The Presidential Mortgage Refi

Six days ago, at the end of a blog post (September 2, Blutarsky’s GPA), we indicated a concern regarding mortgage-backed securities, that during today’s speech a mortgage refinance proposal would be launched that would be a backdoor to QE3.

Almost in passing tonight, the President mentioned his intention to provide refinancing to qualified homeowners at 4% — in the name of creating jobs.

If this American Jobs Act were to pass Congress, the refinancing provision alone would allow $1 trillion dollars of mortgage-backed securities to roll off the books of the Federal Reserve.  Since the Federal Reserve has pledged to buy Treasury bonds with the proceeds of any mortgage roll-offs, this would be a $1 trillion quantitative easing without the public being aware of the stealth QE.

Sneaky, but well played.

From an investment perspective, the prepayment risk puts mortgage-backed security investments in peril.  If $1 trillion in stealth money creation passes, it’s jet fuel for risk assets and a huge negative for the U.S. dollar.

Keep an eye on MBS, the USD, and all things risk to assess the probability that this sneaky QE will actually go through.

I trust the markets (particularly the bond market) to tell the truth.

Far more than any political speech.

Blutarsky’s GPA

In the 1978 film Animal House, there was a scene where Dean Wormer proceeded to read off the GPA’s of all the brothers of Delta House.  Upon reaching the character played by John Belushi, Dean Wormer glared into the camera and said, “Mr. Blutarsky…  zero point zero.”

Perhaps the Labor Department could have added some levity to this morning’s Non-Farm Payroll release by having Dean Wormer make the announcement.  Something like, “Mr. Blutarsky, your GPA has something in common with the growth in non-farm payrolls.  Zero point zero.”  That would have been good for a least a chuckle before the market opened.

As it were, Dean Wormer was no where to be found and the jobs number clanged onto the floor like a 100 pound anvil.  Here are the details:

Non-farm payroll growth:     0 on expectations of +75, 000

Manufacturing payroll:     down 3, 000

Average work week hours:    down 0.1 from 34.3 to 34.2

Average hourly earnings:     down $0.03

Unemployment rate:     Steady at 9.1%

Non-farm private payrolls:     up 17, 000 on expectations of +110, 000

On the news, the market fell 2% and held at that level up to the time of this writing.

The talk has now returned to the increased likelihood of QE3 — a concept I find ludicrous.  But, I wouldn’t discount the probability that we are entering another “through the looking glass” market where bad economic news will be met with a rising stock market because bad news increases the odds of QE3.  Extending that logic, I guess we should hope for 25% unemployment!

Another thing we are keeping our eye on is mortgage-backed securities.  If President Obama’s speech next week includes a plan to implement some type of a national refinancing program for homeowners (as is rumored), mortgage-backed bonds could be in for a huge prepayment.  Further, as Bruce Krasting pointed out yesterday, such a refinancing program could be a backdoor to QE3 with all kinds of political cover.  To summarize Bruce’s thoughts,   Fannie and Freddy would offer new, low cost mortgages to ease the cash flow problems of homeowners.  These cash from the new mortgages will be used to retire the old ones.  The Fed, coincidentally, owns $1 trillion of MBS that (up to now) had been rolling off the books at a normal pace.  If this $1 trillion of MBS were to be prepaid, the Fed’s balance sheet would shrink dramatically.  Now for the finale’…  The Fed has already stated that it will deploy the proceeds of MBS roll-offs into Treasury bonds.  If this refinancing scenario were to occur (one giant MBS roll-off), that would be $1 trillion in additional QE done under the cover of helping struggling homeowners.

While this might sound a little like something that should have me wearing a tin-foil hat, the elegance of the solution has me wondering.  And in light of today’s horrible jobs report, this sort of thing would be much more palatable to the government while being much less understandable to the general public.

If it were to occur, the investment ramifications would likely be bad for mortgage-backed securities and good for all risk assets.


Recession. The Technical versus the Real.

It seems as though every cycle comes with its own new lexicon or isolated points of contention.  During the Great Recession, debate circled around “in what inning of the recession are we?”  For weeks this was bandied about by the “experts” whom had nothing better to do than opine on CNBC or Bloomberg TV. 3rd inning, 7th inning, blah, blah, blah.

Similarly, we heard the same debate about “the Treasury Bubble.”  That one had a shelf-life of over two years until (finally) Bill Gross threw in the towel and went home to “cry in his beer.”  (His words, not mine).  Incidentally, his bottom quintile performance speaks, perhaps, slightly louder than his eventual acknowledgement.

The debate du’ jour happens to revolve around whether the country is re-entering recession.  What is sadly comical about this debate is that is revolves strictly around the technical definition of recession1. A period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters.

I find this debate to be sad due to the fact that, during the exercise of trying to guess whether GDP will fall for two consecutive quarters (and the rafts of graphs, tables, and charts displayed to rationalize one or the other side of the argument); the social damage inflicted by this economy becomes obscured.

At last count, the unemployment rate was 9.1%.  Drive down the street, make a conservative assumption that each home you pass holds only one person actively seeking a job, and understand that (on average), one out of each 11 homes contains an unemployed adult.  Add back the underemployed and those who have simply walked away from the job market and you’ll only have to drive past 7 homes.  That sure feels like a recession.

If you happen to be driving through a minority neighborhood, pass 6 houses and you’ll find someone who is unemployed (source: National Urban League).  Recession?

And while you’re driving by those homes, it could occur to you that 4 out of 10 (on average) are underwater (source: Standard and Poors).  If you’re driving through Las Vegas, 8 of 10 have bubbles rising outside their windows (source: Zillow).  Driving through Orlando, it’s 5 of 10.  That sure feels like a recession.

Let’s keep driving.

With about 46 million Americans now on food stamps, 1 in 7 of the homes we pass will be collecting assistance to eat.  That is 15% of our citizens needing… food.  That sure feels like a recession.

The problem with today’s technical discussion about recession is that it masks the social effects of the present environment.  And from an investment perspective; ignore the social effects at your own risk.

Ignoring the social situation and focusing almost exclusively on monetary policy is short-sighted and ineffective.  If 15% of the country is struggling to eat, 40% of the country has underwater homes, and 9% of the country doesn’t have a paycheck, it strains logic that manufacturing a “wealth effect” by forcing up the price of speculative assets will solve the economy’s woes.  The speculative assets are concentrated with a relative few, and this economy needs broad participation to return to good health.

Further, incessant tinkering with monetary policy has led to bubble after bubble, escalating the social problem each time.

Yet, the debate rages on about recession or no recession, QE3 or no QE3, and risk-on or risk-off.

My thoughts:  If we cannot arrive at a coordinated solution that includes fiscal, monetary, and political sanity, it is hard to consider allocating capital to risk assets.  Sourcing investment returns from areas only loosely associated with risk asset pricing continues to dominate our thinking.

Now…  returning to some observations about the state of our economy, I include some observations from Dr. John Hussman of the Hussman Funds. (

I included the link to Hussman not as an investment recommendation.  Rather, it is a legal condition of reprinting Hussman’s copyrighted material.

“It is now urgent for investors to recognize that the set of economic evidence we observe reflects a unique signature of recessions comprising deterioration in financial and economic measures that is always and only observed during or immediately prior to U.S. recessions. These include a widening of credit spreads on corporate debt versus 6 months prior, the S&P 500 below its level of 6 months prior, the Treasury yield curve flatter than 2.5% (10-year minus 3-month), year-over-year GDP growth below 2%, ISM Purchasing Managers Index below 54, year-over-year growth in total nonfarm payrolls below 1%, as well as important corroborating indicators such as plunging consumer confidence. There are certainly a great number of opinions about the prospect of recession, but the evidence we observe at present has 100% sensitivity (these conditions have always been observed during or just prior to each U.S. recession) and 100% specificity (the only time we observe the full set of these conditions is during or just prior to U.S. recessions). This doesn’t mean that the U.S. economy cannot possibly avoid a recession, but to expect that outcome relies on the hope that “this time is different.”

As always, it’s up to the reader to determine if these facts are “fitted” to support the conclusion, or the other way around.  In any event, Dr. Hussman is a smart guy and usually has some interesting insights.

Waitin’ on Friday

We haven’t blogged for the past few days because, frankly, there hasn’t been much fresh information to share.  Basically, macro factors continued to dominate the markets and volatility remained above normal.  And, the usual suspects were to blame:

  • European Sovereign Debt
  • European Banks
  • Evidence of a slowing global economy
  • Dysfunctional (and now absent) US Government

Today’s action was a little different, however.  The market flipped around like a fish out of water intraday, but closed a mere 37 points from its opening.  This may be the pattern to expect this week.  Until Friday.

Friday is significant for three reasons that come to mind, and the markets may well tread water until the news begins to flow:

  1. While we’re asleep on Thursday night, the European markets will open with the short-selling ban on banks having expired.  It should be an early indication of the state of the banks when the market can vote freely.
  2. Early on Friday, the GDP revision will be released.  As the last few revisions have been downward (stoking fears of a possible double-dip recession), this release will likely carry more weight than usual.
  3. The much-anticipated Jackson Hole conference will conclude and Fed Chairman Bernanke will make his comments.  For my money, this is the trickiest and most significant event of the day.  For the past few weeks pundits have done their best to guess what the Chairman will do.  Per Bloomberg, 10-year Treasury Bonds are now pricing in a third round of Quantitative Easing (QE3) in the amount of $500 – $600 billion.  But here is where it gets tricky…  If QE3 is either overtly or backhandedly announced, it would seem natural for the markets to levitate; if the reaction is anything at all like that to QE2.  But, such an announcement may very well be construed as an indication that our economy is far worse of than originally thought.  Further, it is widely believed (and stock prices would concur) that QE2 was a failure.  Will a redux of a failed policy be greeted by rising stock prices?  Now, let’s look at the other possible outcome.  The Fed decides its 2013 zero interest rate policy is adequate for now and announces no new QE.  If Bloomberg is correct, there are 600 billion reasons for disappointment.  Yet, it could be an indication that the Fed believes we are closer to the end of the tunnel than most would think.  Tricky stuff, this tinkering around with monetary policy.  Maybe we’ll see a compromise…  a smallish QE3 that gives a little bit of something to everyone.

Me…  I have no idea how Jackson Hole will turn out.  And in a way, I’m not really sure that it matters.  While I’d welcome a solution that would reverse some of this month’s stock market declines, I hesitate to embrace it if it creates a bigger problem in 2012.  It’s our job to manage around the micro world of news flow while at the same time keeping our eyes squarely on our overall objective.  And this Friday, like so many other “major” news days, will provide us with more data, more volatility, and the opportunity to assess just exactly how healthy is our economy.

I’d be interested to hear what you think the Fed will do this Friday.  Feel free to leave your thoughts in the comments section.

Captain Obvious. Redux.

As I mentioned last Thursday, it’s difficult to add unique insight on the blog on these large loss, news intensive days.  Over the course of the news day, I have to believe that everything that could possibly be said has already been said!  So, on the heels of today’s 634.8 point loss, I’ll take some credit, some blame, and tell you what we’re looking at in the days ahead.

First, the credit.  We were accurate on our thoughts that the downgrade would be a positive for US Treasuries in the short-run.  That played out in spades today as the 10-year yield fell to 2.34%.

Next, the blame.  I blew the call on US Equities and gold.  I was in the camp of those believing that the S&P downgrade was already priced into those assets…  since S&P telegraphed the downgrade months ago.  Today’s activity in those asset classes proved our thesis wrong; at least for the time being.  Fortunately, portfolios are more fluent than blog posts, so mid-day adjustments kept my inaccurate thesis from being very expensive.  As Ned Davis said in his famous book, “Do you want to be right or do you want to make money?”  I’d like to be both correct and rich, but given a binary choice I’ll opt for the latter.

Now, onto the near-term outlook.  The damage to the stock market has been rather severe.  The market is now trading below it’s level the day that QE2 began.  That’s $600 billion of POMO money that netted $0 in stock market appreciation.  From a technical standpoint, the market is a mess, and closing at the lows of the day today was not very encouraging.


I think there is a very large risk of entering the next day or so with too much short exposure.  The speed and depth of the past few weeks’ selling leads me to think we are due for a bounce.  If only of the dead cat variety.  And those near-term reversals can be brutal.  Shorts can always be added intraday if needed.  Better to leave a few points on the table and avoid the chance of being whipsawed.

The full impact of the debt downgrade has yet to be felt, as it rolls through Federal agencies, municipal bonds, etc.  Those effects may be farther out, but like the rings of water expanding from the point where a rock was dropped in the lake, each wave will probably be shallower and less powerful.  Said another way, I think we’ve come a long way toward pricing this whole mess into the markets.

We also think today’s Treasury rally was more about the European banking crisis than it was a reaction to the debt downgrade.  In spite of the downgrade, Treasuries were still viewed as the safest haven on Earth.  Tomorrow, the Fed plans on releasing a statement regarding rates.  I don’t think the statement will go so far as announcing a QE3 (but if it did you’d see the mother of all reversals!).  Rather, I expect them to announce their plans to hold rates at 0% until…  I don’t know… infinity?  This remains an asset class that is incredibly hard to short; despite the fact that it seems to be a screaming fundamental short.  It reminds me of a quote about irrational markets and solvency.

These are crazy times, and I’d like to hear your thoughts.  Feel free to leave them here as a comment, or better yet, join our monthly conference call on Wednesday at 10 am Eastern.  The dial-in is 1-866-200-5786 and the passcode is 9352720.


I was pleased to see, upon returning home tonight, the Wall Street Journal is reporting that the SEC is subpoenaing High Frequency Trading firms.  The text of the article follow:

The Wall Street Journal reports that the SEC has sent out subpoenas to firms engaged in high-frequency trading (“HFTs”) as a part of its probe into last year’s “flash crash.” The SEC and CFTC released a report last year that lists high-frequency trading as one of the reasons behind the crash.

Regulators are trying to understand which particular actions by high-frequency traders (or cheetahs, as CFTC Commissioner Bart Chilton has dubbed them) contributed to the market’s precipitous decline. It also seeks more information about some of the industry’s more questionable practices, such as “spoofing, ” “layering, ” and “quote-stuffing.” These strategies generally involve placing misleading orders to confuse market rivals or leapfrog the trading line.

HFTs, once a niche group, are now a a dominant force in the securities market, making up over half of the equities trading volume. Though exact percentage is off from its 2009 high of 61%, it is still a substantial share for a trading mechanism that was technologically impossible twenty years ago.

Regulators worry that rules have not kept up to date with technology. In the United States, the CFTC has partnered with the SEC to asses the role of HFTs, and Chilton’s cheetahs may ultimately find themselves penned in by new regulation. Overseas, the European Securities and Market Authority (“ESMA”) published a proposal for managing HFT risk. Yet even as the proposals are debated, electronic systems continue to foment uncertainty. Last Friday, high message volume brought down NYSE Liffe, the second-largest European derivatives trading platform, for an hour and a half. This is the platform’s sixth glitch in two months.

This is significant, if the regulators follow through.  Those who read our blog of Friday were treated to my rant about the quote-stuffing I was watching during Thursday’s 500 point decline.  We provided links to ZeroHedge and Nanex to back up our suspicions.  Today, the robots were at work again.  The security I cited for quote stuffing on Friday was VXX.  Today, I saw the robots roaming in SDS, the 2x short S&P 500.  If you wanted to buy SDS, the market was deep and wide.  If you tried to sell a large block of SDS, the market became so shallow that unloading even 10, 000 shares was difficult at times.  It appeared as if the robots were biased to the downside, were pinging the market to find demand points, then picking the pockets of the non-HFT trader/investor.

This activity should be outlawed.  Period.  Not only does it wreck the price discovery mechanism of the markets, it drives “real” investors out of the market because they are tired of having their pockets picked.  The more rational decision makers that are driven out of the market and replaced by robotic manipulators, the less attractive the equity markets become.  At some point, the market’s other function — namely a venue to access capital — will cease to exist.  Then all the robots can play with each other in the world’s first microsecond version of Pong.