E-piphany

Well, the stock market is back to where it was pre-Thursday, with the S&P rallying some 1.4% today on again-lower volume. There was, for the first time in a while, almost no financial news about Greece (although the unions have called for a strike) and almost nothing about the rescue package, whether the ECB is still buying stuff, which legislatures are approving the measures, or anything else. It is as if the whole thing never happened.

But it did.

I suppose investors may just be waiting for next week, when Greece needs to roll a big maturity, but it is odd to have a “$1 trillion rescue package” (quotation marks used intentionally) fade into irrelevancy that quickly. I guess eventually the trillions lose their meaning.

Now, fixed-income hasn’t completely forgotten. TYM0 was -7/32nds, with the 10y yield back to 3.58%, but that was with an auction today. Inflation swaps rose 5-6bps across the curve and gold rallied further. There is a little tension building between the markets on the true implications of the open checkbook.

One threat to the near-term possibility of inflation is the recent behavior of the monetary aggregates. Since the beginning of the crisis, commercial bank loan growth has been in the toilet, and it’s still at -5% year-on-year; however, recently the growth rate of the broad aggregates has been declining as well. Over the last 52 weeks, M2 growth is only +1.4%, and M3 within the OECD is at -0.8%. This reining in of money growth would almost smack of hawkish central banking, if it were intentional.

Then why are markets around the world responding as if there is easy money sloshing around the streets? I believe it is because of what monetary authorities have done to reverse the plunge in money velocity.

What matters for inflation prospects is not, technically, the amount of money (M), but the quantity of money circulated in a period of time. We measure that by taking the raw amount of money M and multiplying by the number of times each unit changes hands; this latter is designated velocity (V).

When the crisis first hit, central banks released a gusher of liquidity to counteract the plunge in velocity that happened when risk budgets were being sharply curtailed and money was being hoarded. It was all they could do in the short-term, but if velocity had continued to decline the central banks would have been hard-pressed to keep up. If V declines 20%, then M must increase 25% to counteract that decline (0.8 * 1.25 = 1.0), but if V declines 40% then M must increase 67% (0.6 * 1.67 = 1.0); the further velocity falls, the more dramatic the money-printing needs to be. M2 velocity in 2008/2009 in fact fell 10-11%, which was a lot – and could have been much more – but it was a feasible amount by which the money supply could be goosed.

The fact that it fell only 10-11% is testimony to the aggressive moves by central banks not merely to reliquify banks but also to encourage re-leveraging. I’m not saying that is a good thing, but if you take as your major premise that recessions are bad and must be avoided at all costs (rather than natural cleansing occurrences, as I believe) then, well, it seems it was successful.

So which is better?  To have booming growth in M and collapsing V? Or declining M and rising V? Don’t answer right away. The advantage of the latter is that it is easier to reverse M than it is to reverse V, because policymakers actually can control the lever for M. Indeed, we can’t even observe V in real-time; we know it is related to leverage but loosely. The disadvantage of the latter is that you’re sucking away money at the same time that your system is getting levered up, and that would seem to me to risk a sudden breakdown…which would presumably be followed with more M. Does that oscillation – more M, less V, followed by less M, more V, then repeat – dampen over time, or amplify? I don’t want to find out.

So what are the implications for inflation? They are complex. My models look at long-term (several year) changes in M because it is reported in something close to a timely fashion while V is not ‘reported’ at all. But right now, I am wary that the tepid growth in money is sending a false signal because V is coming back with a vengeance if recent bank earnings and returns of fixed-income relative value hedge funds are any indication.

My models had shown a bottom in core inflation to be coming in Q3, and they still do, followed by a sharp jump. Visibility much beyond Q4 is difficult for any model, though, and moreover my models do not strip out housing from core inflation so they are subject to even more uncertainty than usual. That said, they’ve been doing surprisingly well over the last couple of years. Anyway, if the decline in money growth globally is sustained, then the model will likely show that the Q4 –ish turn that I expect doesn’t become a launch but merely an uptrend.

This does not mean that an investor should necessarily eschew inflation-linked assets. If, somehow, the Fed and ECB were to jointly steer core inflation gently back to the 1.5%-2.0% range, then it would be supportive for equities since the best environment for stocks is that of low, stable inflation. Stocks, however, already seem to incorporate this sunny possibility (as well as most other sunny possibilities).

But even if inflation might return to being low and stable, there are good reasons to include inflation-linked assets in a portfolio. Among them:

1. The main investing goal is to maximize after-tax real returns; this implies that holding real assets tends to decrease a portfolio’s real risk (whatever it does for the returns). As Zvi Bodie has pointed out persuasively, being low-risk with one part of the portfolio frees up an investor’s “risk budget” to take more active risks with another part of the portfolio.
2. Along similar lines, I think investors are well-served presently to tilt their portfolios to take relatively less risk since the range of potential outcomes over the next few years is unusually large.
3. Even if you don’t think that inflation is tactically a threat, it may be strategically a threat; in this case you should patiently add real assets when they are less expensive. I think there will be better opportunities to buy TIPS later this summer as weak inflation numbers scare some investors off and the added supply weighs on the market in real as well as nominal rates, and finally,
4. It is bad practice to eschew purchasing insurance merely because the house isn’t currently on fire.

I am not, in short, abandoning linkers. The transfer of debt from private entities to public ones greatly increases, in my view, the odds that monetary authorities will eventually be forced to monetize the debt. Of course, every central banker worth his/her salt will swear that will not happen, but a truly independent central bank does not exist. If the debt threatens to crush an economy, bankers will mix the cocktail they believe they know the hangover cure for: inflation.

When I came in this morning, it looked like another brief EU-inspired rally was over. S&P futures were slumping by 13-14 points, and when I looked for a reason it seemed obvious. Like all of the other packages, this latest from the EU is mostly promises although it also includes some parts that are even less than that.

I hadn’t realized it before, but a friend pointed me to a Reuters article that quotes the number 2 guy at the IMF. Recall that the package announced on Sunday night trumpeted 250mm Euros in direct support from the IMF, loan guarantees from other EU participants, and ECB intervention in markets. We know that the intervention happened, and will (theoretically) be sterilized. By now, having seen these packages before, we all know that the promises of loan guarantees must be approved by the relevant legislatures and may or may not happen. But this package had the large IMF loan as a centerpiece. Or did it? From that article:

While an EU statement said the IMF would make available 250 billion euros, Lipsky said the institution had not earmarked any money for euro zone countries and financial help would be provided on a case-by-case basis.

The 250 billion euros cited by the EU was “illustrative” and a “hypothetical” figure of what the IMF could pony up if needed.

“We haven’t made any blanket commitments,” he said.

No commitment from the IMF means this package is almost the same as the previous packages: mostly words and little substance. Clearly, the cat was out of the bag, and stocks were already headed lower.

Then a funny thing happened. As the day wore on, news outlets simply ignored this not-unimportant detail that the IMF money was not only not guaranteed, but in fact hadn’t even been promised!

I warned yesterday that institutions can sometimes cheat when they are threatened. “Selfish memes,” Richard Dawkins would call it. (See The Selfish Gene: 30th Anniversary Edition–with a new Introduction by the Author)
What I overlooked was the fact that the media is part of the institution. Now, it might merely be incompetence; maybe no one is scanning the Reuters wire. But I rather suspect that it is more likely that, consciously or unconsciously, producers decided that it is “better news” to applaud the saving of Mankind by all-knowing politicos. Or, perhaps, they skimmed the article and all the chatter about how this “clarifies” the IMF role without noticing the little detail that nothing is promised at all.

Whatever the reason, many investors seemed not to have heard the news that the package is something less than 750bln Euros. Closer to zero than to 750bln, in fact. But stocks recovered early losses, and actually had a nice rally on the day (8 points on the S&P or so) for a while.

Illiquidity is a sword that cuts both ways, and it isn’t clear to me that the liquidity is back. The ECB reported that it completed an 8-day tender for 9.2bln at the quite-high rate of 1.22% as part of the liquidity action. That level indicates that some stress is yet in the system, happy smiling faces aside.

Even though no one was throwing the story out there, some observers may have had an unconscious inkling that something was amiss, because Bloomberg was attributing the rally in stocks to the fact that the UK resolved its hung Parliament with a coalition government formed between the Tories and the Liberal Democrats. Because, as we know, the status of a coalition government in England is very important to U.S. equity prices. That sounds like a reach to me.

At around 2:15ET, Bloomberg included the Lipsky quotes in a story on their top news page – right about the time that stocks peaked. Better late than never. At the end of the day, the S&P had lost 0.3%, which is near enough to unchanged given recent moves. Volume fell further, to a mere 1.4 trillion shares. TYM0 rose 2.5/32nds, with the 10y yield at 3.53%. Not everything was unchanged: Gold rose $32 to a new all-time high and frankly looks like it may be entering a blast-off phase (see Chart, source Bloomberg). I am not a gold bug, because gold pays no dividend, but I am invested in the gold juniors ETF (GDXJ), which Fred Hickey of the High Tech Strategist has been talking about for a while.

Someone in the monetary world smells a rat.

I might be wrong, but I don’t think the stock market is out of the woods yet. Because institutions cheat, I’m not bold enough to take a stab at the short side and options are no longer cheap…but I suspect we will see Thursday’s lows again.

There is again no data due tomorrow. The Treasury is selling $24bln of 10y notes tomorrow, and $16bln 30y bonds on Thursday. Does the coiling in the equity market continue, or do we make a move? For some reason I have a bad feeling in my belly. But that might be caused by the spectacle we’re watching.

The weekend finally produced something of substance, although how much substance is clearly still open to question. It has been called an “all-in” bet by the EU, a metaphor meant to indicate that this is meant to be a pre-emptive move so strong that the opposition (in this case, markets) must back down. The metaphor is apt in more ways than one; in an all-in bet, there is nothing left to wagered if the bet is called. It is all or nothing.

“The Bank and the politicians listened to what the dealers were saying and took exactly the kind of rapid, decisive action that was needed to avert a crisis,” said [European Primary Dealers Association director Sander] Schol. “The proof that this it is the right course of action appears to be demonstrated by the market’s reaction.” – “Trichet Defends ECB Independence Amid Market Relief”, Wall Street Journal, 5/10/10

So, the fact that markets are going up proves that everything is all right. Surely nothing is better than a rising market, regardless of the reason it is rising. These are the people driving the train along such a scenic route, without having checked to see if the track goes all the way to the destination.

The EU package is a conceptual grab-bag: a pledge of up to €750bln in loans and loan guarantees, including about a third of that from the IMF; open-market purchases of sovereign and corporate bonds by the ECB and member central banks; the Federal Reserve’s reactivation of currency swap lines; and unlimited auctions of short-term money.

“The central banks are buying government bonds issued by Greece, Spain, Portugal, Ireland and Italy, a spokesman for the Association for Financial Markets in Europe, or AFME, told Dow Jones Newswires.”

Markets rallied, at least partly because (in the case of sovereign debt) the ECB was buying. Investors seemed shocked that leaders on the Continent came up with something meaningful, after months of trying to finesse the problem.

But did they really come up with something meaningful? One bond salesman reported, in a summary of overnight events, “…when asked at the press conference, EU Monetary Affairs Commissioner Rehn could not explain how the money will be used, when the facilities will be operational, or how the decision to allocate access to the funds will be made. It’s not yet clear, who will have this designating power (IMF/EU/EcoFin).”

Moreover, while the European elites believe that this is the way that decision-making in the EU is supposed to work, as the product of a powerful central committee that considers all the ramifications of any action on the fortunes of all member states, it is not yet the case that it really is the way it works in the balkanized politics of Europe. Just this weekend, Angela Merkel’s party lost control of the upper house of the German legislature. Who, then, has the power in Germany to sign off on this pledge? The heat doesn’t necessarily produce a nice, smooth, unified front from the rainbow of political interests. It is more like a box of Mike and Ikes left in the car: a sticky, gooey mess.

The news that the ECB is buying bonds – which is the only part of this that we definitively know is happening – is particularly interesting. The purchases will be “sterilized,” which is to say that the ECB isn’t directly monetizing the debt, as would be the case if for example the various governments issued debt and used the proceeds to help Greece, and then the ECB printed Euros to go buy the debt those governments had issued. The money being injected as a result of those bond purchases will be drained, probably by issuing ECB debt certificates. But this presents problems as well, since the short-term markets have been unhealthy of late (recall the chart of LIBOR from Friday’s comment). That detail aside, this means that the ECB is effectively levering up to replace the leverage that the crisis has been leeching away. Such leverage is normal for a central bank to some degree – when the Fed needs to add permanent reserves, it does so by buying Treasuries outright in a coupon or bill pass. But the difference is that Treasuries are highly unlikely to default. The Federal Reserve is limited in terms of the credit quality of the instruments it is allowed to buy, and in ordinary times they observe those rules (there was, um, some “slippage” from those rules during the crisis). What happens when Greece does default, as she almost surely will since these measures do nothing to soften the impact of the austerity measures? Then the ECB is holding worthless paper, and still is obliged on the debt certificates – and it must roll those debt certificates perpetually, or print the money to pay it off.

Inflation markets, recognizing perhaps that this is at least a small step towards monetization (especially if it fails), rallied smartly today. USD inflation swaps rose 7-10bps.

“The message has gotten through: the euro zone will defend its money,” French Finance Minister Christine Lagarde told reporters in Brussels early today..” (Bloomberg)

Oh really? The EU defends its money…by printing money? That is an interesting theory.

The S&P ended up with a 4.4% rally, which failed to fully reverse the Thursday-Friday plunge but wasn’t a bad showing. Volume was lighter on the bounce, at 1.8 trillion shares compared to 2.3 trillion and 2.4 trillion the last two days. To be sure, 1.8 trillion represents comfortably above-average volumes. While in general technicians like to see volume confirmation of market moves, in this case there is a reasonable excuse in that there was an overnight gap – prices adjusted, in short, without needing volume to push them up. That also means that there may be “trapped money” short, or at least not as long as they want to be, below the market. In turn, that could mean that the next declines will be slower as this money will provide natural buoyancy when prices revisit those levels.

And revisit them I think we will. It is appropriate that stocks didn’t reverse all of the prior plunge, because that drop wasn’t merely about Europe. It wasn’t just about the oil spill, or the volcanic eruption grounding air traffic for a week, or Fannie Mae needing another $8.4bln from the government…oh, wait, that last bit was today’s news. The reaction of the market last week was that of an overvalued market that suddenly had vertigo. It isn’t plain to me that, even if these actions “fix” the problem in Greece, that the vertigo is cured.

That said, we must always be cautious when institutions act to preserve themselves, as they can be brutal. When Lagarde told reporters that the euro zone will defend its money, what she meant was “we are cornered, and we will do whatever is necessary.” Remember that in the 2008 crisis, for the Fed that meant doing a number of things that were not strictly allowed by its enabling legislation. Institutions in crisis can sometimes cheat.

In the long run, markets will win. They will win because fair value is more patient than politicians. But even when he has been bitten by a rattlesnake, the man with two six-shooters can still win a gunfight before the poison does its work. Be on the side of the rattlesnake, but stay out of the crosshairs of the pistols!

The 10y note contract today dropped 24/32nds with 10y yields rising to 3.53%. There is no data tomorrow. Can you guess what the focus might be?

The old saying is that you should “buy on the sound of cannons, sell on the sound of trumpets.” I think that adage applies, however, only if you are not in the crosshairs of the cannons; furthermore, it probably made more sense in the days when news of the cannons’ firing took some time to get around.

We have recently watched politicians trying to psych out the capital markets – today, German Chancellor Merkel said they are “determined to win the battle against the markets.” And later today, the markets responded.

The stock market didn’t start with a huge gap down, but just kept slowly sliding; inflation breakevens on the other hand were hit early as front end TIPS especially have been rather richly valued recently (thanks to the fact that everyone wants to hold inflation protection, but no duration), and whatever else the dollar’s rally does, it dampens inflation in the U.S. relative to Europe.

Stocks kept sliding, kept sliding, and the slide slowly accelerated until abruptly the market hit an air pocket. What happened next will take some time to sort out, but electronic trading systems were overwhelmed as the Dow dropped 998 points with the S&P printing a low of 1065.79 before bouncing. The prices were changing so rapidly that the “real time” ticker on CNBC was lagging behind by more than 100 points on the decline and was briefly 300 points behind when the market suddenly bounced aggressively. (This allowed Cramer to appear to be a genius when he cavalierly declared “just buy ‘em” right before the market leaped 300 points; of course, to the viewer it looked like he bought the market at -980, but unless he doesn’t have a Bloomberg machine he was actually saying it when he knew the market was at -650).

The CNBC crew immediately began to claim that the selloff “must have been an error,” simply because “Procter (and Gamble) doesn’t fall like that.” No authority has yet confirmed (as of this writing, Thursday afternoon) that there was either mechanical or human error involved, although the NYSE said that Nasdaq had “a number of erroneous trades.” We’re waiting to hear whether Nasdaq agrees, but Citigroup, who was rumored to have made the error, says it sees “no evidence of erroneous trades.” Some trades will be canceled, such as the ones where market orders hit no bid until $0.01 (on a $40 stock), but those were not erroneous but careless. Someone meant to sell, and meant to sell at the market, but failed to understand that when there are no specialists “the market” is whatever price someone has put on the screen. No one is obliged to make a market in Accenture.

So stocks rallied 650 points today, and that sure is impressive. Well, that was after they fell 998 points, but what are you – a pessimist?! The net loss on the day was a mere 3.2%. Peanuts, although it leaves the equity chart in shambles (see below). A re-test of today’s lows, followed by a 38% retracement of the rally (1008 on the S&P), would not surprise me over the next few months.

Not the strongest chart in the world.

Again, it helps to remember that none of the news we are seeing is surprising. We have been watching this develop, with the progress of the crisis fairly obvious, for many weeks now. But we have watched the news move from page 31, to page 12, to the cover of the Business section, to the paper’s front page, and now leading off the local broadcast news. So what is happening in Greece ought to be about discounted by now. Buy on the sound of cannons? The problem is that the stresses in Greece are starting to reveal and make plain all of the other faults. Bank solvency and liquidity issues are on page 31, moving up to page 12…(and all the while, financials are valued very highly). And that is but one example.

Oh, and lest we forget, we’re still working on resolving the last crisis. Freddie Mac has said that it needs another $10.6bln from the government, and says there’s more to come. In a statement it said:

“Freddie Mac expects to request additional draws. The size and timing of such draws will be determined by a variety of factors that could adversely affect the company’s net worth.”

Inflation breakevens were -10bps or more today (the marks were a little fuzzy). The June 10y Note rallied 1-08/32nds and the 10y Treasury note finished at 3.40%.

The economic data today is and was an afterthought. Initial Claims were slightly higher than expected at 444k. Productivity was a little higher, and Unit Labor Costs therefore a little lower, than expected, but those data get revised for years – Greenspan once opined that you need at least five years of Productivity data to spot a meaningful trend (which didn’t stop him from spotting one in the go-go 90s). Some investors looked askance at the chain retail sales from ICSC, which fell to only +0.8% year-on-year from the prior +9.0%, but no one forecasts this number and it is a little early to worry about that dip.

And I daresay that the economic data tomorrow may also be an afterthought, although the Employment data is ordinarily the most important release of the month (except of course for CPI, to an enlightened few). The consensus view is for a gain of 190,000 new jobs, with the Unemployment Rate steady at 9.7%. Remember that the official data, unlike the ADP, will include any Census-related hiring.

Last month, there were 162,000 new jobs, but remember that included a weather snap-back from February. Averaging the last two months, and taking out Census workers, produces underlying jobs growth of 42,000 jobs per month. I don’t know what we are expecting from Census hiring this month, but unless it is something over 100,000, the 190k forecast looks generous to me. Keep in mind that we haven’t seen any real improvement in Initial Claims or in any of the other job metrics. I think there is a real chance for a disappointment tomorrow. While I think the 9.7% Unemployment Rate is a little safer, since it was 9.749% last month and we know that some Census workers will be hired, I wouldn’t be shocked to see that number rise either since the approaching end of the Emergency Unemployment Compensation (EUC) program at the beginning of June will get more people out looking for work.

The market will take administrative notice of the numbers, but it will be blended with news from Greece and other EU countries, election results in the UK, and overnight equity markets. We are still in the process of moving stuff from the back page to the front page; I wouldn’t fade this move yet.

This is starting to get confusing.

The market on Friday sold off in part because investors were concerned that, despite another claim from the Continent that there would be a resolution to the Greek crisis this weekend, no one believed them. On Monday, stocks rallied hard (+1.3%) because the plan was trumpeted as being a done deal.

Except that it is anything but a done deal at this point. Already there are concerns because little Slovakia – who is contributing less than 1% of the rescue money – is insisting that they will not disburse any monies until Greece actually cuts spending as it has pledged to do. Slovak Prime Minister Robert Fico said “Personally, I don’t believe that the Greek parliament will be able to approve the restrictions passed by the government yesterday,” and further noted that the money would only be disbursed after parliamentary elections on June 12th. (See story on MSN here.) There are 25 other nations, each with their own issues, that need to act in the affirmative for this package to work, unless Germany (which is facing elections very soon as well) is willing to go it alone. I think this is still an odds-against bet, although finally the amount of money they are discussing is more than a drop in the bucket.

But there is a very deep well of hope which investors keep drawing from. They’re not going to believe that anything bad could happen until Greece actually defaults or withdraws from the EU, and then the market is going to have a sudden, wrenching adjustment. It shouldn’t; the trajectory here hasn’t been terribly hard to figure out. But investors will act like it is a surprise.

Markets also rallied because Warren Buffett said Goldman should not be held responsible for the money lost by one of their clients in the current scandal. Two remarks are appropriate: first, Warren Buffett might be the only man in the world who has such credibility that he can nakedly talk his book and people take his words entirely at face value. This is “dog bites man.” The man-bites-dog story line would be if Buffett thought that Goldman should be held responsible! The second remark worth making is that Goldman isn’t being held accountable for the losses. They’re being held accountable for the fraud.

While stocks rallied hard, it is worth noting that this happened with major European bourses either closed or very inactive due to holiday; NYSE volume was the lowest in a couple of weeks. Let’s see what happens tomorrow.

On the plus side, economic data continues to confound me by coming in better than expected – albeit only modestly. The ISM Manufacturing index for April was 60.4, marginally beating the 60.0 expectation, and the internals weren’t bad. Personal Income and Spending were right on target, but those are March numbers. Vehicle Sales were a little weak, but still: overall, the growth engine continues to sputter and cough, but it hasn’t quit yet. Of course, the main thing that does right now is to help push the dollar higher and to keep interest rates defensive. TYM0 fell 13.5/32nds, with the 10y yield still in the same dull range (last at 3.70%).

Tomorrow’s data slate consists of Factory Orders for March (Consensus: -0.1%) and Pending Home Sales for March (Consensus: +4.0%). What will be interesting though is to see how investors in Europe react to the “deal” announced over the weekend. All wiggles aside, however, I feel this is a pay-me-now-or-pay-me-later deal. If the market doesn’t begin to discount the serious possibility that no deal will get done in time to save Greece, then it risks a sharp discontinuity later. The VIX is still around 20, suggesting that the possibility of a meaningful gap in the market is being given no respect.

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I saw a pretty frightening article today that I don’t think has gotten a lot of play but should. I suppose that as people read through the mammoth finance bill, we’ll get the same sort of news from time to time as when people waded through the mammoth healthcare bill. There will be surprises about some of what it contains.

According to this story in Pensions and Investing (you may need a subscription to access it), defined benefit pension funds will be denied the use of swaps. Now, the unsophisticated voter – which is, of course, what this populist bill is mostly targeting – will say “good! Them dangerous derivatives could blow up my pension!” But in fact, this will exact large costs on pension funds. Many things that pension funds want and need to do cannot be done any way other than with derivatives. For example, pension funds have ultra-long liabilities, and so have an appetite for 40-year bonds. The problem is, there aren’t very many of those, and if a pension fund buys a super-long credit then it has super-long credit exposure. On the other hand, a pension fund that enters a 40-year interest rate swap that is fully collateralized will face no important credit risk, but gets the duration it needs. As another example, pension funds also have exposure to longevity risk: the risk that the retirees covered by the pension fund turn out to live lots longer than the actuary expects them to. This is great for the retiree, except when he or she discovers that the pension fund only has enough money to fund an 80-year average life instead of the 90-year average life that might happen if, say, we discovered a cure for cancer. This risk, when it is addressed, is addressed with longevity swaps in which entities with risk to longer lives (like pensions) lay off the risk to entities with risk to shorter lives (like life insurance companies).

To say nothing of the utility of inflation swaps to a post-retirement medical plan or a pension plan that has inflation-linked liabilities.

Moreover, according to the article this would also affect stable-value wrappers that allow defined contribution plans (IRAs, 401(k)s) to offer stable-value products. Technically, that involves a derivative.

Huge pieces of legislation like this are good for one thing: enacting enormous shifts in the way government interacts with its citizens before they can organize to prevent it. Congress should break up the legislation so that we can look at the pieces of it. Why not? Because then, crazy paternalistic rules like this would never pass muster.

There seems perhaps to be a little bit of second-guessing going on at the moment. Although the Chicago Manufacturing index was stronger-than-expected at 63.8, and although GDP was near-expectations at 3.2% (Personal Consumption was +3.6%) and +0.6% on the PCE deflator, and although the Employment Cost Index recorded a near-expectations +0.6%, the stock market fell (-1.7%) significantly for the second time in a week and the bond market rallied (+15/32nds on TYM0, 3.66%).

This despite the talk, predicted here on Thursday, that the ECB would shortly announce the rescue plan for Greece. Ordinarily, that produces a Friday rally and Monday disappointing selloff, but on Friday the rally did not materialize. Perhaps it was the rumors that the ECB was asking the Fed to renew swap lines, which some people felt implied the ECB expected a possibility of a tight financing environment for European institutions in the near future. I have no information on the rumor other than to observe that a tight financing environment, until we know which institutions are most vulnerable to a Greek default (and others), isn’t a stretch as far as concerns go. If in fact the ECB made such a pre-emptive request, then good for them!

Goldman fell 9.4% on Friday on the news that the SEC had commenced a criminal investigation into the company. That is a significant development. Remember that Anderson was brought low by the criminal charges, not by any proof of the merit of the charges. Success of a criminal complaint might kill the institution, and the mere threat of it is chilling (albeit not undeserved).

I have trouble believing stocks fell so far, however, merely because Goldman is being shot at or because of the shocking news that European institutions may be at risk if Greece defaults or the contagion spreads. To me this appears to simply be an overextended market where investors are taking some chips off the table due to a change in the preponderance of the risks. This should not be surprising, and I would not be surprised to see it extend further.

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I have seen a lot of comments recently suggesting that the ECB or other entities ought to regulate the ratings agencies in some way because the downgrades of Greece and other entities has “fed fuel to the fire” in this developing crisis. Such a suggestion gets it exactly backward, I think.

The ratings agencies are in precisely the same position that real estate appraisers are in, and more importantly were in, when the real estate bubble inflated. That is simply this: all parties have an incentive to see a higher rating rather than a lower rating, just as all parties in a real estate transaction have an incentive to see a higher appraisal. Let’s recall the latter situation first. The home seller has an incentive to see a higher appraisal, because it supports a higher transaction price. Local government likes the higher appraisals and higher prices, because it expands the tax base. The buyer likes the higher appraisal (it was usually the buyer who solicits the appraisal to support the mortgage loan), because it supports a larger mortgage loan and thereby reduces his outlay. The lender likes a higher price, because it makes money in proportion to the size of the originated loan or refi (and, since the loan is securitized, it doesn’t care whether there is a correlation with default). The broker prefers a higher appraisal, because it makes it possible to persuade more market transactions (the value of each of which, since the broker fee is 6% of transaction price, increases with price).  The appraiser has an incentive to appraise properties highly so he gets more business as an appraiser. No one, in fact, has an incentive to see a lower appraisal and the only party that has an incentive to get an accurate appraisal – the investor in the mortgage pass-through security – is the furthest removed from influencing the appraisal. Thus, appraisals are routinely inflated and appraisers are pressured to inflate appraisals by the originator who hires them. There is no mystery about this dynamic, and frankly even in the teeth of the housing bubble some people (ahem) were writing about this dangerous situation.

The same is true in bond ratings. Clearly, the issuer of the security wants a higher rating since it lowers its cost of funding. The buyer of the security, a portfolio manager, likes to see a higher rating since the manager is limited by statute in many cases and by mandate in many others from investing in securities below a certain rating; moreover, if the rating turns out to have been over-optimistic, the buyer can always blame the rating agency. “Hey! It was AA and that’s what I am allowed to buy!” The dealer of course has an incentive to structure securities at the margin where it just gleans the higher rating (and it can do so since the rating agencies make their rating formulas known, for reasons I have never understood), since it is easier to exact a high fee in this case. The rating agency itself wants to make people happy, and it knows people prefer high ratings to accurate ones and they get paid more the more ratings they do – the more bonds that are structured, the more the agency gets paid, if it can be counted upon to rate the bond “appropriately.” The one who cares most about the accuracy of the rating, the investor in the fund, is the one most removed.

What we want to do is to increase the value of high-quality, independent ratings, and we don’t do that by legislating a set of rules that agencies, structuring firms, and investors can just game differently. We need less structure to the rules, not more. How would the ultimate beneficiary of the ratings – that is, the person whose money is invested, look at the problem? They want ratings to reflect the probability of default accurately given the position in the economic cycle. All rating agencies should report publicly the realized default and recovery statistics of the bonds they’ve rated for a forward-looking time period (to prevent sudden re-rating just before default). So, for example, S&P would report that for bonds backed by first-lien mortgage securities that they have rated AAA, 0.05% have defaulted within 1 year of that rating, .11% have defaulted within 2 years; of the same class of bonds they have rated AA, 0.20% have defaulted within 1 year, .22% have defaulted within 2 years, and so on. And then investment managers should be held responsible not for buying bonds of a particular rating but of a particular default probability. “You know that bonds rated B+ by AggressiveCo tend to default at a 2.5% rate, but according to your mandate you should have bought bonds that had less than a 2% chance of defaulting when you bought them.” Rating agencies that gained a reputation for being very astute readers of credit situations would flourish; the hacks would wither. A more finely-grained continuum would also reduce the problem associated when a rating change (for example, to below-investment-grade) essentially produces a run on the credit when its bonds are no longer eligible for inclusion in a mandate.

Because after all, as an investor I don’t want to know whether my manager only bought AAA bonds and they happened to go bust; I want to know why my manager bought this “AAA bond” that yielded 2% more than other AAA bonds and was surprised when it wasn’t as high-quality. What did my manager think about the probability of default? A rating is no substitute for credit analysis, unless the rating is a pretty good proxy for credit analysis. The only way to evaluate that is to look at the history.

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On Monday, March Personal Income and Consumption (Consensus: +0.4%/+0.6%, with 0.0% on Core PCE) will be released at 8:30ET and the ISM (Consensus: 61.0 from 59.6) at 10:00ET (also at 10:00 will be Construction Spending, Consensus -0.3%, but that is not a market mover). Although ISM is ordinarily of interest, I believe it pales in market significance to events in Europe. Friday’s Employment report will be meaningful, but right now it is the growing crisis across the pond that matters.

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One final note: I was in a meeting with a potential client on Friday and one of them remarked that they had seen my Letter to the Editor printed in Barron’s a couple of months ago. It is funny, because I hadn’t realized my note had been published. I looked it up, and indeed here it is in case you’re curious. I regret including Goldman in that list, but the general point is still true (even with respect to many people at Goldman).