Steepening curve - the only logical outcome

Gradually but surely, the US treasury curve continues to steepen. In this environment it's simply inevitable. With the unemployment rate approaching a post Great Depression record, political pressure to keep pumping stimulus will be enormous.




The two ways to finance stimulus spending is via tax increases or by running government deficits. Tax increases however (including state taxes) will exacerbate unemployment further, forcing more budget deficits. The debt supply at the longer end of the curve will continue to grow as the Treasury tries to term out the massive short-term financing they are currently running.




At this stage this steepening seems to be the only logical outcome.

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Risk management wisdom from the math department

Want to learn about the future of risk management? NYU is on top of it - they know risk management is all about mathematics. They are offering a seminar called "Conference on the Future of Risk Management" organized by "The Mathematics in Finance Workshop" and the Courant Institute (the NYU math department).



But wait. The math department? Wasn't the reliance on mathematical models sometimes with little relevance to reality what got us here in the first place? Doesn't matter. NYU is just trying to recruit 2010 applicants for their mathematical finance program (applications have been down for some reason).

So who are the speakers/panelists for the program? Well, here is the list:

Ken Abbott, Morgan Stanley
Steve Allen, Courant Institute
Richard Bookstaber
Aaron Brown, AQR
Christine Cumming, New York Fed
Robert Engle, NYU Stern Business School
Petter Kolm, Courant Institute
William Morokoff, Standard & Poor's
Brian Peters, New York Fed
Lesley Rahl, Capital Market Risk Advisors
Matthew Richardson, NYU Stern Business School
Marc Saidenberg, New York Fed
Anurag Saksena, Freddie Mac
Til Schuermann, New York Fed

This list looks about the same as it did in 2007 for similar conferences. Many of these folks were in senior positions in the last few years. These positions had given them tremendous visibility into the madness that some areas of structured finance had become prior to the crisis. But they went on their speaking circuits, wrote their books, did their consulting work, and developed their VAR models. None of them had been vocal about the rising leverage, the ratings arbitrage and conflicts, the regulatory capital arbitrage, the loose monetary policy, and the mispricing of risk. And now they are here to teach people about risk management? The lesson one will learn from these folks is simple: stick with the status quo, don't rock the boat, "reinvent" yourself after the crisis, and watch your career take off - setting you up for another crisis.

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Sponsors' pain rankings

The chart below from Moody's takes a sober look at the performance of the largest LBO firms. It presents the percentages of LBO deals by sponsor that are either distressed or have defaulted. Cerberus with investments such as Chrysler and IAP Worldwide (IAP provides support services, particularly for the US government/military) seems to have 2/3 of it's LBO deals go bad. Apollo (with deals like Hexion, Berry Plastics, Linens 'N Things, and Harrah's) is not too far behind. KKR on the other hand has done quite well. The group of sponsors as a whole is at 40% (distressed and defaulted). Got to love all that leverage.





Moody's points out that on average LBO default rates are no higher than other corporations - except for the largest deals. Hence the result.

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Colleges struggle with "net tuition" revenue

If you are paying for a private college in the US, you know how painful it is to write that check (often over $20k) every semester. The chart below shows the maddening pace of tuition growth relative to inflation or even healthcare. CPI becomes meaningless for those who plan to put several kids through private colleges.


source: Wikipedia

Private college tuition went up again this year by 4.4% (College Board survey) - way above the CPI growth. So these schools must be rolling in cash, right? Apparently not. The number that colleges focus on is the "net tuition" - tuition revenue after scholarships and financial aid. Net tuition has been growing much slower than the "headline" tuition number (as the full payers subsidize those who can't pay) and is now on the decline. This is particularly the case for the less competitive schools in small towns and rural areas.

Moody's: We recently surveyed rated higher education institutions and found that a far larger proportion of private colleges are experiencing price resistance. These institutions tend to have limited financial resources and less ability to withstand a drop in revenues. The risk of rating downgrades is likely to remain elevated for this segment. Our survey focused on net tuition revenue projections for fiscal 2010, generally ending June 2010. Nearly 30% of private college respondents project a decline in total net tuition revenue, compared with just 9% in the prior year.

Historical and projected net tuition revenue - % of colleges expecting declines:


source: Moody's

The good news for those who can pay the full tuition is that private college admissions may become less competitive over time as colleges struggle to improve the "net tuition" revenue. We may also see more "consolidation" (to the extent such a thing is possible) among colleges (such as Barnard and Columbia as well as other schools in the 80s).

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Only the strongest survive (and thrive) in the CP markets

Money market funds continue to struggle to put cash to work , searching for product that would comply with pending new regulation, yet provide returns that are above treasury bills. The returns on money market funds continue to be pathetic - about 15-25 basis points annualized.

The better rated banking firms have taken notice of this demand. They now have a choice of funding themselves by borrowing from other banks or via the CP market. (Neither was really available on anything but the overnight basis in the second half of 08).


With the 3 month LIBOR hovering above 25 bp, CP funding is cheaper for banks that can get AA rating on the paper (see the CP yield curve below).





And banks are indeed taking advantage of it, issuing CP and selling it to guys like the Fidelity MM fund. That gives the larger/stronger banks a real advantage over the smaller ones. Community banks have to pay depositors 60 bp on checking accounts and over 105 bp on money market acccounts - and that's their key source of funds. The larger banks can fund themselves with CP at 20 bp. That's a significant competitive advantage.

The new issuance of CP has caused the amount of financials-issued commercial paper outstanding to spike,



source: FRB



driving up the overall CP notional.



source: Bloomberg


This new supply is easily absorbed by money market funds. The CP market has simply bifurcated into those who have the credit quality to issue paper and those who don't - there's little in between. With new regulation, money markets won't be able to buy much "tier-2" CP and there aren't other buyers out there. You are either "tier-1" or you are basically out of the market (some stronger "tier-2" can still place paper, but in limited amounts - maybe 5% of the total). For a while the Fed was buying CP via the CPFF program, but that's winding down:



source: FRB


The survivors in the CP market are some of the strongest institutions or institutionally sponsored ABCP programs. Everyone else has to look for other sources of funds.

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The bipolar nature of inflation expectations

Back in July we've discussed the tremendous uncertainty surrounding longer-term inflation expectations for the US. This is not an academic exercise. Getting it wrong could swing the US economy into a deflationary spiral (similar to Japan) at one extreme or a hyperinflationary environment on the other.

The chart below from the San Francisco Fed shows just how divergent the economists' expectations have become.





What's unprecedented about this divergence in inflation outlook is that it also shows up in the market. The following chart shows weekly prices for GLD (a gold ETF) and IEF (iShares medium term treasuries ETF) for the last few months. A rally in gold in a normal market should correspond to declines in treasuries. But here we see stability in the treasury market in the face of rising gold prices.





This is an indication of an almost bipolar market that is betting on price stability (even deflation) from credit contraction and continuing unemployment on one hand and accelerating inflation on the other. It's hard to see both occurring, simply because slow economic growth (or further contraction) in the US can not sustain significant price appreciation due to weak demand. Over time something has to give - either commodities have to sell off or longer term rates have to come up.

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Did "hedge everything" policy push Goldman into a bad deal?

Ed Grebeck, CEO of Tempus Advisors had an interesting story to share that may be pertinent to the recent Sober Look post on the Goldman - Buffett transaction:

1999: gold price declining and volatile. GS approached me [Employers Re., a subsidiary of GE capital] with a transaction to hedge their exposure to 3 gold mines [These firms had sold gold forward to Goldman to hedge their gold production]: Ashanti [Ghana; largely owned by Anglo-American], one in Indonesia [previously part of OK Tedi Gold/copper mine] and another in Southeast Asia that escapes my memory. One of the three was fringe BBB/BB. Other two were solid B. These firms also had significant "emerging market" credit issues all around, and CDS in such markets would've cost mega bps.

Trying to address the counterparty risk on the forward contracts, GS came up with a solution: number crunch "joint probability of default" into synthetic (structured finance) tranche exposure. "We want you to sell protection on MEZZ TRANCHE... which as you can see from our painstakingly researched model is... solid BBB"... our pricing is "standard for BBB, plus [small, almost infinitesimal] premium".

Goldman wanted to buy protection on these firms, but to make it cheaper, wanted protection for losses above a certain level on the portfolio of the three names (a mezz tranche CDS). And they were pricing it based on where standard BBB levels were at the time.

Ed Grebeck continues:

No serious mention of "liquidity... hedging ourselves"... other than "we [GS] don't mind if you reinsure yourself ... of course, we can help YOU hedge in cap mkts".

I rejected outright -- but I'm sure other P&C Re "convergence operations"... AIGFP (as well as other competitive silos within AIG), Swiss Re, Munich Re, names not in business today-- ACEFS, St. Paul Re, Gerling Global, Centre etc etc ... jumped at chance to "write premium for GS".

IF GS risk management went berserk 1999 over relatively small counterparty exposure to physical gold producers, imagine what they must have thought in the summer of 2008, when they saw HUGE, UNCOLLATERALIZED exposure on 10 year + S&P index to Berkshire Hathaway

The conclusion here is that with Goldman's focus on hedging all their exposures (based on internal policies), they must have been desperate to get some money out of Buffett to reduce their rapidly rising Berkshire risk (as the puts went deep into the money). It is therefore likely that Buffett was able to pressure Goldman into a transaction that was significantly skewed in his favor - not just because Goldman needed additional equity capital, but because they had to reduce their Berkshire exposure. This in fact provides additional support to a theory that Buffett took Goldman for a ride using his money losing short put positions as negotiating leverage.

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Foreclosures and the unemployment rate maps

This may be "intuitively obvious", but it's worth looking at these two maps next to each other.

Map of home foreclosures:

source: realtytrac


Map of the unemployment rate by state:


source: the Fed

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