In a note to file under the “Playing for Time” theme, the Curious Capitalist notes:

First American CoreLogic has taken a look at the effect of the government’s efforts to drive down mortgage interest rates, which, among other things, makes for easier refinancing. According to the loan analytics company, in the first half of 2009, refinancing homeowners set themselves up to save some $11.5 billion over the next five years. The typical person who refinanced was able to drop his monthly payment by $120 a month, a reduction of 10.5%… The value of mortgage originations hit $664 billion in the second quarter, and 69% of that was refinancing (by contrast, 37% of origination activity was made up of refis in the last quarter of 2o08). Fair or not, the government’s plan at least worked.

Reconcile this with one of the headlines on the site of Connecticut’s new candidate for U.S. Senate, Peter Schiff, which reads, “What America has succeeded in creating is not an economy impervious to shocks, but merely one which enables their consequences to be postponed to a later date.” I’ve spoken briefly with Peter before, and I’ve read his books, but I’m by no means in complete agreement with his views - yet in this instance, what he says is a perfect application to what the banking system is doing with the blessing of our government. Their strategy? Between the PPIP and mortgages, let’s sell as many options as we can now, book a benefit, and hope the adverse scenario that results in our option position(s) taking losses doesn’t occur.

I’ve wondered before whether or not we can carry trade the U.S. consumer back to health by attempting to force Treasury rates and other borrowing rates to converge; I’m not sure, but we’re certainly giving it the old college try.

If the typical person refinancing can save an extra $120/month, where does the money come from? It’s money that mortgage lenders aren’t making anymore in a lower interest rate environment. Now, the yield curve is steep, and short rates are near zero, so the relative change in rates is still helping banks. But at the same time, we’re more heavily leveraging banks to low rates; net interest margins might be getting fat at present, but they will compress and then some when rates inevitably rise. Zero, as James Grant has said, is the wrong rate for any economy, but more and more, I’m leaning toward believing that short rates stay extraordinarily low because of the idea that the economy depends on it - even when reality is that it aids speculators much more than the economy as a whole.

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I haven’t said much about what I’ve been doing personally here of late. In sum, the general theme is that I’ve been scaling out of positions the entire summer, and am now 100% cash. Had I not sold anything, I would be up more on the year than I am at present – but that’s pretty much par for the course in a rally that has been as sharp and persistent as this one.

There’s still a strong undercurrent of disbelief at this rally, so in that sense not much has changed since March, when the world was bearish and nothing but pain existed for equity holders. The difference now (besides much higher prices) is that there’s a growing contingent with a belief that the recovery is at hand, or their more speculative counterparts who don’t believe in a recovery but are afraid of missing a higher move.

A growing number of financial stocks that are essentially worthless have seen their option values multiply several-fold; the well-documented list includes Fannie Mae (FNM), Freddie Mac (FRE), AIG, Citigroup (C), and Lehman (LEHMQ.PK), and August trading volume has been heavily concentrated in those names. I’m not discounting the option value of a stock; real-world outcomes are probabilistic and stock prices should reflect that. But it does speak to speculation returning to the market, and that’s a sign of caution in a time of great uncertainty – and make no mistake, the short-term bandages are only hiding long-term problems.

Good investing is not about having a myopic focus on maximizing returns, it’s also about managing risk. Winning is important, but so is not losing. With the feedback loop of the last six months, market conditions are such that it’s very easy to forget that losing is a distinct possibility in an era of debt deflation. Although inflation has been the headline worry of Fed watchers, I’m not convinced; the intermediate concern (2-5 years) that seems underestimated is deflation. Central banks are small in comparison to global capital flows, and although we might try to stimulate like crazy, it will be difficult to offset trillions of dollars in irresponsible lending being rationalized.

In light of this, I’m looking at convertible securities that offer yields of 6% or more (about 500 bps over 2-year Treasuries) in industries that will have above-average profitability in the case of an economic recovery. My assumption is that the yield alone will offer an attractive return, and with most at a discount to par, the total return potential approaches double-digits over a two-year time frame. If I’m wrong about the immediacy of a market recovery, the convertible option offers a hedge on rising stock prices – in sum, a better balance of risk and reward than either a straight stock or bond allocation.

A final closing note: I’m going to change up my policy about writing, since I often spend dozens of hours studying something only to determine it is a dead end. So, in the future, I’ll comment on those, instead of just the scarce opportunities I end up acting on.

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One phrase I keep coming back to is “playing for time” – I see it as a good description of the strategy (or lackthereof) underlying most of the economic policy decisions that emanate from Washington.

What areas are being targeted, and how is it being accomplished?

Real Estate

Autos

Banks and Other “Financials”

The entire point of playing for time is to increase optionality. More information becomes available, and perhaps the economic situation will change for the better. But keeping businesses alive comes with indirect costs – more competition reduces the ability of healthier firms to pick up profitable customers – and with an implicit backstop from the government, borderline financial companies are incentivized to take more risks than usual.

The immediate result of those actions is to accelerate consumption, defer pain (losses), or interfere in allowing the market to set the prices it would otherwise set. To loosely quote a recent note from David Rosenberg, only in America are policies that encourage excessive consumption celebrated as a success. Yet that’s exactly what’s being done through a program like Cash for Clunkers, and the public reception has been very enthusiastic – a dangerous turning point in the series of bailouts.

I’m wary of data (and interpretations) suggesting that recovery is at hand, because uneconomic activity can only be encouraged for so long. That’s a lesson the Fed should have learned from previous heroic rescues during downturns, but chooses not to, because the expedient solution is to shovel money into any area of the economy that will take it.

Home prices, which undoubtedly went through an enormous bubble, are now the subject of a great experiment in controlled deflation. “Affordability” products sprung up earlier in the decade, when buyers had no savings for a down payment. Those turned out to have disastrous consequences, and yet policy now is directed toward offering what amounts to down payment assistance via a tax credit, and artificially low mortgage rates through the Fed’s market operations. We’ve been down this road before…

Boosting GDP for one or two quarters with the $3 billion (at present) Cash for Clunkers will quickly be revealed as wasted money; there are only so many new cars that people need. Most shrewd observers have realized by now that the program will skew statistics favorably for a time, without doing any real good. Of course, if the point is to save the “American” automakers, the program has been a failure on that front too.

The silent bailout of the financial system through zero interest rates and guaranteed debt is more pernicious – the TLGP, for instance, is estimated to be a $24 billion gift to those using it. And yet, little will be said about that as long as the impact on the Treasury’s borrowing costs remain marginal. Can we carry-trade weak financial institutions to profitability by leveraging the U.S. government’s borrowing ability? Likewise, can we store the health of balance sheets by stealing from savers through interest rates effectively at zero? We’re certainly trying.

Across sectors, there are many companies awaiting a turn in the cycle – and the only reason they’re still around is due to the good graces of the government. But cycles don’t truly turn until fewer people are around to looking at them, and it’s doubtful policymakers are willing to adopt this position and let liquidations occur. Playing for time comes at a cost – on a personal level, it means delaying decisive action that stands a chance of accomplishing something. I can only imagine what it will mean for the country as a whole.

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Last week, I noted that Primus (PRS) announced a fairly significant “credit mitigation” transaction, which clipped the tail risk on about $1.2 billion in notional CDS. Because Primus discloses such events and credit losses as they occur, and the company not writing new CDS business, non-GAPP earnings aren’t really a surprise – economic results of $47.5 million came from CDS premiums (no credit events in Q2) and a repurchase of debt at a large discount.

The most interesting development is that Primus is now using its float – over $730 million at quarter’s end – to invest in investment grade corporates. On the conference call, CFO Richard Claiden said that $20 million of holding company capital was now allocated this way, and subsequently Primus Financial has started doing the same. In the second quarter, Primus’ interest income from short-duration risk-free assets was a mere 0.61%. With the iShares iBoxx Investment Grade Corporate Bond ETF (LQD) yielding 5.59%, there’s plenty of room for improvement in the yield on that capital (which is about 5.6x Primus’ current market cap). My valuation model ballparks a 100 basis point improvement in yield over the duration of Primus’ current swap portfolio as being worth 58 cents per share in terminal value. There’s value to be captured here, and investing in investment grade corporates is a natural way to leverage Primus’ credit evaluation abilities.

Although low interest rates hurt the investment yield, it also resulted in Primus paying just 3.71% on its debt and preferred securities – roughly equal to the yield on 10-year Treasuries. The debt structure offers cheap financing, is long-term in duration, and is capped should rates rise in the future. In other words, taking financing when it available on favorable terms proved to be a good move, and now gives the company plenty of optionality as it runs off the CDS portfolio.

There was $63 million in capital outside Primus Financial at the end of Q2 (CypressTree acquisition not counted yet), and the holding company debt (PRD) now trades with a $14 handle. Repurchases of both debt and stock have slowed, as the prices have risen dramatically and Primus has re-oriented its capital allocation toward building out asset management. Also discussed was a collateralized CDS seller, but that remains in its early test stages (roughly six months) and has hardly seen a full market cycle, as spreads have been consistently narrowing during that time – see below.

Investment Grade CDX:

High Yield CDX (less applicable to Primus, but still noteworthy):

The real question for Primus - one that backwards looking metrics like credit events don’t capture - is where in the credit loss cycle we are. There were 15 corporate defaults in Q1, and 13 in Q2; does that constitute a deceleration, or merely a pause before the next leg up? With the current public policy doing everything possible to play for time, I believe a long slog to debt rationalization will take place. Ultimately, that’s good for Primus, as it gives more time for CDS to run-off and interest to be earned on premiums, even if it isn’t good for the economy as a whole. My long moral hazard trade continues…

Primus Guaranty Q2 2009 Conference Call Transcript

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Disclosure: I own both Primus debt (PRD) and stock (PRS).

Primus Guaranty (PRS) announced yesterday that it entered into a significant credit mitigation deal with one of its counterparties, reworking $1.2 billion in notional value of credit default swaps. According to the press release, $40 million in notional exposure written on a monoline insurer was terminated for $15 million, or 37.5 cents on the dollar. The other billion-plus is being moved to a subsidiary of Primus Financial capitalized with $36 million, which is the maximum exposure (plus future premiums on those swaps) that can be lost.

Working backwards, ring-fencing certain swaps clips the tail risk existing in the portfolio at about 3.1% – a fairly high level that’s about 50% above what I’ve modeled previously. From the press release, my assumption is that the counterparty is willing to do this to minimize credit/counterparty risk related to Primus; it’s not collateral per se, but it functions in the same way.

As for the monoline settlement, well, it speaks volumes about what happens if you aren’t a systemic risk – privately negotiated solutions actually come about, and it means that companies that took risks take losses (or at least agree to accept more uncertainty/variability). One possibly safe extrapolation: if counterparties to a company that doesn’t warrant liquidity concerns like Primus are willing to take substantial haircuts on their CDS transactions, you better believe that Santa Claus came down the chimney for everyone with claims against AIG that were repaid in full. It’s simply a perverse trait of the financial system, and our government, that smaller players are left to deal amongst themselves, whereas larger players are assisted and handed a different set of rules to play by.

More to come after earnings next week…

Lastly, a non-related note. I’ve learned a lot from David Merkel, and he asked those who read them to link to this about the SEC. It’s the least I can do, and I encourage you to read it.

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Disclosure: I own both Primus stock (PRS) and debt (PRD).