The Cost of Capital

Just a quick note for tonight.

The Cost of Capital
There has been a strange dynamic in play for about a year now in regards to the cost of capital. In normal markets rates are set by various inputs that in the end give both the borrower and the creditor a feeling that they are getting "fair value" both in taking the loan and in making it.

That is not how things work anymore. What would a mortgage written by a bank cost right now if they were left alone to set rates? With the double dip in home prices already here and a slew of inventory on the books, I think the 10 year US Treasury number would not even be in the ball park. Of course policy now is to make sure those rates stay ultra low.

CDS spreads have gone crazy for many European countries, but I have been watching CDS spreads for some time and they fail to make me take them too serious. What is serious is even a troubled state like Portugal is looking at rates going up to the 7% level(up from 4% in March) but along comes the ECB and they say "that is not right, we will lend money at 4% or 5%". The US FED has done much the same here. Add to this troubled US states like California have been taking advantage of US backed muni debt sales at rates far below what a open market would demand.

Now I think we all know that distortions cause problems....eventually. Easy money has a nasty habit of finding poor places to live. You can get things like bubbles or woefully miss priced instruments of all kinds that imply a lack of risk that simply does not exist. I think this should be clear. But let's look at another point.

If creditors are forced by the will and actions of government to lend at lower rates than they might want to, they are going to push rates where they can much higher. I would ask you all to review your credit card rates over the past year and see how they are moving. I just got a huge letter from my bank explaining the monster fees and penalties that will result now if I go into overdraft or miss any kind of payment on anything. Of course no one speaks for the little guy here, we will all just pay high rates and fees because that is where the banking system has pricing power now. They will chase return where they can.

Taking a step back, when you read that Ireland or whomever simply cannot pay debt back at such "high rates" as 7%, or even 10% there is an issue there. If a US state is on the verge of going bust over a 2% difference in a loan rate that is really walking a fine line. Yes, I know we are talking big bucks and it adds up, but really? I have argued that artificial low rates are now a structural necessity, not a short term support mechanism. Can the 10 year really be at 6% in 2 years without major issues? I would ask that the readers ponder what steps will be needed to keep rates of all stripes at all time lows for the next 5 years at a minimum and write them down or write them in the comments. Going further, ponder what avenues will be used by creditors to balance out their "fake risk" book with their "real risk" book. I think the answers will be useful in making investment decisions going forward.

Have a good night.

Compressing the Risk Pyramid

It is indeed Thursday at last! After the last power outage I paid for a 10Kw natural gas generator tonight and look forward to the installation in a few weeks. No more loss of power here!

Tomorrow is Friday night and I should be good to go for the usual festivities. Requests are always welcome!

Compressing the Risk Pyramid
Pyramids for some reason command a large usage in finance, and not just the ponzi scheme type. I was thinking about this post most of the week and I think I have what I want to say straight in my mind. Now let's see if it comes out that way!

I would think all the readers are familiar with the visual representation of various things by a pyramid diagram. Maybe the best known is the food group pyramid. Money and finance has plenty of similar graphics and I think it may be time to re-think some of them.

I found the following pyramid on this site and I give full credit to the author:
Investment Risk Pyramid

Any time you have made 401k selections you have seen this type of chart.

A more detailed pyramid from Oppenheimer Funds splits things up even better and will form the basis for the discussion:
Default Risk Pyramid


On February 8, 2010 I penned a missive titled "The Total Miss Pricing of Risk" and in the piece I noted:

-I came to the following idea as I watched the reaction to the possible Greece bailout over the weekend:
Instead of being scared or fearing the need for another large scale bailout of an entire bankrupt country the reaction was one of joy over another financial rescue.

-What a miss pricing of risk allows is distortions. Just like a bubble causes capital to be invested in non productive ways, the bailout bonanza has made all assets be treated as of the same risk regardless of underlying fundamentals. There is no price discovery in this way and thus right now may be a time where true "value" of many instruments are unknown.

Those ideas apply here.

Consider the Oppenheimer Pyramid:
-The first step up from ultra safe US bonds are shown as Agency Bonds. From Wikipedia:

Agency debt
Agency debt is a security, usually a bond, issued by a U.S. government-sponsored agency. The offerings of these agencies are backed by the government, but not guaranteed by the government since the agencies are private entities. Such agencies have been set up in order to allow certain groups of people to access low cost financing e.g. students and home buyers. Some prominent issuers of agency securities are Student Loan Marketing Association (Sallie Mae), Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).

I guess it is true, Wikipedia does have outdated information!

There is no doubt anymore that Agency debt is now fully backed by the US government. We can now slip that level into the US Government bond section.

-The third step up the default risk pyramid is noted as Mortgage Backed Securities. Usually a very safe mode of investment but unless you have been in a cave for 3 years that is not really true anymore. In fact, over the last 8 months perhaps as much as 80% of ALL MBS has been originated by government AGENCIES like Fannie, Freddie and the FHA. Calculated Risk offers this FED balance sheet chart:

So again, we have to move the third step back into the Government section. Makes it simple I guess!

-The fourth step up from the US bond level is High Grade Corporate Bonds. Thanks to the ratings agencies such stellar high grade players have included: AIG, GMAC, GM, BAC, and C. All such bonds now enjoy an explicit backing of the US government via bailouts and backstops. Many others are included by association (the whole too interconnected to fail idea). Yet another level moves back into the US government base plate.

-The second step up is noted as Non-US Developed Markets Government Bonds. While lists vary (here is a bunch of lists) most include such performers as Greece, Italy, Spain, Ireland, and Iceland. All safe havens to be sure. While I cannot slide this one into the US base section, these countries all have had IMF and/or Eurozone help or implied help to make them as safe as the greater whole. One for all and all that.

I will stop there as this presents plenty to digest.

What I present here is the compressing of the risk pyramid. At the same time that the US has severely deteriorated their balance sheet the borrowing costs for the government are at all time lows never seen before. This is a fundamental economic disconnect if you will.

If borrowing costs in the 7 year time frame were at 7%, what would this mean? Some may argue that borrowing costs are low due to fear or lack of any inflation, but that makes no sense. I believe borrowing costs are low because this cannot work any other way. It is a leap of faith that all of this will be sorted out. That time frame continues to extend every day. If the base of the pyramid cannot hold, US Government Bonds/Debt, the whole thing comes apart. I believe all risk has been herded into that level of assumed protection because that is the last game in town.

Leveraging the United States sovereign name to such things as home flipper mortgages in Phoenix, AIG contracts to Goldman Sachs, and US car makers that fell way behind the competition curve seems like a poor choice, but things are the way they are. Is any of this priced in?

Risk has been effectively removed from the market in an attempt to foster growth. At this point the only thing playing along is the stock market.

There is a line of thought that the US, with relatively low taxes, could simply raise taxes to close funding gaps. That is a nice idea. Talk to a real family and you will see that even so called upper-middle class folks are just managing to get by. Raise taxes by the amount needed and I think serious political change will happen and/or a monster pullback in spending will occur. Is this fact priced in?

I welcome all thoughts and feedback on this one as I think it is important.

Required Reading
Zero Hedge has a great compilation post with all the usual comments made right before a country had a default issue. It is like reading the news today. I cannot embed the Scrib visual, so see it here:
Sovereign Default Time Capsule: What People Were Saying In Real Time As Debt And Currency Crises Played Out

Have a good night.