Free Lunch

In a conversation today about the auction rate market, a friend (who I'll refer to as The Economics Babe) made the observation that people really never seem to learn that there is no such thing as a free lunch. The auction rate market was full of free lunches as long as they lasted. Now that lunch carries a cost which The Economics Babe and I agree will be borne by all the parties involved.

The auction rate market looked like a good deal for everyone involved but especially the broker-dealers. This was not a true market. The broker-dealers who acted as underwriters were allowed to operate with little disclosure (via Bloomberg):

Regulators, who allowed the manipulation of bids and lack of information to persist even after two probes in the past 15 years, are now watching a $342 billion market evaporate at the expense of taxpayers.

Inadequate disclosure ``may have masked the impact of broker-dealer bidding on rates and liquidity,'' Martha Haines, head of the Securities and Exchange Commission's municipal office, said in an interview. ``The large numbers of recent auction failures, which are reported to have occurred due to a reduction in bidding by broker-dealers, appears to indicate those concerns were well founded.'' ....Along the way, New York-based Lehman Brothers Holdings Inc. was fined $850,000 in 1995 by the SEC for manipulating auctions conducted for American Express. Almost two years ago, 15 securities firms paid the SEC $13 million to settle claims of bid-rigging in auction-rate bonds. The banks neither admitted nor denied wrongdoing.

As usual, the brokers are the ones who benefited the most. The underwriters told issuers they could have a free lunch - long term bonds issued at the short term rate. Then they made sure they continued to collect those underwriting fees by propping up the market when there weren't enough bidders. Then they told individual registered reps they could have a free lunch too. If they sold auction rates as a money market alternative, they could get paid on cash balances that would have paid them next to nothing sitting in money market funds. Finally, clients were told they could have a free lunch by getting a higher rate than a money market with only slightly less liquidity.

In the end, all parties get what they deserve because of their greed. The underwriters will lose a steady source of income. The broker-dealers will get formal complaints when clients can't access money they need for other purposes. Brokers will be further penalized, probably by the SEC, for not properly explaining the risks of this "market". The clients will pay when they have to borrow to fund obligations for which the auction rate money was intended. The issuers (and taxpayers in some cases) will feel the pain in the form of higher rates, at least until they can refinance.

I suspect the issuers will actually pay twice. The part of the market that is failing badly now is the auction rate preferred market where leveraged muni funds borrow to purchase more bonds and pump up their dividends. If that market continues to fail, those leveraged funds may be forced to sell bonds into the same market where the issuers are trying to refinance. And that will mean higher rates than otherwise would have prevailed. Taxpayers lose again.

The lesson many people will learn from this is that Wall Street needs more regulation. That is the wrong lesson to learn. The market punishes those who forget the basic laws of economics. As the Economics Babe said this morning, "No Free Lunch", is the second thing you learn in Econ 101. There are inevitable tradeoffs in economics and if it seems like you are getting a deal too good to be true, you are probably right. All the players in this saga forgot that most basic of economic truths - and they should pay the price.

P.S. There were rumors in the market today about a potential bailout of the auction rate market. The details were murky, but if the Feds step into this market, an opportunity for everyone to learn a basic economics lesson (something that is sorely needed in this country) will be lost. A much better solution is to simply let the market work; something our politicians can't seem to bring themselves to do.

White Men Can't Dance

President Bush should have stayed seated...at least he claps in time.

Market Update

My latest market update is available at our website. Just click on the title of this post. Here's an excerpt:

On February 13th, President Bush signed the $168 billion economic stimulus package which he termed a “booster shot for our economy”. Will this rebate package prevent a recession? Well, I’ve been arguing that we aren’t in recession (more on that later) and won’t have a recession this year, but if we are headed for one, this sure won’t keep it at bay. Tax rebates have been tried in the past and have never produced the expected “stimulus”. These rebates are supposed to encourage consumer spending, but it has been shown that previous rebates were more likely to be saved than spent. And the same will likely be true of this one as well. And it’s not true savings either since the government will have to borrow the money for the rebates. Any increase in private saving will just be offset by increased government borrowing. Economic result? Zero.

Read the rest....

Here's the Helicopter

Thomas Nugent has an article at NRO titled,"Who's Flying this Helicopter Anyway?" In it he tries to dispute that the Fed has pumped up the money supply:

Now that the Fed has cut the target funds rate from 5.25 to 3 percent — a reaction to fears of an economic slowdown — the critics are out in force. The Fed, they say, has reverted to the easy-money days of the post-Y2K slowdown, when the stage was first set for the mortgage-market meltdown. They also say current Fed policy is inflationary, and to make their point they dust-off a decades-old analogy: Rather than merely tinkering with his various policy levers, they say the Fed chairman is out flying his helicopter, dumping bales of dollars on the economy.

There’s a big problem with this analogy, however. The Fed chair, be it Alan Greenspan prior to 2006 or Ben Bernanke today, has never been granted a pilot’s license.

Economists point to the monetary base as the source of the Fed’s power to increase or decrease the money supply. The monetary base has two components: currency in circulation (i.e., money in peoples’ pockets) and adjusted bank reserves. Thus, if the Fed chair were dropping dollars from on high, the act would be reflected in the statistics. There either would be a rapid expansion in adjusted bank reserves or an increase in currency in circulation.

And yet, today, neither is the case.

He uses charts of the change in the monetary base and M1 and finds no reason to believe the Fed is dropping money on the economy. I beg to differ. The best definition of money available from the Treasury is MZM and that shows a somewhat different picture:



You shouldn't cherry pick your data Mr. Nugent.

Something from Nothing

Frank Shostak, and adjunct scholar at the Mises Institute, has wonderful primer on the fallcies of Keynesian economics posted at the Mises Blog. If you ever wondered why some of us have a problem with Keynes, just read this paragraph:

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course by tendering for leases of the note-bearing territory), there need be no more unemployment and with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.[2]

Why exactly would the performance of a useless activity increase wealth? This is just ridiculous. Shostak's article uses clear thinking to demolish the logic (or rather the lack thereof) of the current "stimulus" plan.

Searching for the Silver Lining

Irwin Stelzer apparently believes, as I do, that those calling a recession may be jumping the gun:

We know three things, or think we do. The first is that credit is more difficult to come by, both for businesses and consumers. Not because interest rates are unattractive to borrowers, but because lenders have gotten pickier about whose IOUs they are prepared to accept. Second, we know that the housing sector is in almost terminal disarray, with foreclosures and inventories of unsold units rising, and prices falling. Finally, we know that the U.S. economy is, at minimum, slowing, and possibly already in recession. Hence the investment bankers' demands for "more": Ben Bernanke must cut interest rates, and the president must meet the demands of Senate Democrats to enhance the $168 billion stimulus package he signed last week.

Really? Consider each of those certainties in turn. To those who moan about a credit crisis, Warren Buffett, the legendary sage of Omaha, has this to say, "Money is available and it's really quite cheap." What he calls the "dumb money" might have stopped chasing risky investments, but cash is readily available for sound deals and to sound creditors.

He cites a few people who should know about the health of the economy - actual business people rather than Wall Street gurus and economists:

But who are we to believe--the economists and pundits who see gloom and doom, or the businessmen on the sharp end of the economy, producing and selling things? Jurgen Hambrecht is CEO of BASF, a giant manufacturer with 90,000 employees and sales of well over €50 billion, garnered by selling hundreds of thousands of products to a wide variety of industries. He tells the press that he does not foresee a U.S. recession, and that "I am glad to say that business in general does not show the panicking approach of the financial industry. . . . I am sleeping well at night." Hambrecht is not alone. Executives at General Electric, Honeywell, Procter & Gamble, Kraft Foods and the owner of this publication, News Corp, are among the many who claim that their businesses have never been better, that sales and profits are up, and that bookings are strong. The more cautious add, "so far."

Read the whole thing. He's also got a piece in there about why home prices may not be falling as much as some believe.

Pumped Up

This article from The Economist attempts to explain the continued rise in commodity prices, even as economic growth slows:

BANKERS and policymakers may be wringing their hands about the prospects for the world economy, but commodities traders, it seems, see no cause for concern. On Wednesday February 20th the oil price hit a new record of $101.32 a barrel. Soyabeans and platinum, among others, have also reached record prices in the past week. Vale, a Brazilian mining firm, has persuaded some steelmakers to pay as much as 71% more this year for its iron ore. Across the world the inflationary impact is tangible. In America consumer prices in January were up 4.3% on a year-over-year basis. Excluding food and energy, they were up 2.5%, well above the Federal Reserve’s comfort level.

The bull market in commodities is getting a little frothy and most of the reasons advanced in this article, in my opinion, don't answer the question. The answer, as with so many bull markets of recent years, lies in Federal Reserve policy. With China's currency tethered to the dollar, monetary easing in the US has the effect of pumping up demand in China. And that is driving the price of a lot of commodities higher. The article mentions another monetary policy cause at the end:

Nonetheless, the prospects for demand must have diminished at least somewhat as the world economy has slowed, and the outlook for supply has not worsened dramatically in the past few months. Hence some other factor must be at play. Many analysts blame speculation. As falling interest rates, tumbling stockmarkets and contracting house prices drive investors out of bonds, equities and property, the argument runs, there is lots of money looking for a new home. And since commodities have produced such lavish returns in recent years, and have weathered the recent turmoil relatively unscathed, they are an alluring option.

Citigroup believes that the recent rise in the oil price “is driven principally by a sharp uptick in fund flows.” Lombard Street Research sees an “iron bubble”. Others worry that America’s fiscal stimulus may cause trouble by inflating demand for commodities. In Citigroup’s cheery phrase, “the collapse of one bubble often sows the seeds of the next.”

Money flowing out of low yielding assets into higher yielding ones is called disintermediation - a fancy way of saying that individuals chase performance. I wonder how Citigroup will manage to lose money in this bubble...

Leading Economic Indicators

TThe composite index of leading indicators is used to predict the direction of the economy's movements in the months to come. The index is made up of 10 economic components, whose changes tend to precede changes in the overall economy. The ten components are:

1. the average weekly hours worked by manufacturing workers
2. the average number of initial applications for unemployment insurance
3. the amount of manufacturers' new orders for consumer goods and materials
4. the speed of delivery of new merchandise to vendors from suppliers
5. the amount of new orders for capital goods unrelated to defense
6. the amount of new building permits for residential buildings
7. the S&P 500 stock index
8. the inflation-adjusted monetary supply (M2)
9. the spread between long and short interest rates
10. consumer sentiment

For the month of January, the Conference Board reported a decline in the US index of 0.1%. The index declined for the fourth straight month, continuing its downward slope from its high back in July 2007. The index has fallen 2.0% (4.0% annualized) since that high.

4 of the components were positive for the month. The biggest contributor was real money supply. This, of course, makes a lot of sense, considering the fact that the Fed is cutting rates with the sole purpose of injecting more money into the economy. Consumer expectations as a positive component was a surprise, though, as past reports have refuted this claim. Might this be indicating a shift in the consumer psyche, from one which is solely negative to one which is preparing for a brighter future?

Stock prices and building permits were the top two negative contributors. Average weekly hours and new orders for consumer goods held steady.

See Full Report.

Initial Jobless Claims- Feb 16

First-time claims for state unemployment benefits declined by 9,000 in the week ending February 16, the Labor Department reported. Total number of filings were349,000, compared to an upwardly revised 358,000 the previous week. Jobless claims were revised from a decrease of 9,000 to an increase of 1,000 in the week ending February 9.

The report on the health of the labor market was worse than expected. Economists had expected claims to fall to 345,000 for the past week. The 4-week moving average, a less volatile measure which smoothes out any discrepancies, like a strike or weather-related incidents, rose by 10,750 to 360,500. Readings consistently higher than 350,000 is usually indicative of a weakening labor market, which tends to point to a recession.

See Full Report.

Residential Construction- Jan

Housing starts for the month of January rose slightly, by 0.85%, to a seasonally-adjusted annual rate of 1.01 million. This data follows a downwardly revised 14.8% decline in the previous month. Economists' estimates were in-line with the Census Bureau report.

Single-family housing starts fell by 5.2% in the month, but starts on buildings with two or more units rose an astonishing 22.3%.

Regionally, the Northeast and the Midwest were hotspots for housing starts, with an 18.9% and 12% gain recorded for each. The South and the West, where the housing boom was the biggest, saw a decline of 2.9% and 6.2%, respectively.

Building permits, a sign of future construction, fell 3.0% in January. Permits fell to 1.08 million, its lowest level since November 1991.

See Full Report.

Consumer Price Index- Jan

US consumer prices continued their rise into the new year, as inflationary pressures maintained its grip on the economy and on the individual's wallet. Consumer prices rose a seasonally-adjusted 0.4% in January. The gain was mostly attributed to a 0.7% rise in both food and energy prices. Economists were expecting a 0.3% gain.

Core CPI was also up an alarming 0.3% for the month. Since core CPI strips out the more volatile measures of energy and food, a gain of 0.3% is not a good sign. Prices paid for medical care rose 0.5%, while prices for apparel were up 0.4%. Education and communication costs were up 0.4%

In the last year, the consumer price index is up 4.3%, while the core CPI is up 2.5%.

See Full Report.

That's a Downer

LONDON (Reuters) - It's no fun at parties, but when it comes to investing being depressed just might help.

Fund managers, like so many of us, consistently think they are smarter than they are and that their ideas are of an unusually high quality. And to keep thinking these reassuring thoughts, they ignore evidence that contradicts their beliefs while paying rapt attention to data or news that confirms their own biases.

But not the depressed, whom multiple research studies have shown to have a more accurate and realistic view of their own abilities and insights, according to James Montier, a strategist at Societe Generale who specializes in behavioral finance, the study of how emotion and thinking patterns influence economics and investment.

If they have "more accurate and realistic views" of themselves and they're depressed...well maybe they have reason to be depressed? I guess that isn't the point, but I found this idea interesting. I think they've got the wrong emotion though. Why couldn't one have a realistic and skeptical view and also be happy? I've spent a lifetime as a skeptic and I'm generally happy with my life. I'd like a flatter belly...hell a six pack...but that would involve working out which isn't at the top of my list of favorite activities. But I'm happy anyway. I have a realistic view of the likelihood that I will work out regularly. And I'm skeptical that if I start a workout program that I will stick with it. I'd like to think I'm a pretty good investor too... or is that just my unrealistic view of my own capabilities? Damn, I hope not. Now that would be depressing.

The emotion that best describes a good investor I think is...well...actually a good investor is emotionless - at least when it comes to investing. Investing shouldn't have anything to do with emotion except to determine when other investors are acting emotionally so one can take advantage them. Otherwise, it is best to maintain a passion only for knowledge and information. The information is only useful if one has the knowledge to interpret it and act without emotion or bias. I'm not sure why Societe Generale needed a behavioural economist to tell them that. Maybe their money would have been better spent on a decent trade surveillance system.

McCain and the Fed

John McCain, presumptive nominee of the Republican party, has said that he doesn't understand economics and in this interview with Bloomberg, he proves it.

Feb. 17 (Bloomberg) -- Republican presidential candidate John McCain said Federal Reserve Chairman Ben S. Bernanke should have been quicker to cut interest rates to try to avert a recession.

``I personally would have liked to have seen those rate cuts earlier,'' McCain said today on ABC's ``This Week with George Stephanopoulos.'' ``That doesn't mean I want him fired, it doesn't mean I've lost confidence,'' McCain said.

I don't know how many times I have to repeat this but the cure for excessive credit is not more credit. While that may seem apparent to the average person, politicians (and the Fed for that matter) just don't seem to get it.

McCain does go on to say some things I agree with:

He said Bush allowed $35 billion in funding for pet projects, called earmarks, to be included in the budget over the last two year, money McCain said he would have cut.

McCain also pledged not to raise taxes if elected.

``No new taxes,'' McCain said. ``I could see an argument, if our economy continues to deteriorate, for lower interest rates, lower tax rates, and certainly decreasing corporate tax rates, which are the second-highest in the world.''

McCain said he also supports reducing government spending.

``Spending restraint is why our base is not energized,'' he said. ``Spending restraint is why we are having to borrow money from China.''

I'd love to see some spending restraint and lower taxes, especially corporate taxes. Unfortunately, I think the odds of that are pretty low, no matter who is elected.

Consequences of a Weak Dollar

WASHINGTON (Reuters) - U.S. import prices rose 1.7 percent in January, powered by higher prices for oil, while export prices increased 1.2 percent, the largest rise since January 1989, a U.S. government report showed on Friday.

All those people out there that believe we can devalue the dollar and close the trade deficit, here's the evidence of why that will never happen. Import prices are rising faster than export prices and we still import more than we export. Basic math tells me that closing the trade gap through a devalued dollar will be almost impossible. The volume rise in exports required to offset the rise in import prices is just too much to overcome. The only way to close the trade deficit is to reduce the volume of imports while maintaining (or increasing) the volume of exports. That won't happen through trade restrictions - what partner will allow us to restrict their exports to us while welcoming our exports to them?

The better question is why should we want a trade surplus? It seems such a simple thing; we should want to sell more stuff than we buy - but concentrating on the trade deficit as a measure of that is ridiculous. If we sell more stuff than we buy - as a country - that would imply that we are consuming less than we produce and are therefore saving and investing the difference. That's good. But does it matter whether we sell our stuff to foreigners or to our own citizens? I submit that it makes no difference whatsoever and therefore the trade deficit is meaningless. What matters much more when talking about deficits is the budget deficit of our government. That is real money that must be borrowed. A trade deficit in and of itself does not imply indebtedness.

International Capital Flows

The Treasury Department released its monthly report on cross-border financial flows for December today. Here is a quick recap-

Net foreign purchases of long-term U.S. securities were $69.1 billion. Of this, net purchases by foreign official institutions were $35.8 billion, and net purchases by private foreign investors were $33.3 billion.

Of the $69.1 billion, 48% was invested in US equities. What does it mean? Do foreign investors believe US stocks are now cheap enough to further invest in? Maybe...

Foreign holdings of dollar-denominated short-term U.S. securities, including Treasury bills, and other custody liabilities increased $34.2 billion. Foreign holdings of Treasury bills increased $15.5 billion.

Monthly net treasury international capital flows were positive $60.4 billion. Of this, net foreign private flows were positive $8.4 billion, and net foreign official flows were positive $52.1 billion.

In a nutshell, foreigners are stockpiling on short and long-term US securities, and have been for years. Year-over-year, net foreign purchases of long-term US securities were more than $1 trillion, while foreign securities purchased by US residents were a negative $223.5 billion.

Read Full Report.

US Industrial Production

US industrial production (output of the nation's factories, mines, and utilities) gained 0.1% for the month of January, following an upwardly revised gain of 0.1% in December. The news, released by the Federal Reserve today, was in-line with what economists had expected.

Of the three major industry groups, utilities output increased 2.2%, while output at mines decreased 1.8%. Manufacturing output remained the same.

In the past year, industrial production increased 2.3%.

See Full Report.

January Import/Export Prices

US import prices for the month of January rose a larger than expected 1.7%, with rising oil and food prices accounting for most of the gain. Economists were expecting an increase of 0.4%.

Petroleum prices increased 5.5% in January, and have increased a staggering 66.9% over the past year. Imported food prices rose by 3.1%, the largest gain since March 2005.

US export prices, meanwhile, rose 1.2% for the month, the most since January of 1989. This was helped by record prices for food and agricultural products. In January, agricultural export prices rose 5.0%, while food and beverage export prices increased 5.6%. Over one year, export prices are up 6.7%.


See Full Report.

NY Fed Manufacturing Report

The Empire State Manufacturing Survey is a monthly economic report put together by the Federal Reserve Bank of New York detailing business conditions in the region. For the month of February, the report points towards a substantial slowdown in NY manufacturing activity.

The general business conditions index fell 21 points, to a negative 11.7 reading. Anything below zero indicates contraction in the business sector. The new orders, shipments, and employment indexes all fell into negative territory as well. The prices paid index, up for a second consecutive month, is at a one-year high.

Read Full Report.

Auction Rate Securities, Part II

I posted an article earlier about the auction rate market failures. Today I spoke with the bond traders at Fidelity about the possibility of purchasing some of these securities. One example was a bond issued by a hospital in Colorado Springs that was available at a rate of 10%. The ultimate maturity on these bonds is 2030 and while the bonds are insured by AMBAC, the underlying credit is A-. 10% for A- rated long term tax free bonds is a damn good deal. I also talked with a doctor client in Colorado who is familiar with the hospital. It is a relatively new 200 bed hospital owned by the city.

I didn't buy this issue today because there are more disruptions to come. A large part of the auction rate market are preferreds issued by closed end muni funds. These funds borrow in the auction rate market and purchase long term bonds with the proceeds. If they can't get funds at the auctions, they will be forced to liquidate part of their portfolio. We may be able to find bargains in the straight muni market soon.

There is nothing wrong with this paper. The problem is that the underwriters who routinely bought anything that didn't get purchased at auction are now constrained and cannot support the market. I know of at least two firms that have told their brokers that auction rates cannot be purchased. So we're going to have some forced selling by the leveraged muni closed end funds and brokers are being told not to bid at the auctions. There is a lack of liquidity in the market. Those who can provide some liquidity will be able to find major bargains. I'll be looking at closely at these for clients in the next few weeks.

BankUnited's Blacklist

The South Florida Business Journal is reporting that BankUnited has blacklisted some condo projects:

Interested buyers looking for mortgages to buy units in Miami's Opera Tower, Everglades on the Bay or Four Ambassadors shouldn't bother approaching BankUnited. The Miami-based bank has included them on a list of 191 condo projects it won't write loans for.

The Business Journal obtained a list of "non-permissible" projects used internally at BankUnited (NASDAQ: BKUNA) and updated as of Jan. 14. Most of the forbidden properties were in Miami and were added at the last update. It wasn't clear who at the bank wrote the list, but the author stated a reason for almost every project declared off-limits.

If BankUnited won't lend on condos in these projects and other lenders follow suit, these projects will likely fail. Banks that lent to developers on these projects are about to own some condo towers. Its just another step toward the bottom of this market. This happened in the 80s as well and there were bargains for years. It'll probably take even longer this time.