statement. "More needs to be done to jump-start housing and ensure the economy does not fall into a recession."

Gee, weren't these the same folks who were begging for rate cuts in 2001/02? Didn't they keep cheering when Greenie took rates down to 1%?

The builders group must be saying to themselves: How could you have made us build all those homes! What were you thinking?

I guess the concept of personal responsibility has little meaning to lobbyists. . .

Source:
Builders: No More Campaign Contributions
Tuesday February 12, 5:58 pm ET
Homebuilders Lobbying Group Cuts Off Contributions to Federal Congressional Campaigns
http://biz.yahoo.com/ap/080212/homebuilders_campaign.html?.v=2

Quote of the Day: Bill Gross on Monolines

Monday, February 11, 2008 | 12:30 PM

in Credit | Derivatives | Fixed Income/Interest Rates

Bill Gross, in the FT, asks some rather intriguing questions late last week:

"How could Ambac (ABK), through the magic of its triple-A rating, with equity capital of less than $5bn, insure the debt of the state of California, the world’s sixth-largest economy? How could an investor in California’s municipal bonds be comforted by a company that during a potential liquidity crisis might find the capital markets closed to it, versus the nation’s largest state with its obvious ongoing taxing authority?"

- Bill Gross

The alchemy identified by Gross: Wrapping high risk paper in a high risk derivative / insurance contract does not eliminate any of the risk, nor does it make high risk paper investment grade.

This is slowly being realized for what it actually is: Massive fraud on a widespread structural basis.

Source:
Rescuing monolines is not a long-term solution
William Gross
Published: February 7 2008 18:14
http://www.ft.com/cms/s/0/bb7e80c8-d58c-11dc-8b56-0000779fd2ac.html

Global Financial Crises, Part II: Norway 1987

Sunday, February 10, 2008 | 07:33 AM

in Credit | Derivatives | Economy | Federal Reserve | Fixed Income/Interest Rates

Yesterday, we looked at 5 Historical Economic Crises and the USA.

That discussion led to a reader in Norway referring us to this 2005 commentary about the Norwegian Financial Crisis, which began circa 1987. It was the first systemic crisis in a major industrialized country since the 1930s.

As the nearby chart shows, Real Interest rates in Norway were negative from 1980-84. The crisis hit five years later.

In the United States, real interest rates were negative between 2002-03. The crisis hit five years later. (Real Interest rates just flipped negative again in 2008).

The Norwegian banking crisis had several features which will look familiar to any observer considering the present deterioration of the US financial situation. Both can be described as classic boom-bust crises, containing several universal features:

Long Island Financial Iced Tea

• Deregulation and liberalization paved the way for the boom
• Macroeconomic policies were largely pro-cyclical
• Lending growth became exceptionally strong
• Prudential capital regulations were relaxed
• Regulatory/Supervision efforts were reduced

The author notes these five factors was "a deadly cocktail." We seem to have drunk the same heady and dangerous brew here in the US. I call it a Long Island Financial Iced Tea -- five liquors mixed with reckless abandon, invariably producing a pounding hangover.

I suspect where there will be significant differences in the manner of how the two crisises will be resolved. The Norwegian crisis resolution contained five features:

Norwegian Hangover Cure

• Private solutions were explored before the government intervened.
• Share capital was written down to zero before committing public funds.
• The government acted swiftly to limit contagion, but did not provide a blanket guarantee.
• Liquidity support was given to illiquid, but solvent institutions.
• The government did not use an asset management company.

This is a rather intriguing guide to resolving the current sub-prime debacle. Note that the Norwegians avoided any moral hazard, refused to bail out speculators. It will be interesting to see if the US can follow a similar path -- especially with the monoline insurers. Will share capital be written down to zero before committing public funds in firms such as Ambac (ABK), MBIA, FGIC ?

The alternative leads us to a situation where grossly speculative profits remain private, but systemic risk is public. This would be a wholly unsatisfactory conclusion.

Source:
A Norwegian perspective on banking crisis resolution
Kristin Gulbransen
Norges Bank, 16 June 2005
Conference on Banking Crisis Resolution - Theory and Policy, Oslo
http://www.norges-bank.no/Pages/Article____13822.aspx

The Flawed Fed Valuation Model

Tuesday, February 05, 2008 | 07:18 AM

in Data Analysis | Earnings | Fixed Income/Interest Rates | Quantitative | Valuation

There are lots of things that investors believe which I find perplexing. The Superbowl indicator is one, but the oddest to me is the so-called Fed Model, also known as the IBES Valuation Model.

It is not that the Fed model is so terribly wrong -- it has been both right and wrong over the years. Rather, it is the way too many people conceptualize it.

First, the definition of the Fed Model: Yield on the 10-year U.S. Treasury Bonds should be similar to the S&P 500 earnings yield (forward earnings divided by the S&P price). This, in theory, should inform you of when equities are over-priced or under-priced.

Note that the formula contains two variables: While it is commonly described as a way to evaluate when stocks are over- or under- valued, the other variable in the formula above is the forward S&P500 earnings consensus. SPX prices and the 10 year yield are the knowns, but while valuation and forward earnings are the unknowns.

Thus, the Fed model today might be telling you to things: When equities are undervalued -- or when consensus earning estimates are too high.

Let's see how that looks on a chart:
>

graphic courtesy of Hays Advisory (June 2007)

>
Looking at the chart above, we can identify some rather odd periods. The model had stocks extremely undervalued in 1979 -- just before a major 30% selloff. In 1981, stocks were fairly valued on the eve of the greatest bull market in history. From 1982-85, stocks bounced between slightly overvalued to undervalued, according to the model. In 1987, a very timely crash warning. 1998, an extremely early crash warning, missing a huge 2 year run in the indices. In 2001, it had stocks as undervalued -- and they proceeded to get a whole lot cheaper over the next 2 years. Equities have been extremely undervalued ever since.

Now, given that rather inconsistent track record, I find it hard to get too excited about this. But the most damning evidence against the Fed model is the period prior to 1960s. Over that entire, the Fed model had no utility whatsoever. "Out of sample" testing -- looking at a different set of data than the one proffered -- is quite damning to the Fed model.

Which brings us back to today. We continue to see the Fed model used to rationalize a bullish stance in equities. However, given that it is based in large part on analysts consensus for future SPX earnings, investors need to be extremely cautious relying solely on the Fed model. Why? Analysts are unflaggingly inaccurate at turning points. Example: Q3 S&P500 earnings consensus were +8% -- S&P500 earnings came in at -8%. Q4 has been similarly lowered, undercutting the earlier forecasts of undervaluation.

Now let's look at 2008. S&P 500 forward earnings over the next 4 quarters are as follows: Q1 = 3%; Q2 = 4%; Q3 = 20%; Q4 = 50%, according to UBS.

So stocks, so we are confronted with two possibilities. Perhaps, equities are seriously undervalued (that assumes earnings explode in 2H). An alternative explanation, and one I suspect is more likely: Analysts consensus earnings are wildly exuberant for the second half.

One last issue: Let's ignore the analysts, and merely consider mean reversion: As the chart below shows, earnings have been unusually high relative to history. If they merely mean revert, they will come down another 25%. Even worse, most mean reversion blows right past historical averages to opposite extremes.

Graphic courtesy of Vitaliy’s Contrarian Edge, from the book Active Value Investing: Making Money in Range-Bound Markets

The bottom line -- either equities are extremely under-valued, or analyst consensus earnings are significantly too high.

But to treat the Fed model as if it merely looks at valuation is to ignore a key variable -- future earnings consensus -- that tends to be wrong at the worst possible moment . . .

Sources:

Active Value Investing: Making Money in Range-Bound Markets
by Vitaliy N. Katsenelson
Wiley, September 28, 2007

A Profit Fumble -- or Not?
TOM LAURICELLA
WSJ, February 4, 2008; Page C1
http://online.wsj.com/article/SB120208551253339345.html

Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns
CLIFFORD S. ASNESS
AQR Capital Management, December 2002 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=381480

The Fed Model: The Bad, the Worse, and the Ugly
JAVIER ESTRADA
IESE Business School January 2006
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=877245

Solving the Price-Earnings Puzzle
CARL CHIARELLA
University of Technology, Sydney - School of Finance and Economics
SHENHUAI GAO University of Sydney - Economics and Business
April 2002UTS Working Paper No. 116
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=880002

Blog Synthesis: Gunning for the Fed Model? http://www.cxoadvisory.com/blog/internal/blog-fed-model/

Read it here first: CDO Lust Undercut AAA Success

Thursday, January 24, 2008 | 04:00 AM

in Derivatives | Financial Press | Fixed Income/Interest Rates

Last week, we discussed the foolish shift among the monolines from staid Bond insurers to derivative dab blers in Counter-Party Risk.

Now Bloomberg has picked up the same meme:

"Municipal bond insurers such as MBIA Inc. and Ambac Financial Group Inc. had a good thing going.

For years, they earned some of the highest profit margins in any industry -- by writing coverage for securities sold by states and cities to build roads, schools and firehouses. During the past five years, MBIA's average profit margin was 39 percent, more than four times the average of the Standard & Poor's 500 Index, according to data compiled by Bloomberg. Ambac's average profit margin was 48 percent.

The good times are over, and the culprit isn't municipal bonds; it's subprime debt, a market the insurers waded into in pursuit of even greater profits. Some of the biggest bond insurers are facing potential claims that may deplete their capital. Their share prices have plunged, and credit rating companies are scrutinizing their AAA status. Ambac became the first insurer to lose its triple-A rating, when Fitch Ratings downgraded the company to AA on Jan. 18.

The WSJ had a long column on monolines last week (but not on the AAA to CDO/CDS shift). Usually, the MSM is 6 months to a year behind us. This was only 4 days.

That's not too bad. . .

Source:
Ambac, MBIA Lust for CDO Returns Undercut AAA Success
Christine Richard
Bloomberg, Jan. 22 2008
http://www.bloomberg.com/apps/news?pid=20601109&sid=aw1Oh4B0Wvv8&

8 Big Numbers

Friday, January 11, 2008 | 10:00 AM

in Data Analysis | Fixed Income/Interest Rates | Markets | Mathematics

Andrew Burkly of Brown Brothers Harriman & Co puts out a list of significant numbers each January. Its a clever way to think about various aspects of the market and the economy -- by the numbers.

These are his "8 Big Numbers" for 2008.

The S&P 500 Index needs to close above its March 2000 peak of 1552, as well as break its 2007 trading range of 1575 – 1370 to keep the structural bull market intact. An upside break of the range would indicate that the volatile trading of 2007 was merely a high-level consolidation. One indication that the bull market is back in gear would be the number ofcommon stocks hitting net new 52-week highs climbing back into the 500 range.

Domestic equity funds witnessed outflows in 2007 totaling $54 billion suggesting that investor sentiment is far from euphoric. Finally, the average gain during year 4 of the presidential election cycle has been 8.9% since 1928.

Meanwhile in 2008, 3.6% is a key level to watch for the 10-year Treasury yield, the commodity bull market moves into its 6th year, and the S&P 500 Energy Sector looks for its fourth sector performance crown in five years - a winning percentage of .800.

1. “1552” The March 2000 peak in the S&P 500 Index
2. “1575-1370” – The 2007 trading range in the S&P 500
3. “500” The number of stocks hitting net new 52-week highs in a healthy market
4. “-54” Outflows ($billions) from domestic funds in 2007 (through Nov.)
5. “4 2008 is year 4 of the presidential election cycle
6. “3.6%” A significant support level for the 10-year Treasury yield
7. “6” 2008 marks the 6th year of the commodity bull market
8. “.800” Energy going for its fourth sector performance crown in five years

Good stuff. Thanks, Andrew . . .

Wonk Attack: Interest Rate Spreads & LEIs

Thursday, December 20, 2007 | 02:00 PM

in Economy | Fixed Income/Interest Rates

I have previously mentioned Paul Kasriel's work with interest rate spreads and leading economic indicators.

Paul notes that if you don't like the reconfigured LEIs -- and I was critical of the white wash the cheerleaders at the Conference Board did to cover up the inverted yield curve -- you can still derive value from them.

His suggestion: Corroborate the LEI signals by also looking at the negative spread between the yield on the Treasury 10-year security and the federal funds rate (on a four-quarter moving average basis) and a year-over-year contraction in the quarterly average of the CPI-adjusted monetary base.

Let's call these two charts the Kasriel Recession-Warning Indicator:
>

>
The 1966 LEI signal was false, but the Rate Spread should have kept you out of trouble.
>

Regardless, the combo of both of these have flipped negative, suggesting that the economy is slowing down . . .

Source:
Recession Imminent? Both the LEI and the KRWI are Flashing Warning
Paul L. Kasriel
Northern Trust March 22, 2007
http://tinyurl.com/2p2ftr

Real Interest Rates Are Negative

Tuesday, December 18, 2007 | 11:30 AM

in Federal Reserve | Fixed Income/Interest Rates | Inflation

Teresa Lo points out that a small but important factoid about what real yield: we now have Negative Interest Rates.

Real 10-Year T-Note yield since 2005

Subtract the 12-month change in the consumer price index from the month-end CBOE 10-year Treasury Note yield ($TNX).

Reccession Odds: Greenspan 50%, Merrill 100%

Friday, December 14, 2007 | 11:51 AM

in Credit | Economy | Fixed Income/Interest Rates | Media | Real Estate

In an interview this morning with NPR, former Fed Chairman Alan Greenspan said that the odds of a recession are "clearly rising" and are now about 50%.

click for NPR radio broadcast
Earlier on Thursday, CNBC reported that Greenspan raised his view of chances of a U.S. recession to 50%, from 30%:

"Greenspan said it's too soon to say whether a recession is coming, "but the odds are clearly rising."

"We're getting close to stall speed" in economic growth, he said. "And we are far more vulnerable at levels where growth is so slow than we would be otherwise. Indeed ... somebody who has an immune system which is not working very well is subject to all sorts of diseases, and the economy at this level of growth is subject to all sorts of potential shocks."

~~~

The former Fed chair is downright chipper compared with some of the data crunchers over at Merrill Lynch: They look at the simple formula involving the Yield Curve and Corporate Spreads. This correctly forecast the 2001 and 1990-91 recessions.

Based on Merrill's read of these two elements -- and I don't know precisely what they do to generate this chart based on those factors -- they have a much more distraught view of the economy than the Maestro:
>
100% Chance of Showers

Chart courtesy of Merrill Lynch, Gartman Letter

If any one can tell me how this chart gets assembled and massaged, it would be greatly appreciated . . .

Sources:
Greenspan: Recession Odds 'Clearly Rising'
NPR, Morning Edition, December 14, 2007
http://www.npr.org/templates/story/story.php?storyId=17210282

Merrill Lynch Global Research

Greenspan Says Recession Odds Are `Clearly Rising'
Vivien Lou Chen
Bloomberg, Dec. 14 2007
http://www.bloomberg.com/apps/news?pid=20601087&sid=aGyhKOCi4xdU&