Pushing On A String?

Is The Fed Too Easy Or Too Tight?
There has been much talk recently about the need for the Fed to raise rates to stop rising global inflation. Our work shows that money is still tight, even though the Fed has lowered the Fed Funds rate to 2.00%. The Fed surveys senior bank loan officers about lending practices at banks. This information is gathered through the “Federal Reserve Board’s Senior Loan Officer Opinion Survey on Bank Lending Practices”. The Fed conducts this survey quarterly with about 60 large domestic banks, and 24 U.S. branches of foreign banks. The information from this survey is quite interesting in today’s environment. The chart below shows the availability of credit and the cost of credit as shown through the Fed’s survey. As you can see

the credit lending standards have become progressively more restrictive. This is shown by the blue line in the chart. As bank lending standards have grown stricter, the cost of credit has been climbing rapidly (shown by the red line). In fact, the percentage of senior bank lending officers who are raising credit costs to businesses is currently higher than at anytime since the survey began in June 1990. It is interesting that banks have been tightening credit during the same time that the Fed has been trying to ease credit conditions. The chart below shows the cost of borrowing plotted vs the Fed Funds rate during the same period of time (6/1990-6/2008).

The chart shows the expected lags in bank lending costs, but recent developments are an anomaly, since borrowing costs are soaring as the Fed continues to lower short term rates. This implies that the Fed is currently “pushing on a string”. The tool of using rates to control the economy is no longer working as it has in the past. This is an alarming development, because it shows the seriousness of the current credit crisis in the U.S.

The Party’s Over
Over the last few decades the Fed has gained enormous credibility as an institution with the ability to manage our economy out of recessions in a non-inflationary way. The Fed as lender of last resort created the “Greenspan Put”, which meant when things got bad the Fed would be there to make things better. This policy has not, however, been without costs, and has only postponed the inevitable. This led to an incredible leveraging of our financial system, the creation of the shadow banking system, and massive amounts of debt being accumulated by the consumer and guaranteed by our financial institutions. The lax lending standards and cheap credit shown in the first chart during 2005-2007 helped create the debt hangover we are currently suffering. Rising delinquency rates and massive write-down's of loans have created deteriorating balance sheets for our banks and investment banks. They want to forget about the lax credit party that got them where they are today. The Pushing On A String chart shows the party is over. Banks are in no position to party again any time soon. Their hangover is too great. We should expect them to concentrate on re-building balance sheets, by raising capital, deleveraging, and cutting back anyway they can. The thought that money is easy, because the Fed cut short term rates is a misconception. Money is tight and will remain tight until the financial system begins to recover from the excesses of a couple of years ago.

Auction Rate Securities: What Now?

The Background
Auction Rate Securities (ARS) are typically either a debt instrument with a long-term maturity or preferred stock in which the interest rate is determined through an auction process. These rates normally are reset either weekly or monthly through periodic auctions. The ARS market reached about $350 billion at its zenith. About half of this market was for tax exempt securities. The issuers of tax-free ARS are municipalities, closed-end muni funds, and corporations that qualify under the “public purpose” provisions of the tax code. The ARS market was designed to act as a low cost funding mechanism for these issuers. Since early this year this market has been in disarray due to liquidity disruptions. Many investors have had their funds frozen because of a rash of failed auctions. At one point, over 80% of all auctions failed. When an auction fails the investor receives the penalty rate which is disclosed in the initial offering papers for the security. This penalty rate varies widely from a very low rate up to 20% depending upon the terms outlined in the offering documents of each issue. These securities normally come in $25,000 denominations.

Who Was At Fault?
Bankers and other Public Finance types get paid by generating revenues. The ARS market, just like Sub-Prime structured products, grew out of this need by Investment Bankers to generate out-sized year-end bonuses. The ARS market needed a “hook” to be successful. The “hook” for the issuer was cost savings from the ability to avoid paying for another bank to provide liquidity for their money market securities. The “hook” for the investor was that they would receive better than money market rates for taking virtually no risk of a failed auction, because their broker’s firm always made sure the auctions were successful. These securities were appealing to ignorant and greedy brokers who were now able to get bigger commissions on “money market” alternatives. For awhile this strategy worked and the Bankers were able to create a $350 billion market that was a fee generating machine. Unfortunately, early this year investors and issuers both discovered that the Emperor had no clothes. When auctions failed, issuers found that their costs were much higher than the Bankers had promised, and the investors lost access to their funds despite being told “they were as good as money markets, no they were even better than money market funds”.


How TFS Avoided The ARS Debacle?
Virtually all credit crises were caused by investors underestimating the amount of risk they were taking. The ARS market meltdown is no exception. Our perception of risk helped us to avoid ARS. We chose to invest in Variable Rate Demand Notes (VRDN) instead of ARS, because we knew we were not getting paid to take the additional risk of a failed auction. The chart below shows that prior to the ARS meltdown we actually received on average about an extra .04% yield by purchasing VRDN’s instead of ARS. These instruments are money market eligible and trade in $100,000 denominations. They are issued by many of the same issuers that also issue ARS. It is common knowledge that ARS are not money market eligible, because the investor does not have their liquidity guaranteed when he/she desires to liquidate their securities. Institutional investors know that a VRDN is money market eligible, because there is a liquidity facility guaranteed by a Standy Purchase Agreement. We reasoned, “why would anyone buy an ARS at a lower yield when it is an inherently riskier investment?” The only explanation for this enigma is that investors were unaware of the liquidity risk in these securities, and they let their brokers spin them around by selling them something with more risk than they thought they were taking. This situation clearly shows the conflict of interest that may exist between a broker/salesman and the investor.

Prospects For The Future
The ARS market has rapidly shrunk to half its former size. The cost savings the Bankers promised have turned into additional expenses instead. So, issuers have called outstanding issues of ARS with high penalty rates and replaced them with VRDN’s, put bonds, or long-term bond issues. This trend will likely continue for the next 6 months until most investors’ ARS funds have been freed up, and issuers have escaped the fiasco known as the Auction Rate Securities market.

Is There More Inflation In The Future?

Inflation Outlook
Recently, there has been much talk in the press about inflation. The argument is made that the recent rise in food and energy prices has to filter into the inflation numbers sooner or later, and that interest rates have to rise because inflation is so bad. Frequently this argument is further editorialized with comments such as “I don’t know why the Fed only looks at core inflation. After all, don’t we all have to eat and drive to work? Of course, if you take out everything that goes up, we won’t have any inflation at all!”. This is commonly followed by snickers, as if they are the only ones who could figure this out.

We pay close attention to inflation, which is a lagging economic indicator. Studies show inflation tends to peak at about the same time the economy is bottoming. It has been our opinion that we are in a temporary cyclical upturn in inflation, and we should see inflation come down as the economy slows. The chart below is a Fed model (Chicago Fed National Activity Index)

which shows economic activity and the likelihood of increasing inflationary pressures. The blue line is the value of the index and is charted against the axis on the left. We have added an index of inflation to the graph. The gray area is a graph of the year over year Personal Consumption Expenditures Index. This is the Fed’s preferred measure for inflation and the axis on the right shows the inflation rates. The CFNAI uses 85 different economic indicators as inputs which measure:

1. Production and Income
2. Employment, Unemployment, Hours Worked
3. Personal Consumption and Housing
4. Sales, Orders, Inventories

The Fed model uses a 3 month moving average to smooth the data. The index is designed to be 0.0 when the economy is growing at the long term trend rate. The index is positive when the economy is growing rapidly, and is negative when it is growing slowly. When the index is below –0.70 it is increasingly likely we are in recession. The index has been below –0.70 for the last 5 months. The current value is –1.25. This suggests a continued weak economy in the future. When the index is above 0.7 after the economy has grown for more than 2 years it is likely inflation will rise. This model shows the strong correlation between the overall strength of the economy and inflation. Since the index is in negative territory, this model shows it is likely that inflation will moderate in the future.

Conclusion
Investors should not become distracted by the chatter in the press about the need for interest rates to rise because of inflation. High oil prices and inflation are certainly today's problem, but the leading indicators show inflation is likely to moderate in the future, because of the weak economy.

The End Of The Muni Carry Trade?

Supply/Demand Imbalance
There has been steady growth in the assets held by Tax-Free Money Market funds since their inception. During the last 10 years the holdings of these funds have more than doubled in size as their assets increased by about 123%. Last year about $430 billion was invested in short-term Tax-Free funds. The chart above shows the “gap” between assets held by money market funds and the amount of issuance of short-term tax-free securities that are available for them to purchase. These securities have maturities of 13 months or less, or are longer maturities that have floating-rates and a put that gives short-term liquidity to the debt. Most of these floating rate securities are issued as Variable Rate Demand Notes. This money market supply gap has continued to widen over the last decade.

The Muni Yield Curve
The strong demand for short-term paper by money market funds causes munis to trade “richer” in the short-term part of the yield curve relative to U.S. Treasuries than in the longer part of the curve. This means that munis have a long history of having a positively shaped curve, even when treasuries are inverted by Fed induced tightening measures. The chart below shows the spread between a 1 year muni and a 30 year muni over the last 3 years. When the Fed was
in a tightening mode the curve flattened to a low of 40 bp’s on 2/27/2007. During that same period of time the Treasury curve was inverted. Since the muni yield curve has a history of having a positive slope even when money is tight, it works well for strategies that borrow short and lend long.

The Muni Carry Trade
Tender Option Bond programs (TOB’s) and leveraged Closed End muni funds both borrow short and lend long in the tax exempt marketplace. TOB strategies are funded by money market eligible instruments that allow the programs to purchase long muni bonds by employing leverage. The amount of leverage varies by the entity that is employing the strategy. The muni “carry trade” has become increasingly important over the last 10 year period. The chart below shows the holders of municipal debt as of 12/31/2007. Banks held about $193 billion at the end of last year and Closed End funds held about $92 billion of munis. During the last 3 years the growth in assets held by each category of investor can be seen below. Commercial Banks grew their holdings by about $50 billion since 2004. Much of this growth came from a few large banks that employed carry trade strategies in the muni bond market.


The chart below shows the increase in holdings by the 7 largest holders of muni debt by commercial banks over the last 3 years. The 5 largest holders were all significant purchasers of munis during this time period and accounted for about 50% of the growth in holdings by all the commercial banks. The addition of these large positions of muni debt in such a short time period can only be explained by the use of leveraged TOB strategies. In addition to the TOB’s issued by the commercial banks, there was considerable growth in the number of these strategies employed by hedge funds/arb accounts. It is estimated that Merrill Lynch’s TOB is about $40 billion. Many of these strategies were offered as Alternative Investments or as Fund of Funds strategies. Data on the size and number of these programs is not readily available, but the amount is impressive. Closed End muni funds had little impact and did not experience much growth during this time period. These funds are leveraged through the use of Auction Rate Preferred securities which are not money market eligible, because their liquidity is not guaranteed.

Filling The “Gap”
The leveraged strategies employed by TOB’s are primarily funded by the tax-free money market funds. For example, La Salle Bank would purchase a large block ($15-$50 million) of long muni bonds and deposit them into a trust. The trust splits these bonds into 2 different parts:
1. The short-term holder gets a weekly floating rate security that is money market eligible and can be put back to the marketing agent on 7 days notice.
2. The residual certificate holder (La Salle Bank) receives the difference between the rate paid on the short-term piece and the rate received on the long bonds that were purchased.
This is a “carry trade” for the Bank, because they borrow short and lend long. The steepness in the yield curve has made this a desirable trade for the Bank and the shortage of money market eligible paper has made it beneficial for the tax-free money market funds. The residual holder assumes the market risk of the bonds, and the short-term holder assumes the credit risk of the securities. The credit risk is minimized through the use of insurance or guarantees. The market risk for La Salle Bank is hedged with derivatives. Historically, this strategy has worked well for both money market funds and TOB programs. This type of funding has been useful in filling the “gap” between demand and available supply for the Money Market funds.

Auction Rate Securities
Closed-End funds and Municipalities both issue auction rate securities. The Closed End funds primarily fund their leverage through the issuance of Auction Rate Preferred (ARP’s)securities. These are high quality securities that are secured by the assets of the fund. These are not money market eligible securities, because their liquidity is not guaranteed by anyone. Instead, the rates and liquidity are set by an auction process. Auction Rate Preferred’s are purchased mostly by individuals and corporations. Municipalities issue Auction Rate securities (MAR’s) that are also not money market eligible for the same reason as the ARP’s. These securities are usually either credit enhanced by an insurer or bank, or are of very high quality.

Crisis In Confidence
The huge write downs by municipal insurers of CDO’s with sub-prime exposure has called the creditworthiness of the insurers into question. The rating agencies are imposing tougher rating standards and are calling for more capital from the insurers of municipal credits. Moody’s has downgraded FGIC from AAA to A-3 and Fitch lowered XLCA from AAA to A. This has led to serious disruptions in the short term muni markets. Money Market funds are only able to hold securities (Variable Rate Demand Notes) that are AA rated or better. These funds are not able to hold weaker underlying credits with an insurance wrap that might get downgraded below AA. This has caused Money funds to “put back” weaker credits whose insurers are likely to get downgraded.

In the Auction Rate market, many auctions have recently failed. This is due to liquidity concerns, rather than credit concerns. Dealers have been unable to provide enough liquidity for all of the auction rate securities. Roughly $10 billion of auctions failed during the last 2 weeks. The sudden lack of confidence in the auction process has led this market to unravel. This is causing financing costs to increase for issuers of these types of securities, because when an auction fails the holder of the security gets the maximum rate payable according to the original documents. These rates have been as high as 12-20%. This is causing issuers to look for alternative modes of financing instead of using the Auction Rate marketplace.

Recent Developments
We have noticed these developments due to the distortions in the short-term muni market:

1. There is extreme pressure on banks, dealers, and hedge fund TOB programs due to downgrades of securities that can no longer be funded in the short-term markets. There is constant fear that these programs will be or are unloading long munis to unwind trusts due to downgrades. There is also pressure caused by increased financing costs for these programs. Cheap funding in the money market arena has given way to much higher financing costs. This increase in costs has made the carry trade unprofitable for some hedge funds, which has led to liquidation of some of their long bond holdings. This has caused the long end of the market to underperform relative to Treasuries.
2. Issuers are searching for ways to lower soaring financing costs of Auction Rate securities. Some of these will be converted to VRDN’s and will be bought by the Money Market funds. Others will be reissued as long term debt. Since rates are low on an absolute basis, we expect many of these loans to be converted to long term bond deals.
3. There is now a severe shortage of acceptable money market eligible paper for the funds to purchase. This has led to short-term rates for quality paper falling rapidly to levels around 1%. This is below levels that are justified by current tax rates for taxable accounts. Money has continued to flow into Money funds during this recent scare. Assets are now up close to $500 billion.
4. The Auction Rate market has suffered a serious setback from the large number of failed auctions. Some investors, who are not concerned with liquidity, have been attracted by the high rates currently available in this market.
5. The muni yield curve has continued to steepen which will provide an incentive to investors to extend to pick up yield when the market returns to normalcy.

Conclusion
Guarantees of liquidity and credit are an integral part of the short term muni market. The current disruptions have been caused due to concern about the credit-worthiness and dependability of these guarantees. This has led to a contraction in the supply of capital as a funding mechanism for carry trades. We do not expect this shift in supply to be reversed any time soon. This will make it much more difficult for TOB’s to do carry trades in the future.

Ambac Insured Auction Rate Securities

What Do I Own?
Some investors have become concerned because they own securities that are AMBAC insured and Fitch recently downgraded the insurer to AA from AAA. We are not particularly concerned about munis that are strong credits on their own. However, there may be instances when an investor should be concerned.

The example below is for Arizona Public Service Company and is in a weekly Auction Rate mode. It is important for the investor to understand what this security is in order to determine if it is a suitable investment for him/her. A weekly Auction Rate security has a rate that resets weekly. This rate is determined by an “auction” process. The stated maturity is shown to be 6/1/2034. This security is not deemed to be Money Market Fund eligible because a money fund can normally only invest in maturities out to a little over 1 year. It is possible, but highly unlikely, in the event of a failed auction that the investor would end up owning a security with a maturity in 2034, instead of a money market alternative. The underlying credit quality of APS is BBB-. This is shown in the Bloomberg screen shot below. While it is normally unlikely for an auction to fail, the current stress on the guarantors (in this case AMBAC) and the weak underlying credit quality of APS increase the possibility of this unlikely event occurring.

We have avoided these securities and invest in Variable Rate Demand Notes instead. These securities are money market eligible because the liquidity to put them back to the dealer on 7 days notice is guaranteed.

Conclusion
We would caution investors to be aware of the risk of a failed auction on a weak underlying security that is guaranteed by an insurance company that cannot maintain their AAA rating.