Market Rallies 3 1/2% in Seven Trading Hours: How Did You Do?

For several weeks at "A Dash" we have tried to highlight the importance of the bond insurance companies.  It is difficult for the market to rally without any strength in financial stocks.  Since the financials have insurance (credit default swaps) with the monoline insurers, all of these companies will be forced to take write-downs in various positions if the credit ratings of the insurers is reduced.

Background

This story is mostly about recognizing expertise.  Wall Street analysts and pundits are not very good at this.  Almost by definition, punditry means having an opinion about everything and getting media exposure.

The Key Expertise.  Pundits tend to dismiss any expertise that they personally lack.  If this related to repairing their car or a home appliance, they would quickly be proven wrong (as we were when trying to do these things on our own!)  When it comes to government action in solving  problems, the Street Pundits are just as ineffective, but the proof takes longer.

These are the main problems:

• Pundits and media do not have public policy experts on their staff.  As a result, they rely upon many commentators with an agenda -- a pre-conceived market opinion.
• Pundits talk about what they believe government should do, a normative approach.  We believe that they should instead look at the motivations and missions of the various government actors, an empirical approach.  This would have helped them do a better job of predicting behavior: why the Fed took aggressive action, why political actors with disparate views came together to pass a stimulus package, and why insurance commissioners worked to create a package to help the bond insurers.
• Pundits get attention for problems, and much less for solutions.  This has contributed to an overwhelming media blitz on issues -- something that has lasted for months.
• Pundits expect fast and comprehensive solutions.  That is not the way government works, but it does not mean that public policy will fail.  There is no concept that is more important to the investor.

Here is the question for a thoughtful investor.  Does your chosen pundit have the relevant expertise? If a scientist on stem cells told you that a plan would not work, that would have meaning.  If a physicist challenged the cold fusion concept, you might well listen.  When economists opine on the effects of fiscal stimulus, we should listen.

When someone with absolutely no experience in a field tells you that intelligent people, spending their careers on the subject, have no clue -- well, that is time to see a red flag.

Bond Insurer Examples

The key concept for bond insurers is the systemic effect.  If the credit ratings for a couple of companies decline, there is another round of write-downs triggered by FAS 157.  We have written extensively, and with little notice, on this subject.  This is a well-intentioned policy that has an unintended consequence.  Securities that trade in highly illiquid markets must be marked to these prices.  Securities marked to a model, no matter how strong or relevant the model might be, are viewed with suspicion--more write-downs expected.  We are delighted to note that Doug Kass has also noted this issue, suggesting, after careful analysis, the following:

If my observations are correct, a mistaken pricing of debt is serving to constrain bank lending, slow the economy and has produced artificially low stock prices (especially of a financial sector-kind) as investors could be overreacting to the huge financial writedowns at some of the world's largest financial institutions.

These are complex issues.  Individual investors and traders alike look to major journalists to highlight what is relevant.  Here are two examples from mainstream media bloggers whom we respect and read throughout the day.

Colin Barr at Fortune's Daily Briefing told us on Friday that the bailout plan would dilute investors at the bond insurers.  Today's afternoon article pointed out the stakes for other companies, while mentioning the effect on other financial stocks.  We agree with everything written, but it is, somehow, unsatisfying.  The big story was not the effect on these two companies, but the implication for the market.

David Gaffen chose to highlight a collection of the usual suspects.  He quotes Jim Bianco, “If the fate of the financial system only needs $3 billion to get ‘fixed,’ why did it take eight banks a month to negotiate coughing up $300 million each?”

There is an answer to this, the subject of a future article.  Simply put, it is a collective action problem, a classic situation calling for government involvement.  It is a somewhat difficult problem because each stakeholder has a different level of interest, and the various insurers have different relationships with the stakeholder.  The government agency is acting to protect the policy holders -- those who purchased the credit default swaps-- but it is tricky since they were parties to creating these opaque instruments.  Bianco -- a savvy guy who does a lot of great work -- has unrealistic expectations for the speed of the solution.

Gaffen next talks about the notional exposure of the bond insurers.  This is simply not fair.  No insurance company has assets matching the entire notional exposure of what they insure.  It is misleading to make these comparisons.  The bond insurers must pony up the stream of payments, not cover the entire notional amount.  If the underlying concept is sound, covering the stream of payments is enough.

So what about the underlying risk?  On this point Gaffen quotes Michael Shedlock as follows:

“Oh sure, the market may rally a bit, especially if Moody’s, Fitch, and the S&P keep their collective heads buried in the sand and reaffirm the AAA ratings on a mere $2 billion infusion, but long term the problem cannot go away until the entire package of CDOs guaranteed by the monolines is properly marked to market at a value close to zero,” writes Mike Shedlock of Sitka Pacific Capital, on his blog.

We are very curious about why David Gaffen thinks that Shedlock knows more about bond ratings than the experts at the various agencies.  The average reader assumes that David Gaffen makes a judgment about his sources.  We would enjoy his work even more if the range of sources quoted showed more discernment and balance.  For now, let us leave it at that.

Conclusion

Any intelligent investor, reading the principal mainstream sources and the most popular investment blogs would have been scared silly on Thursday.  If this issue were not enough, investors could worry about alleged "stagflation", our next subject for analysis.

Meanwhile, we have been trying to highlight the various fundamental and technical signals, as we did last Thursday.

Investors who got on board in the last hour of trading Friday enjoyed some major returns, highlighted by Bespoke Investment Group.  These are the stocks that have been depressed by the bond insurer obsession.

Bespoke has shown a game plan for investors.  We think that there is still plenty of time.  In a market with low forward P/E ratios, one should not worry about missing a single leg up, even a really good one.

Comments

[Jeff]

Venn --

Thanks. It is nice to know that some readers see it as I try to present it.

My focus groups say that I should go for style and humor. I try on occasion, but the world does not always "get it." My son calls it "Dad humor" with an obligatory laugh.

Jeff

[VennData]

I do not find your writing style to be smug and it's academic in style rather than pedantic.

And Jeff if you ever are pedantic, one hour in the Skinner Box for you.

[Jeff]

Anonymous - The fact that the insurance commissioners were in frequent contact with the ratings agencies was public knowledge. They also were not procrastinating. It is a difficult problem with a lot of players whose interests are not completely in alignment.

I will also agree that at the moment--the very moment--the 14% borrowing was going on, the companies did not deserve AAA ratings. The view of some -- including all of the bearish pundits and a few CNBC commentators -- is that the rating agencies were not doing their job.

In fact, the ratings agencies and the insurance commissioners do not define their jobs the way CNBC and the bears want them to. As you suggest, they are looking at a broader public interest.

What I am trying to persuade you and others to do is to look at how these institutions actually behave. Use that for your investment decision making. Your opinion (or mine) of what they SHOULD do will not matter.

In short, I am trying to describe the methodology of a professional social scientist who is a behaviorist. I do not mean to come off as "smug" or pedantic, but it is difficult to describe these concepts in the breezy tones favored by some bloggers.

I appreciate your comment -- no doubt shared by many --- and I'll try to say it better in the book version!

Thanks,

Jeff

[Bill aka NO DooDahs!]

^
|
typical web customer of financial punditry ...

[Anonymous]

No genuine AAA-rated company needs to borrow money at 14%. This is a rate-to-make-believe whitewash. There may well be higher public policy considerations, other than the mere economic merits, that dictate this outcome, and if they can actually pull it off in the long run, well hats off to them. Sometimes, paradoxically, procrastinating in recognizing or dealing with a problem turns out to be the right thing to do.

The trouble is, rather than acknowledging any of the above, you seem to be taking the position of "see, there wasn't any problem here after all"... and a tad smugly at that.

Or, who knows, perhaps there's more to the story. Perhaps the rating agencies were tipped off in advance that some government bailout or loan guarantees will be forthcoming, especially for the muni part of the split-up companies. I guess we'll soon see.

[Bill aka NO DooDahs!]

Eh, I'm not a fan of the WSU anyway.

Allow me to expand and clarify my previous comments with an analogy. The market for online financial punditry isn't monolithic – no market is. So it is with the market for produce. Huh?

Most of what sells, by the pound or by the dollar, are staples of the produce world, like bananas, iceberg lettuce, tomatoes, and yellow onions. Some stores get high or low quality staples, that's just how it is. Some customers judge which stores to go to by the amount of traffic they get, because those customers think it's an indication of quality. Some customers buy brand names for the same reason, i.e. frequent certain stores, without knowing that the source of the produce varies inside stores of the same chain. A store that sells extremely high quality produce, or exotic produce, limits its customer base accordingly, and may have to educate its customers ~ "hey, how exactly do you COOK a plantain?" Etc.

Some customers are attracted to a store by its chain's reputation for quality, such as the blog/comment-linker on the WSU, or perhaps with blogging networks that Forbes and others are trying to build.

Some marketers aim for the lowest common denominator, such as GM staple produce that transports well and keeps longer, but is less tasty and arguably not very good for customers.

Those that market the healthiest, freshest produce, and the widest variety of new and unfamiliar tastes, will attract very few customers, but those they attract will likely be dedicated ones, who have some skill at selecting and preparing tasty dishes with their produce purchases.

[Jeff]

Bill -- I hope you are wrong! What should be the role of the MSM blog? Should it not be something different from the many thousands who just start writing?

When someone is a salaried professional journalist, writing for a major media source, the expectations of the average reader will be much different. My clients who read David treat it just like reading the WSJ. They figure that the sources and overall approach is consistent with a high journalistic standard.

It is much different from Barry's recent explanation of blogging -- that bloggers should be opinionated, gonzo-economics, etc.

My understanding of the major media blogs is that they are extensions of the mainstream effort, albeit faster and more agile.

Thanks for making this point. Maybe I am wrong about the raison d'etre for these blogs.

Jeff

[Bill aka NO DooDahs!]

The web customer for financial punditry is bearish, and wants to hear consistent, repeated calls for recessions and economic collapse, wants to hear about the potential for rapidly falling stock prices, and wants to hear about "what's wrong" in the markets. Mish and his like deliver on that regard. I think David does make a judgment about his sources, and chooses the likes of Mish because they are popular.

[David Merkel]

The guarantors are a complex situation, and I have tried to be nuanced on it. It doesn't make for the best headlines or the most links, traffic, etc., but it is the honest way to go.

The regulators will do all that they can to keep the operating insurers alive; the holding companies are another matter. I could see this one going either way, and personally, I don't think that anyone has enough data to come up with the right answer here -- certainly not those "outside the wall," and even those "inside the wall" are probably scratching their heads over what the likely losses will be, because they are still evolving, and will depend on things that no one can today forecast with accuracy, like, how much will residential and commercial real estate prices fall over the next few years in nominal terms?

Anyway, keep it up, Jeff. Good post.