Mid-Year Sector Performance Confirms ABCT

From Bespoke Investment Group:

As we come to the end of the first half of the year, below we take a look at S&P 500 sector performance so far in 2010. At this point, no sector is up year to date. The S&P 500 as a whole is down 6.17%, while the Materials [capital goods] sector is down the most at -12.22% and the Consumer Discretionary sector is down the least at -0.31%. Four sectors are outperforming the overall index (Consumer Staples, Financials, Industrials, and Consumer Discretionary), while six sectors are underperforming (Materials, Energy, Telecom, Technology, Health Care, Utilities). When markets are down, the cyclical sectors are usually down the most, while defensive sectors are down the least. That hasn't really been the case so far at this point in the year.

In related news, the latest Twilight saga "generated record sales of more than $30 million from midnight showings in U.S. and Canadian theaters."

Why the 10 Year Yield is Dropping, and Why the 30 Isn't Catching Up

In response to RW's post yesterday on the drop in the 30 Year fixed rate mortgage to 4.375%, I commented:

Ultra-low mtg rates are why the Fed announced a coupon swap today on to-be-settled Agency MBS. On-the-run 5.5's are expensive because of low supply. Doubt these were purchased prior to the Mar 31 termination of the purchase program, but as a result of dollar rolls. Each transaction is a hidden subsidy to favored PD's.

Another unintended consequence: MBS duration models are triggering long term Treasury purchases to compensate for increased prepayment risk. These models are slow to adapt, however, and many data sources suggest refis are slowing, not growing (incl. Consumer Metrics Institute). 10's could go to 2%, but the ultimate unwind will be enhanced when the artificial demand evaporates.

Today, ZeroHedge runs with a Morgan Stanley report, part mea culpa, part defensive posturing with regard to Jim Caron's prior (and continuing) non-deflationary stance. After some hilarious predictions about 3.5% annual growth for the US in 2010 (globally 4.8%!), Caron reasons as follows:

But for now, here are some of the reasons the UST 10y has broken down below 3.00%

1. Fundamental reasons: The most common reason is that people feel the mkt is headed into a disnflationary double dip and buying UST 10s at this level is a good play for that scenario.

2. Hedging reasons: as one long/short equity manager put it to me, "USTs are big and liquid, you've gotta own them". This was in the context of owning USTs as a preferred hedge against their equity longs. They felt owning USTs was akin to owning tail risk. And at least you got paid some carry to own this hedge. If mkt conditions improved, you could exit easily.

3. Asset Allocation and Indexers - these reasons are more technical:

• people were short/underweight USTs through May. Recently, fund managers have been getting back to a neutral weighting, which implies they will need to buy USTs in the process.
• as the universe of USTs increase, indexers need to buy more and more USTs to remain at the prescribed weighting of their index.
• the Fed announced yesterday it was going to swap the 5.5% coupon mortgages it bought during QE for 4.5% coupon mortgages. This was done for liquidity to alleviate delivery fails in the 5.5%s. The impact of moving to a lower coupon is that it's duration is longer. So, if you sell the 4.5% mortgage to the Fed in exchange for a 5.5%, then you are effectively short ~$2Bn UST 10y equivalents. This means you need to BUY $2Bn 10s. This caused the mkt to drop 6bps in UST10y yields in a flash. Also, people speculated this may be a signal QE may re-start, which we think is nonsense.
• Month-end/Quarter end window dressing. Although there is not much of an extension, managers want to show investors they own nice safe USTs.
• people view the roll-off of the €442Bn 1yr LTRO in Europe on July 1 as a potential event risk. We disagree with that notion (as per Mutkin's last weekly).

4. Rumors: there have been some articles in the UK Telegraph suggesting that the Fed will enter QE again and buy over $2Tr more in assets. This has not been verified as a reliable source.

A Counter Point to the Deflationistas

If true deflation fears were at work in the market then one should expect the longest duration points on the curve to rally most and we would see a significant flattening of the yield curve, especially the UST 10s30s segment of the curve. We use this as a check against deflation fears. Instead, we see the opposite with the UST 10s30s curve right up against its 20-year highs. If deflation is truly at work in the market, then someone ought to tell the UST 10s30s curve. And for that matter, all curve segments should be much flatter. Yet the curve flattening has been slow and grudging. Thus the yield curve is more representing an overall shift to lower yields as the Fed is expected to be on hold for a long time, not that deflation is truly at work. Don't confuse the two. It's too early to conclude that deflation is truly at work in the marketplace.

His justifications for the yield drop are pretty much spot on (though the conditions will likely persist longer than he thinks); however, his observations on the 10s30s spread are leading to an erroneous conclusion. That segment will be the last to contract because (a) there is a real and rising risk of US default as evidenced by credit default swaps (30 years is 3 times as long as 10 years, after all), (b) the 30 year is not used as a primary hedge instrument against duration, nor is it materially a necessary embedded component in the half quadrillion in interest rate swaps (IRS) (whereas the 2, 5 & 7 tenors--and to a lesser degree the 10--are), and (c) the greatest demand for the 30 year will be the Fed itself when it restarts Treasury QE.

Until Gentle Ben's QE 2.0 capitulation, the 10s30s spread should not be read as a non-confirmation of deflation as there is simply not the same artificial structural demand for the 30 year as there is with the 10. This is also in line with my previous explanation of how artificial distortions in the yield curve will hinder its predictive power.

Long term, it's going to be inflationary turtles all the way down, but for the time being, Treasurys are more than likely to rally (that is, unless you think the S&P 500 puts in a quadruple bottom here).

(IL)liquidity Alert

Market liquidity, as measured by proxy through the eMini S&P 500 futures contract via a proprietary measure, had improved over the last few weeks, but just deteriorated significantly. The last time it approached these levels from the downside (greater to less liquidity) was May 6. This doesn’t mean there will necessarily be another flash crash, but that it is very easy to push prices around on low volume. Caution is warranted with all positions.

Fed VP concerned with meat supply, not money supply

NY Fed Vice President Joseph S. Tracy waxed philosophical today at the Westchester County Banker's Association, as he weighed the nomenclatural merits of "The Panic of 2007" versus "The Great Recession." While he educates us on the Knickerbocker Trust, the shadow banking system and the similarities between the recent asset bubble in housing and the bubble in copper preceding the Panic of 1907, at no time are we treated to a discussion of the Fed-induced subnaturally low interest rates in 2003 that led to an explosion in money supply--a necessary condition precedent to the greatest bid up of risk assets and relaxation of diligence standards in modern times. For that matter, the term "money supply" did not garner a single mention, though a close derivative did:

Why did the point at which house prices peaked and started to fall in some housing markets spark a run on the repo market? Additionally, why did the problems in subprime mortgage assets spread quickly to other assets? Gary Gorton uses the analogy of an E. coli breakout.12 Suppose that E. coli is thought to have infected a small quantity of the country’s meat supply. The difficulty is that no one knows which batches of meat have been infected. If eating infected meat will cause the individual to become very sick, then the natural reaction is for everyone to immediately stop eating meat altogether. This will continue until the entire meat supply has been recalled and inspected. Subprime mortgage defaults were the E. coli that infected the financial system. Some mortgage assets would lose significant value as a result, but it was difficult to know which mortgage assets were "infected" and who was holding these assets. The natural response was to pull back from these assets.

File under "your central bankers at work."

The Internet Police Are Coming: Introducing the Internet "Kill Switch"

A bill recently introduced by Joseph Lieberman in the US Senate threatens the basic tenets of a free and open internet through the creation of a new National Center for Cybersecurity and Communications (NCCC) within the Department of Homeland Security. In addition to giving the President the power to declare indefinite "National Cyber Emergencies", it would grant broad powers to the NCCC to coerce and entice key private internet infrastructure companies into compliance with new arbitrary government standards. A thorough read of the bill reveals the Feds may intend to rewrite the very structure of the internet for their own ends. ZDNet Australia covers many of the more onerous features:

A new US Senate Bill would grant the President far-reaching emergency powers to seize control of, or even shut down, portions of the internet.

The legislation says that companies such as broadband providers, search engines or software firms that the US Government selects "shall immediately comply with any emergency measure or action developed" by the Department of Homeland Security. Anyone failing to comply would be fined.

That emergency authority would allow the Federal Government to "preserve those networks and assets and our country and protect our people," Joe Lieberman, the primary sponsor of the measure and the chairman of the Homeland Security committee, told reporters on Thursday. Lieberman is an independent senator from Connecticut who meets with the Democrats.

Due to there being few limits on the US President's emergency power, which can be renewed indefinitely, the densely worded 197-page Bill (PDF) is likely to encounter stiff opposition.

According to the bill, the statutory limits on what would constitute a "National Cyber Emergency" are indeed broad:

an actual or imminent action by any individual or entity to exploit a cyber vulnerability in a manner that disrupts, attempts to disrupt, or poses a significant risk of disruption to the operation of the information infrastructure essential to the reliable operation of covered critical infrastructure;

A simple statement by the President every 30 days would maintain the state of emergency with no details required to be revealed to the public.

TechAmerica, probably the largest US technology lobby group, said it was concerned about "unintended consequences that would result from the legislation's regulatory approach" and "the potential for absolute power". And the Center for Democracy and Technology publicly worried that the Lieberman Bill's emergency powers "include authority to shut down or limit internet traffic on private systems."

The idea of an internet "kill switch" that the President could flip is not new. A draft Senate proposal that ZDNet Australia's sister site CNET obtained in August allowed the White House to "declare a cybersecurity emergency", and another from Sens. Jay Rockefeller (D-W.V.) and Olympia Snowe (R-Maine) would have explicitly given the government the power to "order the disconnection" of certain networks or websites.

On Thursday, both senators lauded Lieberman's Bill, which is formally titled Protecting Cyberspace as a National Asset Act, or PCNAA. Rockefeller said "I commend" the drafters of the PCNAA. Collins went further, signing up at a co-sponsor and saying at a press conference that "we cannot afford to wait for a cyber 9/11 before our government realises the importance of protecting our cyber resources".

Under PCNAA, the Federal Government's power to force private companies to comply with emergency decrees would become unusually broad. Any company on a list created by Homeland Security that also "relies on" the internet, the telephone system or any other component of the US "information infrastructure" would be subject to command by a new National Center for Cybersecurity and Communications (NCCC) that would be created inside Homeland Security.

The only obvious limitation on the NCCC's emergency power is one paragraph in the Lieberman Bill that appears to have grown out of the Bush-era flap over wiretapping without a warrant. That limitation says that the NCCC cannot order broadband providers or other companies to "conduct surveillance" of Americans unless it's otherwise legally authorised.

Though the limitation on wiretapping is a blatantly hollow bone thrown to counter legitimate arguments against free speech encroachment, more dangerously, the new law will institutionalize the chilling repression of online free speech. It will establish a multi-tiered internet with assets that are either within the new National Information Infrastructure or not. For those that are in, the NCCC has broad powers, both carrots and sticks, to induce compliance with what it would deem acceptable content, both here and abroad. From ZDNet:

The NCCC also would be granted the power to monitor the "security status" of private sector websites, broadband providers and other internet components. Lieberman's legislation requires the NCCC to provide "situational awareness of the security status" of the portions of the internet that are inside the United States — and also those portions in other countries that, if disrupted, could cause significant harm.

Selected private companies would be required to participate in "information sharing" with the Feds. They must "certify in writing to the director" of the NCCC whether they have "developed and implemented" federally approved security measures, which could be anything from encryption to physical security mechanisms, or programming techniques that have been "approved by the director". The NCCC director can "issue an order" in cases of non-compliance.

Incentives to private companies that are critical to national infrastructure include civil immunity and/or taxpayer indemnification from civil lawsuits arising as a result of compliance, as well as large contracts for internet security providers, such as antivirus software developers.

Not mentioned in the article are a formalized citizen cyber-snitching program (page 101) and, more troubling, the ability of the new NCCC to rewire the internet from a standards and framework standpoint. From page 66 of the bill:

"(b) ANALYSIS AND IMPROVEMENT OF STANDARDS AND GUIDELINES.—For purposes of the program established under subsection (a), the Director shall—

"(1) regularly assess and evaluate cybersecurity standards and guidelines issued by private sector organizations, recognized international and domestic standards setting organizations, and Federal agencies; and

‘‘(2) in coordination with the National Institute of Standards and Technology, encourage the development of, and recommend changes to, the standards and guidelines described in paragraph (1) for securing the national information infrastructure.

With the weight of federal resources behind it, "encourage" and "recommend" may be read as "dictate" and "police".

The incredible success of the internet is based upon its guts being mere conduits for information that is processed at the ends. As David Isenberg wrote in his seminal paper in 1997, it is a Stupid Network, one

• with nothing but dumb transport in the middle, and intelligent user-controlled endpoints,
• whose design is guided by plenty, not scarcity,
• where transport is guided by the needs of the data, not the design assumptions of the network.

Any attempts to push information processing back into the middle of the network is a step back toward the old telephone company model. It is an inherent cap on future productivity gains even in the best-intentioned administered world. In a world of suspect intentions, abuse of new control powers is guaranteed. Opponents of (the deceptively named) net neutrality proposal should be especially alarmed as this new bill will put power they were afraid to give to ISP's into bureaucrats in Homeland Security. Opponents of the (also deceptively named) Fairness Doctrine should balk as it is the Fairness Doctrine on steroids.

Though horrific and sometimes avoidable, previous national emergencies were at least visible. With no public transparency or accountability, a National Cyber Emergency could be created with the push of a button and shut down all non-sanctioned internet traffic. The level playing field created by the Internet, with its unprecedented information sharing capabilities, is under attack. Senate bill 3480 must not be allowed to pass.

(ht The Coming Economic Depression)

Did Bernanke just tell Congress the Fed is supporting the stock market?

"On the monetary side, the Treasury and the Federal Reserve System must stop creating artificially cheap money — i.e., they must stop arbitrarily holding down interest rates. The Federal Reserve must not return to the former policy of buying at par the government's own bonds. When interest rates are held artificially low, they encourage an increase in borrowing. This leads to an increase in the money and credit supply. The process works both ways — for it is necessary to increase the money and credit supply in order to keep interest rates artificially low. That is why a "cheap money" policy and a government-bond-support policy are simply two ways of describing the same thing. When the Federal Reserve Banks bought the government's 2½% bonds, say, at par, they held down the basic long-term interest rate to 2 percent. And they paid for these bonds, in effect, by printing more money. This is what is known as "monetizing" the public debt. Inflation goes on as long as this goes on."

Henry Hazlitt, "What You Should Know About Inflation" - 1964

Following Federal Reserve Chairman Bernanke’s February 24, 2010 testimony to Congress, Congressman Alan Grayson--perhaps best known to those outside his home city of Orlando for his periodic comedic and dramatic YouTube moments--submitted 17 questions to the Chairman. Bernanke's response raises more questions than it answers, as ZeroHedge notes. A cursory review confirms our worst fears, revealing a man at the helm of the world's most powerful central bank that is either (1) so clueless he cannot grasp the most basic of economic tenets and/or (2) willing to respond dishonestly to Congress in writing. Anyone with a hint of understanding of economics will want to put down their coffee before learning the beguiled Chairman “[doesn’t] believe that monetary policy during the early and mid-2000s was responsible for the boom and subsequent bust in the U.S. housing market.” The material deserves a thorough point by point refutation, which will be the subject of a later post. For now, however, we turn to the patently dishonest response to question 1 regarding the Fed’s intervention in the stock market.

Questions for The Honorable Ben Bernanke, Chairman, Board of Governors of the Federal Reserve System, from Congressman Grayson:

1. The Federal Reserve has taken extraordinary measures to prevent losses by large financial institutions. This has led to widespread speculation that such measures might include intervention in the stock market. Has the Federal Reserve--alone or in concert with the Treasury Department or any part of the government--ever taken any action with the purpose or effect of supporting the stock market or an individual stock? The means to do so included in this inquiry include, but are not limited to, the futures market, the Exchange Stabilization Fund, foreign custody accounts, the System Open Market Account, and any other account, mechanism or financial instrument. Has the Federal Reserve, Treasury, or any part of the government ever directed, acted in conjunction with or otherwise engaged a proxy or intermediary--including but not limited to a private sector entity or foreign central bank--with such a purpose or effect? Please respond to both parts of this question. Please note that we are asking you to enumerate each such action, with a description on each occasion of who, what, when, where and why.

[Answer:] The Federal Reserve has not intervened to support the stock market or an individual stock.

At fifteen words, this is by far the shortest response—revealing perhaps that the Fed has more to hide here than anywhere else. The question clearly asked if the Fed had taken any action with either the purpose or effect of supporting the stock market. Yet, Gentle Ben replies only to the former when he writes the Fed has not intervened to support the stock market. The evasion is not surprising because documents obtained through Lehman bankruptcy proceedings reveal that during the maelstrom of the post-Lehman crash in September, 2008, the Fed at one point held as collateral some $4.4 billion in equities on its books, including among other things 5,136 shares of bankrupt retailer Shaper Image. ZeroHedge provided a full analysis as well as the following proof:

While it can be argued that the intent was not to support the stock market or any individual stock, the effect was certainly to do so, as it provided a fleeting floor for equities during that turbulent time. As we lack granular data on the numerous other interventions that preceded and followed, we can only speculate as to the Fed’s complete role in supporting the equities markets. However, as we demonstrated in August, 2009, there was an incredible correlation between days on which the Fed would pay primary dealers billions for their Treasury securities (as part of the Fed's quantitative easing program) and paint-the-tape closes in the stock market.

Then, there is the curious statement by Nouriel Roubini in December, 2008 suggesting the Fed might intervene to buy stocks indirectly. Regular EPJ readers are apprised that the highly connected Roubini does not simply shoot his mouth off, but echoes his conversations with the power elite. Washington’s Blog covered it here:

As I pointed out in December 2008, Nouriel Roubini wrote the month before that the government might buy U.S. stocks:

The Fed (or Treasury) could even go as far as directly intervening in the stock market via direct purchases of equities as a way to boost falling equity prices. Some of such policy actions seem extreme but they were in the playbook that Governor Bernanke described in his 2002 speech on how to avoid deflation.

Given that Roubini was previously a senior adviser to Tim Geithner, he probably knows what he's talking about

Finally, we turn to the Maiden Lane LLC portfolio—the $30 billion cesspool of Bear Stearns Assets actively managed by BlackRock Securities to this day (though sold to the public as a wind down portfolio), originally taken on by the NY Fed after Bear Stearns was gifted to JP Morgan in early 2008. As we count down the days to Maiden’s two year anniversary--and we greatly anticipate the 4:00 pm Friday June 25 press release stating JP Morgan will be reimbursed ahead of the taxpayers to the tune of $1.xxx billion--it’s worth pointing out that BlackRock, on behalf of the NY Fed, has actively bought and sold interest rate futures, putatively for hedging purposes:

Excerpt from Maiden Lane LLC Holdings as of January 29, 2010

Source: Federal Reserve Bank of New York

And therein lies the rub: if BlackRock can buy interest rate futures for hedging purposes, why couldn’t the Fed buy massive amounts of equity index futures and options, also for hedging purposes? Hedging does not imply intent to support prices, but to mitigate loss in an extant portfolio. With the NY Fed's System Open Market Account bloated to beyond $2 trillion in assets, any number of hedging strategies could be concocted that would provide direct support of the equities markets and possibly individual stocks. So when Chairman Bernanke only answers half of a question and in the negative, it implies a positive response in the other half. Namely: the Fed has intervened in the stock market with the effect of supporting it.

While a redirect to Bernanke for clarification would be appropriate, it’s time to stop playing footsie with those that are squandering what’s left of our future for their personal gain. What the people need is a line by line accounting of every transaction executed by or on behalf of the Federal Reserve Banks of the US. What is needed is a full audit of the Fed.

Where's the Steve Jobs Foundation?

After reading two EPJ posts by Michael Labeit and Bob Wenzel, I had to ask the above question. Wenzel writes that according to the WSJ, the Federal Trade Commission and Department of Justice are about to harass Apple because of its dominant #2 spot in the smart phone industry. Heads up to the DOJ: Apple has also captured the PC market with an 8% and "surging" share.

Labeit posts a Walter Block lecture from 2005 that concludes with Block speculating that Bill Gates will no longer face anti-trust harrassment since he became a serial (and prolific) philanthropist. A quick Google search revealed that the Bill and Melinda Gates Foundation is connected to the Council on Foreign Relations and Melinda Gates is herself a Bilderberger. Consultation with the authoritative Wikipedia entry for the antitrust suit led me to believe it's largely done with, and I can't remember the last time I read anything about it at ZDNet. Was Windows Vista a conciliatory, strategic flop?

The more important question: is Steve Jobs safe or is he connected enough to put the dogs back in the kennel? Does he have his own charity that gets him in the club? A search for "Steve Jobs Foundation" led me to a January 25, 2008 report by one "Comrade Che" that:

Apple billionaire Steve Jobs announced a new direction Friday as he pledged hundreds of dollars in grants to develop design awareness among itinerant farmers in poor countries.

Hundreds? Upon reflection, it may have been satire. However, a rapid-fire succession of Google searches (see how easy it is to be a citizen journalist) revealed that Jobs was not a Bildeberger, nor a CFR member, nor an Illuminati, nor a shape changing lizzard. The number one authority on what organizations Steve Jobs belongs to (by virtue of being the number one Google result for "Steve Jobs Organization") is Steven Berglas. And though he didn't touch on the subject of Jobs' affiliations (when will Congress finally will pass a law to compel better search results?), I did learn this from the article written back in October, 1999:

Think about this: Jobs initiated a rapprochement with Bill Gates. Bill Gates! Just how much of a good thing can Jobs tolerate?
...
To his credit, Steve Jobs, the enfant terrible widely reputed to be one of the most aggressive egotists in Silicon Valley, has an unrivaled track record when it comes to pulling development teams through start-up hell. Using monomaniacal zeal and charisma, he's a natural Pied Piper in an industry littered with good ideas that have been killed by bad managers. In Accidental Empires, an exposé of Silicon Valley's movers and shakers, Robert X. Cringely commented on Jobs's first stint as Apple's CEO: "Like the Bhagwan driving around Rancho Rajneesh each day in another Rolls-Royce, Jobs kept his troops fascinated and productive. The joke going around said that Jobs had a 'reality distortion field' surrounding him. He'd say something and the kids in the Macintosh division would find themselves replying, 'Drink poison Kool-Aid? Yeah, that makes sense.' "

So Jobs was dissing Gates eleven years ago, but now Gates is all connected and giving his stuff away. On top of it, Jobs creates his own reality and has zeal. Zeal! Then, I remember hearing a few weeks ago that Apple has now overtaken Microsoft in market capitalization. So maybe those HFT NYSE collocated trade bots are running on iPads, helping to explain the 2 million in unit sales the first month. But really--just who does Steve Jobs think he is? I'm afraid he's playing with fire and Apple's gonna get burned.

Jobs: if you're reading this, you need to stop concentrating on satsifying consumer demands with sleak, stylish electronics, and instead focus on how you're going to give all your money away to inefficient and corrupt NGO's that will recycle your money into the hands of the global banking elite.

posted from my iPhone

Why the Yield Curve May Not Predict the Next Recession, and What Might

Gone are the days when "green sh#%ts" was bleated daily on CNBC amongst a chorus of permabull snorts. Even the experts now recognize the recovery as a BLS swindle, and it is important to reintroduce the possibility of not only a low growth future, but one of outright and persistent contraction. As “double dip” has recently worked its way into the popular lexicon, we will explain why a traditional forecasting tool of recessions may not flash a warning this time around. Afterward, we explore why even “double dip” may not be an accurate term, as well as what a cutting edge-new economic indicator is forecasting.

Gary North wrote an excellent article explaining why yield curve inversions predict recessions. It is instructive now to illustrate how the fundamental backdrop has changed amidst unprecedented government intervention.

The interest rates for more distant maturities are normally higher the further out in time. Why? First, because lenders fear a depreciating monetary unit: price inflation. To compensate themselves for this expected (normal) falling purchasing power, they demand a higher return. Second, the risk of default increases the longer the debt has to mature.

In unique circumstances for short periods of time, the yield curve inverts. An inverted yield occurs when the rate for 3-month debt is higher than the rates for longer terms of debt, all the way to 30-year bonds. The most significant rates are the 3-month rate and the 30-year rate.

The reasons why the yield curve rarely inverts are simple: there is always price inflation in the United States. The last time there was a year of deflation was 1955, and it was itself an anomaly. Second, there is no way to escape the risk of default. This risk is growing ever-higher because of the off-budget liabilities of the U.S. government: Social Security, Medicare, and ERISA (defaulting private insurance plans that are insured by the U.S. government).

We are no longer in a persistently inflationary environment, despite the best multitrillion-dollar reflationary efforts to the contrary. Disinflation and outright deflation keep popping up in critical areas of the economy. While the central banks will likely overshoot in the end, resulting in an hyperinflationary spiral, for the time being, lenders are not worrying about inflation. And, while one may doubt the BLS’ calculation expressed by the Consumer Price Index, the below chart of CPI year-over-year is nonetheless striking, as it indicates the recent crisis brought it into the most negative territory since inception.

On the rise are medical and food costs, but continued deleveraging by banks and consumers are offsetting deflationary drags. Banks are writing down (and off) private and commercial real estate loans, and consumers will remain in spending retrenchment as long as they continue to work off credit in a high unemployment environment. Indeed, year over year consumer credit is in the most negative territory post-WWII.

Though headline civilian unemployment from the BLS’ household survey is ticking down from the ominous 10% level, this is largely a result of the birth/death model adjustment and the removal of so-called discouraged workers from the counted pool. When viewed from the larger perspective of the civilian employment to population ratio, the job losses are staggering and unprecedented in the modern era. When the economy eventually does show improvement, these discouraged workers will reenter the job market and keep the headline unemployment rate persistently high.

Finally, creation of money supply, as expressed by non-seasonally adjusted year-over-year M2, continues to reflect slow money growth, notwithstanding the trillion or so in excess bank reserves sitting at the Fed earning interest at 0.25%. The very fact that banks are content to earn interest at this absurdly low rate indicates risk aversion and little fear of inflation.

North continues:

What does an inverted yield curve indicate? This: the expected end of a period of high monetary inflation by the central bank, which had lowered short-term interest rates because of a greater supply of newly created funds to borrow.

The obvious failure of the central banks to reflate the economy has now renewed fears that monetary inflation will not return for some time.

This monetary inflation has misallocated capital: business expansion that was not justified by the actual supply of loanable capital (savings), but which businessmen thought was justified because of the artificially low rate of interest (central bank money). Now the truth becomes apparent in the debt markets. Businesses will have to cut back on their expansion because of rising short-term rates: a liquidity shortage. They will begin to sustain losses. The yield curve therefore inverts in advance.

On the demand side, borrowers now become so desperate for a loan that they are willing to pay more for a 90-day loan than a 30-year, locked in-loan.

Aside from government darlings, businesses and critically, small businesses, have largely stopped expanding and are in defensive retrenchment. The problem is a reduction in both the supply and demand for new loans. There is definitely a liquidity shortage, but it is being expressed unconventionally as central bank quantitative easing and government stimulus are directed into non-productive parts of the economy. It is these zombie behemoths in the financial and transportation sectors that are most desperate for funds, yet they are not penalized for it. Instead, they are encouraged to feed at the government trough even as their smaller (and more productive) competitors are edged out through oppressive regulation and inability to access loans at a similar rate. This will continue to be a drag on overall growth, and without small business growth, the threat of recession relapse is greatly heightened.

On the supply side, lenders become so fearful about the short-term state of the economy -- a recession, which lowers interest rates as the economy sinks -- that they are willing to forego the inflation premium that they normally demand from borrowers. They lock in today's long-term rates by buying bonds, which in turn lowers the rate even further.

Though long term US Treasurys are benefitting from safe haven flight-to-quality status, short term Treasurys are similarly benefitting to a greater degree, thus widening the spread between the two. As stated above, banks are content to park over a trillion dollars in excess reserves at the Fed earning interest at 0.25%. A combination of a (currently low but slowly rising) fear of eventual US default, extreme desire for short term safety in T-Bills, and low fear of inflation is keeping the spread wide. Also troubling is the recent disconnect between short term Treasury yields and the borrowing rates actually available to businesses with excellent credit.

North concludes:

An inverted yield curve is therefore produced by fear: business borrowers' fears of not being able to finish their on-line capital construction projects and lenders' fears of a recession, with its falling interest rates and a falling stock market.

Indeed, these are the fears being expressed, but in different manners that are not immediately obvious. Small productive businesses are throwing in the towel as their larger competitors build Potemkin villages.

A further problem is that nearly all yield curve studies look back no further than the mid-1950’s, the inception of Fed data on US Treasury rates. Inasmuch as every recession since then (save the last) has been manufacturing based as opposed to credit based and has occurred in an overall inflationary backdrop, there lacks a crucial window into prior deflationary times concurrent with extreme government meddling—in particular, the Great Depression.

Many economists from the Austrian school follow M2 money supply as a harbinger of economic growth or contraction, as it tracks the creation and destruction of money through economic activity at the margins. As noted previously on EPJ, Rick Davis and others at the Consumer Metric Institute have created a novel indicator that tracks, in real time, consumer demand for capital goods. Accordingly, it should and does reflect similar activity, though with enhanced granularity. Indeed, it anticipates US GDP by an average of 17 weeks. A future post will explore this aspect of their data and possible uses for market timing. For now, Davis tells a different story than the governments that collude to forge a statistical recovery:

Our 'Daily Growth Index' represents the average 'growth' value of our 'Weighted Composite Index' over a trailing 91-day 'quarter', and it is intended to be a daily proxy for the 'demand' side of the economy's GDP. Over the last 60 days that index has been slowly dropping, and it has now surpassed a 2% year-over-year rate of contraction.

The downturn over the past week has emphasized the lack of a clearly formed bottom in this most recent episode of consumer 'demand' contraction. Compared with similar contraction events of 2006 and 2008, the current 2010 contraction is still tracking the mildest course, but unlike the other two it has now progressed over 140 days without an identifiable bottom.

As we have mentioned before, this pattern is unique and unlike the 'V' shaped recovery (or even the 'W' shaped double-dip) that many had expected. From our perspective the unique pattern is more interesting than the simple fact of an ongoing contraction event. At best the pattern suggests an extended but mild slowdown in the recovery process. But at worse the pattern may be the early signs of a structural change in the economy.

While confounding the average GE cheerleader, this new normal of increasing destructive intervention is intuitively understood by the consumer, who responds to this reality by pocketing the debit card. So what can we expect in the ensuing quarters?

Davis aptly describes what has happened so far:

[I]t has instead, unfolded so far as a mild but persistent kind of
contraction, more like a 'walking pneumonia' that keeps things miserable for an
extended period of time.

Until governments stop punishing innovation, stop rewarding incompetence, stop distorting economic signals with arbitrary econometric targeting, stop coddling failures--we will continue to walk with this pneumonia indefinitely. The solution, as always, is nothing. Stop intervening and let the chips fall where they may. Markets will correct things faster than you might think.

Curious Trading by Federal Reserve Advisor May Result in JPMorgan Chase $1.264 Billion Windfall

Since the Federal Reserve Bank of New York finished purchasing $1.25 trillion in mortgage backed securities in March 2010, it has continued to support those markets with billions in so-called dollar rolls. Even as this is not well known, what is less well known is that the advisor to the Fed's other MBS portfolio also continues to actively trade the account. The annual turnover appears to be 12%. One has to ask what the purpose of this turnover is, given it was sold to the public as a portfolio simply being wound down. Just what has BlackRock been selling off and who is buying the discards? (Could it be the Fed itself?) Is this a case of getting stronger paper into the portfolio for the benefit of JPMorgan Chase, run by President Obama’s "Favorite Banker", Jamie Dimon? Will an easily overlooked disclosure in the portfolio’s audit allow a $1.264 billion windfall payment to JP Morgan in the coming weeks? Nothing can be known for sure unless the Federal Reserve provides further data. But the trading in the portfolio and its valuation is very suspicious. Below is some background followed by a forensic analysis of what is known to date, with a discussion of what further data needs to be provided by the Fed to gain a full understanding of what BlackRock is attempting to accomplish with the unusually heavy trading in Maiden Lane.

Background

On the wings of the US housing boom, Bear Stearns had become the second-largest underwriter of US mortgage bonds, but from the summer of 2007 through March 2008, it quickly devolved into fire sale fodder as the subprime market imploded. It was eventually sold for $10 a share (down from $159 per share) to JP Morgan Chase (JPMC). In testimony before the Senate Banking Committee, bank president Jamie Dimon said his firm was “acquiring some $360 billion of Bear Stearns assets and liabilities.” However, they “could not and would not have assumed the substantial risks of acquiring Bear Stearns without the $30 billion facility provided by the Fed.” Maiden Lane LLC was to be this facility, financed on June 26, 2008 with a $28.8 billion senior loan from the New York Fed and a $1.15 billion subordinate loan from JPMC. The loans would purchase part of the Bear Stearns portfolio and be managed by BlackRock Financial Management, Inc. as Investment Manager. JPMC’s losses would be limited to its $1.15 billion contribution. The loans would each have a ten year term, with the Fed scheduled to be paid back starting as soon as June 26, 2010. The NY Fed was also granted certain discretionary options with respect to the timing of the payback which will be explored later.

This unprecedented intervention by the Federal Reserve was fiercely contested, and Chairman Bernanke was brought before the Senate Committee on Banking, to explain post facto that:

The sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence…The purpose of our action, as with our other recent actions--including our provision of liquidity to financial firms and our reductions in the federal funds rate target--was, as best as possible, to improve the functioning of financial markets and to limit any adverse effects of financial turmoil on the broader economy.

Despite that what the Fed attempted to avert became a new chapter in history and economic text books, it would be reasonable to infer that the new facility would be purposed with the orderly wind down of certain Bear Stearns assets after liquidity later improved. Indeed, on March 24, 2008 the NY Fed published a summary of terms, which referenced BlackRock only to the extent that it had “been retained by the New York Fed to manage and liquidate the assets.” The accompanying press release said that “BlackRock Financial Management, Inc. will manage the portfolio under guidelines established by the New York Fed designed to minimize disruption to financial markets and maximize recovery value.” As will be demonstrated, rather than merely referring to opportunistic liquidation, “maximize recovery value” would come to mean aggressive opportunistic purchasing of new assets as well.

In addition, the summary provided the repayment order as follows:

Repayment of the loans will begin on the second anniversary of the loan, unless the Reserve Bank determines to begin payments earlier. Payments from the liquidation of the assets in the LLC will be made in the following order (each category must be fully paid before proceeding to the next lower category):

to pay the necessary operating expenses of the LLC incurred in managing and liquidating the assets as of the repayment date;

to repay the entire $29 billion principal due to the New York Fed;

to pay all interest due to the New York Fed on its loan;

to repay the entire $1 billion subordinated note due to JPMorgan Chase;

to pay all interest due to JPMorgan Chase on its subordinated note;

to pay any other non-operating expenses of the LLC, if any.

Any remaining funds resulting from the liquidation of the assets will be paid to the New York Fed.

The two important points thus far are: (1) the portfolio would be used to wind down certain Bear Stearns assets and (2), JPMC is lower on the repayment ladder than the American taxpayer, inasmuch as the NY Fed can be said to represent such.

In the meantime, things did not go well for the Maiden Lane portfolio. Though Dimon denied before the Senate that the riskiest assets had been placed in the facility, as Janet Tavakoli wrote on February 18, 2010:

The assets included financing in the process of being restructured for Hilton Hotels and financing for Extended Stay, a hotel operator that is in bankruptcy. Since June 2008, the Maiden Lane I portfolio deteriorated further, and the Fed's reported value had fallen from the original $30 billion (including JPMorgan's $1 billion "cushion") to $27.1 billion at the end of 2009. If Jamie Dimon didn't give the Fed his riskiest assets, then he must have taken on some interesting risk in that original $360 billion from Bear Stearns.

Approximately ten months after Maiden Lane’s June 26, 2008 inception, in April 2009, the NY Fed published for the first time detailed disclosure of its portfolio composition in the form of the 2008 Maiden Lane audit and a summary web page. Long after BlackRock had commenced management of the portfolio, the public became privy to the fact that its investment directive was not only to liquidate, but to remain fully invested—specifically, to re-invest any wound down securities for a period of at least two years. From the web page:

During the period from June 26, 2008 (the Closing Date) to the second anniversary of the Closing Date (Accumulation Period), any proceeds realized on the Asset Portfolio (including interest proceeds and proceeds from maturity or liquidation of the Asset Portfolio) after payment of certain fees and expenses and any payments made pursuant to the derivative contracts will be deposited into a reserve account (Reserve Account) and reinvested in certain eligible investments.

…

BlackRock Financial Management Inc. (Investment Manager) has been retained by the New York Fed to manage the assets held in the ML LLC portfolio.

The Investment Manager’s primary objective in managing the ML LLC portfolio is to pay off the Senior Loan, including principal and interest, while refraining from investment actions that would disturb general financial market conditions.

The Investment Manager may purchase new assets in pursuit of the objective noted above. Eligible assets for reinvestment must be dollar-denominated and must fall within one of the following two categories:

All U.S. Treasury securities

Agency securities (MBS and debentures)

New York Fed, at its sole discretion, may add permissible categories for reinvestment.

Additionally, the Investment Manager may enter into OTC and exchange-traded derivatives solely for the purpose of hedging interest rate risk. Derivative contracts that would create new exposures to equities, commodities, foreign currency-denominated assets or sub-investment grade assets are expressly prohibited.

Agency securities are the mortgage backed securities and debt of the various housing related enterprises that enjoy a direct or indirect guarantee by the US Treasury, such as Fannie Mae, Freddie Mac and Ginnie Mae. While certainly not immune from toxicity, there is a well established, relatively liquid (during normal times) market for their instruments. They are also sold under a prospectus and therefore registered with the Securities and Exchange Commission. Contrasted with the extremely illiquid loan portfolio and non-Agency (private label) MBS, it makes sense that if there were to be trading allowed, it would be in Agency MBS and, of course, US Treasurys.

Maiden Lane Holdings Analysis

In April and May, 2010, the NY Fed released detailed reports of Maiden Lane holdings as of January 31, 2010 and March 31, 2010, respectively. As the Current Principal Balance (CPB) and CUSIP were provided for each security held, an algorithm was applied to match the unique CUSIP for each Agency MBS for both report dates to reveal changes in the holdings over the two month period, specifically looking for: (1) changes in CPB, (2) acquisition of new securities, and (3) elimination of securities from the portfolio. With most MBS, as prepayments and defaults occur over time, CPB will decline into the final payout. However, depending on the structure of the MBS and market conditions, it can stay the same or rise. It is important to note that CPB does not give information about a security’s fair value.

Composition of Maiden Lane LLC Holdings

	January 31, 20101	March 31, 2010	Difference
Total Assets in Maiden Lane2	$74,894,458,000	$73,740,103,587	$(1,154,354,413)
Federal Agency & GSE MBS Assets3	$31,938,562,000	$31,447,314,996	$(491,247,004)
Agency MBS ($) as % of Total Assets ($)	42.64%	42.65%	0.01%
Number of Agency MBS Securities	1,430	1,472	42

1 Rounded to thousands for this reporting date

2 Current Principal Balance or Notional Amount (e.g., swaps and hedges)

3 Current Principal Balance

Source: Detailed ML holdings Federal Reserve Bank of New York

While total assets and Agency MBS decreased over the period, the number of issues of Agency MBS increased sufficiently to keep the percentage of the Agency MBS portion of the portfolio nearly constant with respect to total assets over the period.

Changes in Current Principal Balance of Maiden Lane LLC Holdings of Federal Agency & GSE MBSfrom January 31, 2010 to March 31, 2010

Beginning Agency MBS Assets	$31,938,562,000
Agency MBS with CPB Lower1	$26,364,322,408
Agency MBS with CPB Unchanged2	$2,886,046,328
Agency MBS with CPB Higher	$727,401,888
Newly Acquired Agency MBS	$1,469,544,372
Agency MBS that was Liquidated or Received Final Payment	$(278,136,000)
Ending Agency MBS Assets	$31,447,314,996

1 Current Principal Balance (CPB)

2 Differences of less than $1,000 are considered unchanged because January 31, 2010 figures are rounded to the nearest thousand

Source: Detailed ML holdings Federal Reserve Bank of New York

Additions of new Agency MBS total 1.96% of Agency MBS assets as of the beginning of the period, which suggests that the total turnover for this part of the portfolio in the first two years ended June 26, 2010 could be 23.52%, or $7.512 billion. Some of the newly acquired securities were for forward delivery, such as FNMA 10-45 (CUSIP 31398PMD8) for $100 million, so the portfolio composition could conceivably change even after the two year accumulation period as forward contracts are settled.

Six months after Maiden Lane’s inception, the NY Fed began its $1.25 trillion Agency MBS purchasing program in January, 2010, and continued through March 31, 2010. Detailed holdings of these assets, which are managed by the NY Fed in its System Open Market Account (SOMA) are similarly disclosed weekly at par, or face value. An analysis was performed of the SOMA’s assets over the same two month period. Though little crossover between the SOMA and Maiden Lane disclosed assets was found, it would be necessary to obtain detailed holdings since inception to determine whether or not BlackRock possibly sold Maiden Lane assets to the NY Fed, especially since the January 31 to March 31 period was one in which the Fed was winding down Agency MBS purchases.

A similar analysis was also performed of the Maiden Lane residential mortgage backed securities (RMBS) portfolio. According to the NY Fed’s website, BlackRock was constrained to investing proceeds only in US Treasury securities and Agency MBS and debentures, and was expressly prohibited from creating any new exposure to sub-investment grade securities. Though the NY Fed retained sole discretion to add permissible categories for reinvestment, no disclosure has been made indicating that it did so.

It was curious then to find that four new RMBS appeared in Maiden Lane over the two month period, totaling $9.430 million. One in particular stands out as it is was underwritten by JP Morgan Securities Inc. and Countrywide Securities. Namely, $5.000 million of one Class M-8 (CUSIP 46626LBA7) of J. P. Morgan Acquisition Corp. 2005-FLD1, originally issued via a prospectus supplement dated July 29, 2005 in gross amount of $15.247 million, which was downgraded to CCC (junk status) by Standard & Poors on July 23, 2008. The other tree non-Agency MBS were ATRIUM V 2006-5 (CUSIP 04963WAJ5), CARRINGTON MTG LN 2006-NC5 (144539AN3), and CARRINGTON MTG LN 2006-NC5 (CUSIP 144539AM5).

Because JPMC is not only a subordinate debt holder of Maiden Lane, but also involved in its hedging transactions, there was a potential violation of section 23A of the Federal Reserve Act and the Board’s Regulation W. As such, it was granted an exemption by letter dated June 26, 2008 from the Board of Governors. The exemption was qualified as follows:

This determination is specifically conditioned on compliance by JPMC and JPMC Bank with all the commitments and representations made in connection with the request. These commitments and representations are deemed to be conditions imposed in writing by the Board in connection with granting the request and, as such, may be enforced in proceedings under applicable law. This determination is based on the specific facts and circumstances of the existing and proposed relationships among JPMC, JPMC Bank, and Maiden Lane. Any material change in those facts and circumstances or any failure by JPMC or JPMC Bank to observe any of its commitments or representations may result in a revocation of the exemption.

While the $5 million RMBS purchase constitutes an immaterial portion of the Maiden Lane portfolio, it is material that, in the limited public disclosures released to date, there is not only an apparent violation of the original terms of the facility, but a glaring potential conflict of interest. In light of this, a review of the June 26, 2008 exemption letter may be in order.

Motive

The question remains: why all this trading by BlackRock for a relatively insignificant taxpayer asset, and why all these recent data releases by the NY Fed?

To answer, one must return to the updated terms page for Maiden Lane published in April, 2009, where for the first time there is disclosed an interesting statement about the repayment of the loans:

At the sole discretion of the New York Fed, repayment of the Senior Loan could commence during the Accumulation Period [sic prior to June 26, 2010], but only so long as the ML LLC pays in full the outstanding principal amount of the Subordinate Loan plus any accrued and unpaid interest.

It appears to be a backhanded escape clause that would allow JPMC to be repaid ahead of the NY Fed. No mention is made of any qualifications to ensure that the NY Fed would have a chance at future recovery. Additionally, the use of the term “commence” means it was not contemplated for both parties to be repaid in full ahead of time. Delving into the 2008 Maiden Lane audit for clarification, there are a few more details:

Repayment on the Senior Loan may only begin prior to the second anniversary of the closing date of the Loans if the Subordinated Loan has been paid in full. Repayment of the Loans will only occur after payment in full of closing costs for the LLC, operating expenses, and maintenance of a reserve account for loan commitments.

The only preconditions to early JPMC payout ahead of the NY Fed seem to be payment of certain immaterial expenses and a reserve account for loan commitments. Whether these loan commitments refer to the NY Fed’s loan to Maiden Lane of $28.8 billion, or to loan assets of the portfolio, or to something entirely different, is unclear. In the 2009 audit, there is even less disclosure:

Repayment of the Loans will begin solely at the discretion of FRBNY and will be made pursuant to the order of priority described in Note 4 except that repayment of the Senior Loan may begin prior to the second anniversary of the closing date of the Loans only if the Subordinated Loan is first paid in full.

What is found is a troubling Subsequent Events note at the end:

On April 8, 2010, an agreement was reached to modify approximately $4.1 billion of commercial mortgage and mezzanine loans held in the LLC’s investment portfolio. These loans, which represent the LLC’s largest investment based on unpaid principal balance, are reported as hospitality loans in the table in Note 6 that discloses the concentration of unpaid principal balances in the LLC’s investment portfolio. The key provisions of the modification include the discounted payoff of certain mezzanine loans, the conversion of the most junior mezzanine loans to preferred equity, an extension of the final maturity date of the remaining loans from 2013 to 2015, and an increase in interest rates and fees. Management is evaluating the impact of the modification and does not believe it will result in an adverse effect to the consolidated financial statements of the LLC.

These loan modifications include those of the famous Red Roof Inn, which Congressman Alan Grayson recently highlighted. As ZeroHedge commented:

The [11] properties [held by the Red Roof Inn] are part of the 131 Red Roof hotels which special servicers Centerline and LNR Partners are "working out" in restructuring $368 million of debt. As Debtwire reports: "The securitized debt backing the properties held within four CMBS trusts, represents a portion of the total USD 775 million senior mortgage. A good portion of the remaining USD 407 million in debt, held on lenders' balance sheets and intended for later securitization, landed with the Federal Reserve via Bear Stearns. The Fed holds $444 million in Red Roof Inn debt, which appears to be a mix of mortgage and mezzanine debt, through its Maiden Lane I vehicle." And here is why you should not trust any updates of Maiden Lane I from the Fed: "This month [April 2009], the appraisal reduction amount on the Bear Stearns loan was upped from $64.5 million to $102.3 million, according to Trepp, which amounts to a roughly 40% reduction in loan balance."

Despite Maiden Lane management’s cleverly worded claims to the contrary in the 2009 footnote, it is likely that these loan modifications will result in a material adverse valuation of Maiden Lane.

Valuation

Measurement of fair value has garnered much attention in the media as accounting gimmicks have allowed banks to postpone losses and keep them off their balance sheets. Investments are hierarchically categorized, with Level 1 representing actual market prices, Level 2 reflecting market prices for similar instruments, and Level 3 using only financial models. Who performs the valuations for Maiden Lane? According to the 2009 audit notes:

The LLC values its investments on the basis of last available bid prices or current market quotations provided by dealers or pricing services selected under the supervision of the Investment Manager. To determine the value of a particular investment, pricing services may use certain information with respect to market transactions in such investment or comparable investments, various relationships observed in the market between investments, quotations from dealers, and pricing metrics and calculated yield measures based on valuation methodologies commonly employed in the market for such investments. Financial futures contracts traded on exchanges are valued at their last sale price. The fair value of swap agreements is provided by JPMC as calculation agent, subject to review by the Investment Manager.

Market quotations may not represent fair value in certain instances in which the Investment Manager and the LLC believe that facts and circumstances applicable to an issuer, a seller or a purchaser, or the market for a particular investment cause such market quotations to not reflect the fair value of an investment. In such cases, the Investment Manager applies proprietary valuation models that use collateral performance scenarios and pricing metrics derived from the reported performance of bonds with similar characteristics as well as available market data to determine fair value.

…

In certain cases where there is limited activity for particular investments or where current market quotations are not believed to reflect the fair value of a security, valuation is based on inputs from model-based techniques that use estimates of assumptions that market participants would use in pricing the investments. To the extent that such estimates of assumptions are not observable, the investments are classified within Level 3 of the valuation hierarchy. For instance, in valuing certain debt securities and whole mortgage loans, the determination of fair value is based on proprietary valuation models when external price information is not available. Key inputs to the model may include market spread data for each credit rating, collateral type, collateral value, and other relevant contractual features.

Below shows the composition of the Maiden Lane portfolio based on the NY Fed’s unaudited quarterly data provided on its website.

Two things stand out. First, throughout the entire period, net assets from Agency MBS grew, from $15.654 billion to $18.794, a 20.1% increase. Second, Other Liabilities, the only liabilities category disclosed, steadily shrunk from its March 31, 2009 nadir of $(5.505) billion to $(1.173) billion, a 78.7% reduction. Concurrently, Swap Contracts shrank from $2.454 billion to $0.903 billion. Because the Other Liabilities line contains collateral posted to Maiden Lane by swap counterparties, these two categories net somewhat. If Swap Contracts are netted with Other Liabilities and added to the contribution of the increase in Agency MBS, there is a $5.367 billion increase over the period, or 229.6% of the increase in fair value. Clearly, swaps and Agency MBS have been most influential with respect to fair value.

The below table is excerpted from the 2009 audit and depicts the fair value hierarchy of Maiden Lane in more detail.

Not all the lines agree with the NY Fed’s unaudited table, but it is possible this is a result of categorization. What is important is to recognize that nearly all Agency MBS is categorized as Level 2, and nearly everything else in Maiden Lane is categorized as Level 3.

As market prices only exist for Level 1 assets, or approximately 1% of the portfolio, BlackRock is therefore final arbiter of the fair value prices for the remaining 99%. While 71% of the assets are Level 2, the remaining (without getting into the complexities of the Netting category) are completely model based and thus, more opaque.

Peter Wallison comments on the fallacy of fair value accounting in this week’s Institutional Risk Analytics Newsletter. However, we can test the BlackRock model’s performance directly by examining the Federal Reserve’s H.4.1 release. It discloses the factors that affect reserve balances, namely its assets and liabilities. Inasmuch as it has a claim on Maiden Lane’s portfolio holdings, the Fed discloses Maiden Lane as an asset at fair value. According to the footnote:

…Fair value reflects an estimate of the price that would be received upon selling an asset if the transaction were to be conducted in an orderly market on the measurement date. Revalued quarterly. This table reflects valuations as of March 31, 2010. Any assets purchased after this valuation date are initially recorded at cost until their estimated fair value as of the purchase date becomes available.

Below is a graph of Maiden Lane’s fair value since the week of its June 26, 2008 inception, through May 26, 2010.

Most striking are the smooth rises followed by abrupt drops from inception into mid-May 2009, after which the drops become less severe, finally becoming large gains in February and April, 2010. These sudden changes are consistent with the quarterly valuation cycle, and typically occur about four weeks after the end of each quarter. This is the time when existing assets are revalued and newly purchased assets intra-quarter are valued for the first time.

The intra-quarter changes are not simple linear extrapolation, as there were some (but few) declines intra-quarter. Nor has there ever been an intra-quarter net decline from beginning to end. Also note that, during the week containing the flash crash of May 6, there was virtually no disruption to the model’s estimation of the portfolio’s fair value, despite massive interest rate and currency market dislocations, which affected all derivative classes.

Thus, one can conclude that intra-quarter reports of fair value are solely the result of a model (1) based nominally, at best, on market prices, (2) that has a positive bias, and (3) that is unable to predict changes to quarterly valuations. Removing the 7 weeks in which revaluations took place, the BlackRock model for Maiden Lane disclosed an average rate of return of 0.15%, with 94.6% positive returns, and only 1.02% annualized standard deviation. For reference purposes, according to a study by Bernard (no relation) and Boyle, Bernard Madoff’s Fairfield Sentry fund had monthly returns that were 92.33% positive with an annualized standard deviation of 2.45%. Similar suspicious metrics were part of the evidence Harry Markopolos presented to the Securities and Exchange Commission in his November 7, 2005 memo “The World’s Largest Hedge Fund is a Fraud.”

Annualized volatility of the quarterly results for Maiden Lane (thus eliminating intra-quarter fluctuations) is still a very low 8.02%, all the more remarkable when one considers that these were the very securities that brought Bear Stearns to the brink of bankruptcy and blew out many similar portfolios during the same period.

In his April 19, 2010 article for Institutional Risk Analytics, Alan Boyce of Soros Fund Management detailed the Federal Reserve’s mammoth exposure to interest rate fluctuations vis a vis its $1.25 trillion purchases of Agency MBS held in the System Open Market Account (SOMA), which is managed by the NY Fed. He calculated its risk exposure as $1.071 billion for each basis point move (0.01%) in interest rates, meaning, “if rates go up by 50bp, the FRB and Treasury would expect to lose $54 billion.” This begs the question of why bother to manage a $30 billion portfolio when a multi trillion dollar behemoth sits next door completely unhedged.

Conclusion

While it would be necessary to obtain all agreements related to the formation, acquisition and management of Maiden Lane LLC to determine exactly what occurred, a reasonable guess would be as follows. Maiden Lane’s substantial losses in the wake of the Lehman collapse in the Fall of 2008 made it unlikely the portfolio would ever regain its value and allow it to repay the $1.15 billion loan plus accrued interest to JPMC. In January, 2009, the New York Fed began its purchasing program of Agency MBS, and over the next fifteen months would purchase a total of $1.25 trillion of such securities. BlackRock would aggressively trade the very same classes of derivatives during this time, taking advantage of the Federal Reserve’s support of the MBS market and perhaps trading directly with the NY Fed. In April, 2009, the NY Fed would post the 2008 Maiden Lane audit and a disclosure to its website that allowed JPMC an early payout of its $1.15 billion loan plus accrued interest ahead of the NY Fed. Over the next year, BlackRock would methodically trade and value the Maiden Lane portfolio higher.

The two year early payout window for JPMC of June 26, 2010 is quickly approaching; however, the last quarterly valuation is as of March 31, 2010. Though mortgage backed securities have largely rallied throughout May on a flight to quality basis (being putatively government insured), Maiden Lane’s commercial mortgage loan portfolio has likely taken further hits since the April 2010 write downs, especially since it has 83.1% hospitality exposure. The second quarter 2010 revaluation will not be released until the end of July, 2010—itself largely based on mark-to-model accounting.

Accordingly, the NY Fed should be circumspect as it considers whether or not to repay JPMC prior to the next revaluation inasmuch as Maiden Lane was, by BlackRock’s own numbers, $2.519 billion underwater with respect to the total loan principal and accrued interest as of March 31, 2010. Should such payment be made and the second quarter revaluation reveal that Maiden is now in the black—thus, perhaps justifying the payout retroactively--the exposure to Level 3 assets would probably not be adequately measured by BlackRock’s model to provide enough of a cushion against future deterioration in its $4 billion commercial loan portfolio. An early payout to JPMC is a bet on the health of commercial real estate loans made to the hospitality industry at a time when underwriting standards were at a multi-decade low. The latest April write downs will not be the last.

Finally, while it is remotely possible that Maiden Lane is simply the best hedged and managed portfolio of modern times, it is important to recall that its purpose was to wind down and recover as much as could be expected for the taxpayers, with JP Morgan Chase taking the first $1.15 billion in losses. If Maiden Lane is eventually able to pay back the NY Fed and JPMC in full, it will be the result of BlackRock’s MBS trading, which was directly and/or indirectly subsidized by the Fed through its MBS purchase program. As the Fed’s $1.25 trillion in MBS assets are only reported at par and were acquired to support the market (meaning bought high and sold low), it would be difficult to justify a payback of any amount to JPMC until the Federal Reserve can demonstrate it has liquidated all of its MBS holdings without a loss.