Important Considerations and Our Agenda

Here at "A Dash" we like to keep things objective and impersonal.  For reasons that will be apparent, I would like to depart from that mode for today's article.  My objective is to provide the most immediate help both for investors and for traders.  I also hope to stimulate discussion.

My focus group often says that I sound too professorial.  That comes with sticking to what I know about and trying to educate readers.  A few of those commenting think that I place too much value on credentials.  Same answer.  Credentials frequently encompass knowledge.  Beware of thinking that shorthand methods are good answers.  And someone on Seeking Alpha even suggested that I was "long-winded."  Indeed!  (TM OldProf)

Let us just say that I like to explain fully.  Good writing is terse.  One way to start is by getting the ideas down and then editing.  For the moment, I am just trying to explain things.  This article is a typical example.

An Explanatory Anecdote

Here is a little story.  Many years ago I was a young aspiring student, trying to pass something called "prelims" so that I could begin my doctoral dissertation.  The prelims involved an oral examination covering everything you had learned in all of your courses.  It was an awesome task.  The courses we took typically involved several books and many articles in each of thirteen weeks for each of four courses.  Every year.  You were also fighting against time.  If you delayed too long, those teaching the courses (and therefore the topics of the prelims) would change.  There were many students who had a continuing need to audit the classes of the new professors so that they could pass prelims.  They often postponed their prelims, year after year.

I violated the norm.  I made a list of everything that I needed to read and know before taking my exams.  I scheduled the exams.  Each day I crossed something off of the list as I read it, and I also added any new topics that required review.  I took the exams on schedule without regard to the list.

Here is the question from this story:  At what point in my study did the list reach its apex?

Since I was reading and crossing off, an initial guess might be Day One.  The astute readership of "A Dash" is undoubtedly way ahead of the story.

The list was the longest on the day I took the examination!

The key takeaway is that the more you learn, the more you realize how much you do not know.

To be an authority, you should stick to what you really know about.  Look for your pitch.

Our Agenda

Since we are behind in a race with the market, we are going to do something a bit different.  Listed below are a number of propositions.  These are all conclusions we have reached based upon evidence we find convincing.  We hope and expect to write on each topic, so this is a preview, almost a data dump of thoughts in an effort to be timely with help.

Individual Investor Advice

We are getting plenty of calls and questions.  Here are the topics:

  • Market reaction reflects plenty of unusual features, mainly "forced selling."  We will try to talk more about how to recognize this.  Meanwhile, Warren Buffett said (something like) if you don't know jewelry, know your jeweler.
  • Most individual investors cannot figure this out for themselves and will make big mistakes if they try.
  • The average investor should be cautious about making any big decisions.  There is no rush.
  • My intelligent investors want to understand how this could have happened.  We have some articles planned.

Public Policy

There are plenty of opinions about what caused our problems and what solutions are best.  Most important for investors is the market implication.  Here are some topics:

  • The original TARP plan was focused on what Bernanke called the "root cause."  That would be housing.  Counter-party risk forced the government to address immediate symptoms rather than the cause.
  • A key question is the actual value of mortgage securities on the books of every financial institution.  Current methods of valuation range from a few cents on the dollar to the actual performing value of the loans.  Accounting rules favor the former, forcing financial institutions to shrink balance sheets at WARP speed.  A wise accounting expert recently wrote us that there would have been no problem if FAS 157 had been in place for ten or fifteen years before this crisis.  As we have said, it is a good idea, poorly implemented.
  • The Treasury will create a working market for illiquid assets.  Nearly everyone thinks that this means that taxpayers will lose.  Wrong!  The test for this plan will be what we call "Win-Win-Win."  This means that the financial firms will no longer be stuck with a foolish and unrealistic price.  The taxpayer, qua taxpayer,  will enjoy the purchase of an asset that will probably appreciate.  The taxpayer, qua citizen, will benefit because a normal trading market in these securities will be established, creating a fair market value.  This means that the taxpayer will not lose in employment, government benefits, local services, and home values.  For a preview, read the insightful article from David Altig, one of our featured sources.
  • The government actions will eventually restore normal credit markets for business and for home loans.  Most of those commenting on the housing market begin with a pre-conceived notion of the "correct" level of home prices.  The government plan will restore mortgage lending and facilitate actual price discovery.  No one knows for sure what this will be.

Pundit Pontification

For the moment, let us just say that many pundits are pontificating well outside of their happy zone.  In the shaded area of the Ted Williams picture, he explains that a good hitter becomes a 230 hitter if he swings at pitches even two inches outside of the strike zone.  The strike zone is increased by 37%.  We have too many pundits offering conclusions about things where they know nothing at all.  Their comments are what the average investor or trader reads every day.  This will be a theme for several articles, but the daily example is the insistence on "explaining" the stock market moves by some piece of news that would normally have a marginal effect.

Bonus Prediction

This is something you have not seen anywhere else.  In a few weeks, you will see it everywhere.  There is general consensus that the credit default swap market is flawed, unregulated, and possibly manipulated.

No one seems to have noticed that the ABX, the Market Index used to shrink the financial balance sheets and drive ratings downgrades, consists of only twenty securities — all credit default swaps.

Connect the dots….

Do you think that these CDS's might have been manipulated by those seeking short sale profits on financial firms?  At some point we will see that the "marks" used by accountants were not only illiquid securities, but possibly manipulated securities.  If there is ever an SEC investigation, we will see some "perp walks."

You heard it here first.

If this is correct, we will see — at some point — a review of assets, an expansion of assets.  It requires a method that correctly prices mortgage securities, not the ABX.

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  • Paul Nunes October 17, 2008  

    Jeff; your blog and David Merkel’s offer some of the most original thinking out there. as a professional with retail clients, I am impressed by what your team has accomplished with this. Great work!

  • John Sweda October 17, 2008
    Excellent article, Dr. Miller. Your writing style is very readable and the content is first-rate. Regarding the SEC, “Business Week” had a news item addressing possible manipulation of CDS’s dated Wednesday, Oct 8th, but it did not bring up the ABX as you have:
    “While little known to most individual investors, credit default swaps are commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt. But they also are bought and sold as bets against bond defaults — a buyer doesn’t necessarily have to own a bond to buy the credit default swap that insures it.
    Banks and other institutions have used credit default swaps to cover the risk of default in mortgage and other debt securities they hold. Many credit default swaps have sunk in value as the mortgage-backed securities they support have imploded.
    The over-the-counter market for the swaps has provided a “significant opportunity” for market manipulation, Cox said Wednesday.
    The SEC last month began a sweeping investigation of the market, looking at whether investors used credit default swaps to illegally profit from sharp declines in stocks of financial companies.”

  • VennData October 19, 2008  

    Is there an ETF made up of Gang of Nine CDSs?
    …and please stop picking on the hedgies; they’re mostly going out of business anyway. The market works… when government gets in the way.
    Deflation cometh: Sell your gold! Head from the hills (to the urban centers.) …and buy a steak dinner, which will be getting cheap.

  • Jeff October 19, 2008  

    Thanks to all for the encouraging comments and a reason to smile.