The Systematic Mispricing Of Debt by James Grant, Grant’s Interest Rate Observer from 2014
(May 15, 2015) How a $50 million loan to RadioShack turned into an $81 million gross impairment was the featured topic on the May 7 earnings call of Fidelity & Guaranty Life of Des Moines, Iowa (FGL on the Big Board). Stage one was that $50 million plainvanilla credit, the company explained. Stage two involved a $63 million equity tranche in a collateralized loan obligation, of which a certain portion was invested in RadioShack debt—nothing vanilla here. Stage three concerned a $33 million investment in a reinsurance vehicle that also came equipped with RadioShack exposure.
Dialers-in listened as the chief financial officer, Dennis Vigneau, summed things up. “Following extensive evaluation analysis. . . ,” said Vigneau, “the $50 million loan participation was impaired by $35 million, or 70%, to a fair value of $15 million. Next, the $63 million CLO investment, which was partially exposed to RadioShack, was impaired by $25 million, or approximately 40%, to a fair value of $38 million. And lastly, the $33 million preferred stock investment. . .was impaired by $21 million, or 64%, to a fair value of $12 million. In total, these impairments were $81 million gross. . . .”
Fidelity & Guaranty Life, an offshoot of the old U.S.F.&G., of Baltimore, is the firm that “helps middle-income Americans prepare for retirement,” or so claim its copywriters. If so, the life insurer’s investment department, with its RadioShack trifecta, itself needs help. Certainly, it gets none from the world’s central banks—or, as far as that goes, from the post-1981 interest-rate zeitgeist.
Great bond bull markets don’t come around all the time. There have been just three in America for the past 150 years—1865 to 1900, 1920 to 1946, and 1981 to the present. In the nature of things, bull markets end at extremes of valuation. In the case of bond bull markets (again, bearing in mind the limited sample size), ending points are also marked by the metallic scraping sounds of conservative fiduciaries searching for suitable income-producing investments in the bottoms of barrels.
This particular bull bond market, the post-1981 episode, is unique. It owes its extreme valuations, in good part, to radical monetary policy. In no previous modern interest-rate cycle did short-dated sovereign yields make their lows at less than zero or the 10-year Bund its low at just five basis points above zero. As for sensible-shoes Midwest fiduciaries harboring triple exposures in a credit that The Onion, for Pete’s sake, marked as a goner as long ago as 2007 (Grant’s, Feb. 20), that, too, is one for the record books.
The mispricing of biotech stocks or corn and soybeans is of no great consequence to finance at large. Interest rates are another matter. Universal prices, they discount future cash flows, calibrate risk and define investment hurdle rates. Interest rates are the traffic signals of a market economy. Ordinarily, some are amber, some are red and some are green. Since 2008, they have mainly been green.
Please find nearby a table that lays out the damage to government bondholders since the third week of April. As of midday Tuesday, it would have taken a dozen years of coupon income to compensate the owners of French and German 10-year notes for the mark-to-market losses they have borne in only a few weeks—losses, let it be noted, that have propelled yields, in the case of the French obligation, to just 98 basis points from a starting point of a mere 36 basis points.
“There is a lot of soul-searching at the moment,” an interest-rate strategist is quoted as saying in the May 8 Financial Times, “because a lot of people thought Bund yields were en route to minus 20 [basis points].” Minus 20 basis points for a 10-year obligation denominated in a fiat currency? Posterity, reading about this era in finance, may need some persuading to believe that what is purported to happen did actually happen, and to sentient human beings at that. It seems implausible even now, when we are living through it.
Except for manhandling by the central banks, Steven Kandarian, chairman of MetLife, is on record as suggesting that 10-year Treasury yields would trade at between 4% and 4 ½% (“based on the Fed’s 2% inflation target and expectations for long-term economic growth,” he wrote in the MetLife 2014 annual report). As it is, the Treasury 2s of 2025 are quoted at a hair less than 98 to yield 2.25%. A yield of 4 ½% implies a price not far from 80. Not much coupon protection there, either.
Which brings us back to Fidelity & Guaranty Life’s triple stumble in RadioShack. As an isolated investment error, it would mean little. As a sign of the times, it would be much. “I guess,” Brian Horey, president of Aurelian Partners, a long-short equity fund, tells colleague David Peligal, “you can think of it as the structural manifestation of the reach for yield. I have no idea how widespread the use of junk credits as reference entities for derivatives like these have become, but I’ll note that, in this case at least, it is all well outside the Paul Volcker-and Elizabeth Warren-neutered banking system that so many obsess over today, and thus likely to be invisible from a regulatory standpoint. As such, it seems like quite potent fertilizer for a ‘hoocoodanode’ moment some quarters or years hence. If regulators have carried forward any scar tissue from the last cycle that can be put to use, that scar tissue should start to feel itchy upon review of FGL’s RadioShack adventure.”
The repricing of interest rates will be its own kind of adventure.
Essence of China
(February 6, 2015) China is a riddle wrapped in a mystery inside a phony press release, to adapt a line of Winston Churchill’s. By official contention, the GDP of the People’s Republic registered year-over-year growth of 7.3% in the fourth quarter. Yet, also in the fourth quarter and likewise measured year-over-year, profits at Chinese industrial companies tumbled by 5.8%. In December, the China Leading Index, which is derived from stock prices, credit spreads, a consumer expectations’ survey, real estate investment and freight traffic, among other soundings, dropped to its lowest level since February 2009.
Ping An Insurance Group Co. of China (2318 on the Hong Kong Stock Exchange) is one of two featured topics in the essay now unfolding. The financial system in which this important company has its cosmetically luminous being is the second. In preview, we’re bearish on the stock and astonished anew at the system. China, the supposed once and future driver of world economic growth, remains a laboratory experiment in how much debt a society can bear without actually collapsing.
“You have to keep in mind that the GDP number is a bureaucratic target, not an analytic result,” replies Anne Stevenson-Yang, the co-founder and director of research of Beijing-based J Capital, in response to the question: Why do China GDP data seem to have so little to do with reality? “The Stateowned Assets Supervision and Administration Commission, the nominal owner of all the state-owned companies, makes its budgets with reference to the posted GDP target. Each industry has a number that is based on a correlation to historic GDP figures and you are given that formula and that is your production target for that year. If the premier were to say, ‘Actually, growth is 3%,’ then SASAC takes down all the targets and it becomes a self-fulfilling prophecy. You can’t afford to do that.”
Grant’s isn’t the only observer that missed the run-up in the Shanghai stock market last year. Plenty of Chinese wanted no part of it, either. Outbound flows of local currency have pushed the renminbi-dollar exchange rate to an eight-month low. Once upon a time, the People’s Bank bought dollars—all told, $4 trillion of them—in order to tamp down the renminbi’s value. Now it is selling dollars—$150 billion in the six months ended December—to support the renminbi’s value. In buying dollars, the PBOC expanded the money supply. It is selling dollars, it is contracting the money supply. Is this the way modern communist functionaries minister to a sickly economy?
Pity the Red planners (or try to). The government lashes the renminbi’s value to the dollar through an administered trading band. The dollar has been on an upside tear. Beijing would welcome stronger exports. It chafes at the collapsing yen and euro. But an explicit devaluation of the renminbi could touch off a spasm of capital flight. Likewise, an explicit gesture of monetary easing might have undesirable consequences in a country in which—as Charlene Chu observed at the Fall 2014 Grant’s Conference—debt is twice as large, and is growing twice as fast as GDP.
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