AIG Was Broke

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Photo Credit: Ron

There’s a significant problem when you are a supremely big and connected financial institution: your failure will have an impact on the financial system as a whole.  Further, there is no one big enough to rescue you unless we drag out the public credit via the US Treasury, or its dedicated commercial paper financing facility, the Federal Reserve.  You are Too Big To Fail [TBTF].

Thus, even if you don’t fit into ordinary categories of systematic risk, like a bank, the government is not going to sit around and let you “gum up” the financial system while everyone else waits for you to disburse funds that others need to pay their liabilities.  They will take action; they may not take the best action of letting the holding company fail while bailing out only the connected and/or regulated subsidiaries, but they will take action and do a bailout.

In such a time, it does no good to say, “Just give us time.  This is a liquidity problem; this is not a solvency problem.”  Sorry, when you are big during a systemic crisis, liquidity problems are solvency problems, because there is no one willing to take on a large “grab bag” of illiquid asset and liquid liabilities without the Federal Government being willing to backstop the deal, at least implicitly.  The cost of capital in a financial crisis is exceptionally high as a result — if the taxpayers are seeing their credit be used for semi-private purposes, they had better receive a very high penalty rate for the financing.

That’s why I don’t have much sympathy for M. R. Greenberg’s lawsuit regarding the bailout of AIG.  If anything, the terms of the bailout were too soft, getting revised down once, and allowing tax breaks that other companies were not allowed.  Without the tax breaks and with the unamended bailout terms, the bailout was not profitable, given the high cost of capital during the crisis.  Further, though AIG Financial products was the main reason for the bailout, AIG’s domestic life subsidiaries were all insolvent, as were their mortgage insurers, and perhaps a few other smaller subsidiaries as well.  This was no small mess, and Greenberg is dreaming if he thought he could put together financing adequate to keep AIG afloat in the midst of the crisis.

Buffett was asked to bail out AIG, and he wouldn’t touch it.  Running a large insurer, he knew the complexity of AIG.  Having run off much of the book of Gen Re Financial Products, he knew what a mess could be lurking in AIG Financial Products.  He also likely knew that AIG’s P&C reserves were understated.

For more on this, look at my book review of The AIG Story, the book that tells Greenberg’s side of the story.

To close: it’s easy to discount the crisis after it has passed, and look at the now-solvent AIG as if it were a simple thing for them to be solvent through the crisis.  It was no simple thing, because only the government could have provided the credit, amid a cascade of failures.  (That the failures were in turn partially caused by bad government policies was another issue, but worthy to remember as well.)

Spot the failure

Time to Chase Bill Gross?

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Jason Zweig at the Wall Street Journal had a very good piece on whether to follow Bill Gross as he goes from Pimco to Janus.  Let me quote one paragraph:

Morningstar estimates that over the past five years, the average investor fell behind Pimco Total Return’s 5.6% annual gain by 1.6 points a year—largely as a result of buying high and selling low. That gap is among the widest of any large bond fund; at the Vanguard Total Bond Market Index Fund, for example, investors have earned returns only 0.4 point lower than those of the portfolio itself.

In the short run, this offers a reason to follow Bill Gross to Janus.  He is starting with a clean slate, and will be able to implement positions that seem attractive to him that would not have been attractive at Pimco because they would have been too small.  Managing less money lets Bill Gross be more choosy.

Second, in the short run, growth in bond assets at Janus will temporarily push up the prices of bonds held by Janus.  Those that get in early would benefit from that if bond assets grow under the management of Bill Gross.  Just keep your eye on when assets stop growing if you are buying for that speculative reason.

A third potential reason to follow Gross depends on how much Pimco continues to use his quantitative strategies.  If Pimco abandons them (unlikely, but not impossible), Janus would get the chance to use them on much less money, which would make the excess returns greater.  If I were considering this as a reason, I would watch the turnover in Pimco’s main funds, and see if certain classes of assets disappear.

My last point here is that the abilities of Bill Gross will do better managing less money, but the effect won’t be so great if he is competing with Pimco to implement the same strategies.  At minimum, he’s not likely to do worse than at Pimco, and in the short-run, there are some reasons why he will likely do better.

PS — please remember that Bill Gross has two hats: the showman and the quant.  The quant makes money for clients while the showman entertains them.  The showman opines about the Fed, politics, etc.  That can get investors interested because it sounds clever, but that is not how Bill Gross makes money.

This brings up one more point.  If you do decide to invest with him at Janus, review the prospectus to see what degree of flexibility with derivatives Gross will have.  If it similar to what he had at Pimco, he is likely following the same strategy.

Two Questions on Fixed Income from the Mailbag

From my readers:

What are your thoughts on Pimco’s new strategy for its flagship fund?

This concerns me because its one of the few “safe” funds in my company’s 401k plan.

I haven’t heard anyone critique this and thought you’d be the best that I know of.

It seems to me that its a disproportional risk. And that due to its size could potentially cause problems.

 http://blogs.barrons.com/focusonfunds/2014/09/17/deriving-returns-at-pimco-total-return/

This is not a new problem with Pimco.  You can review these two articles here:

Pimco has always used a lot of derivatives, though for marketing reasons some of their funds have fewer derivatives, even as Pimco tries to follow the same strategies.  You can view this three ways:

  • It hasn’t had horrible effects in the past, so why worry now?
  • We haven’t had the market event that would test the limits of this strategy yet, but can it really get that bad?
  • Now that the bond market is more crowded, Pimco’s quantitative bond strategies have less punch.  They don’t have the same room to maneuver.  Like the London Whale, have they become the market?

I lean toward the last of these views.  When you manage so much money, it becomes difficult to wrench alpha out of the market because mispricings are limited, and it is difficult to keep your trades from moving the market.

You might want to split your “safe monies” in your 401(k) plan if you have other credible investments.  That said, the likelihood of a large disaster harming Pimco is small — but you could try to cover that risk by setting a relative stop loss where you would exit Pimco versus a similar maturity fund run by Vanguard.

Another letter:

I’m a fledgling portfolio manager and blog reader.  Would you care to comment on the bounce we’ve seen in Treasury rates this month? (28 bp on the 10-year month to date).  I just don’t get it.  I see global growth continuing to underwhelm, more monetary opiates out of Asia, persistent dovishness from the Fed and the arrival (?) of the Godot that has been ECB stimulus.  These circumstances plus ongoing geopolitical issues make me wonder why Treasury yields have not gone further down or at least held the line.  I know it might be mean reversion or a supply/demand phenomenon but do not feel qualified to say and would enjoy reading your perspective.

Separately, are you aware of any Readers’ Digest Condensed summaries of monetary policy in Europe since 2007?  My career is not so old and each time I read about their approach to sorcery I encounter yet another acronym of which I am ignorant.

Best and thank you!

Back when I was a corporate bond manager, and things were moving against me, I would do a few things:

  • Seek out contrary opinion, and see if there was something I was missing.
  • Go out to lunch for Chinese food, dragging my trading notebook, and a sheaf of research with me, and schmooze over the data while there was no Bloomberg terminal in front of me.

Now, my own current views are conflicted, because I view the global economy like you do.  There is no great growth anywhere.  Geopolitical events should lead to a Treasury rally, and sanctions should weaken growth prospects.  I’m still long a moderate amount of the iShares 20+ Year Treasury Bond (TLT), for myself and clients — it is difficult to see too much of a bear market with monetary velocity so weak.

That said, my recent 2-part series on the shape of the yield curve suggested that the curve shape was the sort where we often get negative surprises.  Despite the Fed’s confident mutterings that amount to little more than “Trust us!” the Fed has never been in a situation like this one and does not have the vaguest idea as to what it is doing.  They are proceeding largely off of untested theories that so far haven’t done much good or bad, aside from allowing the US Government to finance its deficits cheaply, thus cheating savers who deserve a better return on their money.

This is my thought: the slightest hint of tightening coming sooner moves the forward yield curve up, particularly in the 3-5 year region of the curve, but extending to 2- and 10-year notes as well.  But the questions remain how well growth holds up, how sensitive will the economy be to higher interest rates, and whether banks start genuinely lending against their expanded liabilities.

Personally, I expect rates to go lower after further growth disappointments, but I could be wrong, very wrong, so don’t be too bold here — scale into positions as you see opportunity.

Full disclosure: long TLT

On LinkedIn Endorsements and Registered Investment Advisors

I’m going to be away for a few days.  Maybe I will have time to post; most likely I won’t.  Before I go, I want to thank my readers who have endorsed me at LinkedIn.  You are most generous in your assessments of my abilities.

But as for now, until there is better clarification of whether it is legitimate for advisors to accept endorsements at their LinkedIn profiles, I am disabling endorsements on my profile.  For those that want to do the same thing, you can find out how to do it here.

I would just rather be safe than sorry.  Aside from that, how many people use LinkedIn to find or vet out an investment advisor?

As an aside, I’ve been blogging for about 7.5 years and for the most part, I haven’t hit many dry spells.  I’m feeling a little dry at present.  If you have an idea for me on what to write about, you can send it to me here.  Thanks!

Volatility Can Be Risk, At Rare Times

Photo Credit: Matt Cavanagh

Photo Credit: Matt Cavanagh

There is a saying in the markets that volatility is not risk. In general this is true, and helps to explain why measures like beta and standard deviation of returns do not measure risk, and are not priced by the market. After all, risk is the probability of losing money, and the severity thereof.

It’s not all that different from the way that insurance underwriters think of risk, or any rational businessman for that matter. But just to keep things interesting, I’d like to give you one place where volatility is risk.

When overall economic conditions are serene, many people draw the conclusion that it will stay that way for a long time. That’s a mistake, but that’s human nature. As a result, those concluding that economic conditions will remain serene for a long time decide to take advantage of the situation and borrow money.

When volatility is low, typically credit spreads are low. Why not take advantage of cheap capital? Well, I would simply argue that interest rates are for a time, and if you don’t overdo it, paying interest can be managed. But what happens if you have to refinance the principal of the loan at an inopportune time?

When volatility and interest spreads are low for you, they are low for a lot of other people also. Debt builds up not just for you, but for society as a whole. This can have the impact of pushing up prices of the assets purchased using debt. In some cases, the rising asset prices can attract momentum buyers who also borrow money in order to own the rising assets.

This game can continue until the economic yield of the assets is less than the yield on the debt used to finance the assets. Asset bubbles reach their breaking point when people have to feed cash to the asset beyond the ordinary financing cost in order to hold onto it.

In a situation like this, volatility becomes risk. Too many people have entered into too many fixed commitments and paid too much for a group of assets. This is one reason why debt crises seem to appear out of the blue. The group of assets with too much debt looks like they are in good shape if one views it through the rearview mirror. The loan-to-value ratios on recent loans based on current asset values look healthy.

But with little volatility in some subsegment of the overly levered assets, all of a sudden a small group of the assets gets their solvency called into question. Because of the increasing level of cash flows necessary to service the debt relative to the economic yield on the assets, it doesn’t take much fluctuation to make the most marginal borrowers question whether they can hold onto the assets.

Using an example from the recent financial crisis, you might recall how many economists, Fed governors, etc. commented on how subprime lending was a trivial part of the market, was well-contained, and did not need to be worried about. Indeed, if subprime mortgages were the only weak financing in the market, it would’ve been self-contained. But many people borrowed too much chasing inflated values of residential housing.  As asset values fell, more and more people lost willingness to pay for the depreciating assets.

We’ve had other situations like this in our markets. Here are some examples:

  • Commercial mortgage loans went through a similar set of issues in the late 80s.
  • Lending to lesser developed countries went through similar set of issues in the early 80s.
  • The collateralized debt obligation markets seem to have their little panics every now and then. (late 90s, early 2000s, mid 2000s, late 2000s)
  • During the dot-com bubble, too much trade finance was extended to marginal companies that were burning cash rapidly.
  • The roaring 20s were that way in part due to increased debt finance for corporations and individuals.

At the peak some say, “Nobody rings a bell.” This is true. But think of the market peak as being like the place where the avalanche happened 10 minutes before it happened. What set off the avalanche? Was it the little kid at the bottom of the valley who decided to yodel? Maybe, but the result was disproportionate to the final cause. The far more amazing thing was the development of the snow into the configuration that could allow for the avalanche.

This is the way things are in a heavily indebted financial system. At its end, it is unstable, and at its initial unwinding the proximate cause of trouble seems incapable of doing much harm. But to give you another analogy ask yourself this: what is more amazing, the kid who knocks over the first domino, or the team of people spending all day lining up the huge field of dominoes? It is the latter, and so it is amazing to watch large groups of people engaging in synchronized speculation not realizing that they are heading for a significant disaster.

As for today, I don’t see the same debt buildup has we had growing from 2003 to 2007. The exceptions maybe student loans, parts of the energy sector, parts of the financial sector, and governments. That doesn’t mean that there is a debt crisis forming, but it does mean we should keep our eyes open.

Retirement – A Luxury Good

Recently I was approached by Moneytips to ask my opinions about retirement. They sent me a long survey of which I picked a number of questions to answer. You can get the benefits of the efforts of those writing on this topic today in a free e-book, which is located here: http://www.moneytips.com/retiree-next-door-ebook.  The eBook will be available free of charge through September 30th.  I have a few quotes in the eBook.

Before I move onto the answers, I would like to share with you an overview regarding retirement, and why current and future generations are unlikely to enjoy it to the degree that the generations prior to the Baby Boomers did.

The first thing to remember is that retirement is a modern concept. That the world existed without retirement for over 5000 years may mean that it is not a necessary institution. For a detailed comment on this, please consult my article, “The Retirement Tripod: Ancient and Modern.” Here’s a quick summary:

In the old days, when people got old, they worked a reduced pace. They relied on their children to help them. Finally, they relied on savings.

Savings is the difficult concept. How does one save, such that what is set aside retains its value, or even grows in value?

If you go backwards 150 years or further in time, there weren’t that many ways to save. You could set aside precious metals, at the risk of them being stolen. You could also invest in land, farm animals, and tools, each of which would be the degree of maintenance and protection in order to retain their value. To the extent that businesses existed, they were highly personal and difficult to realize value from in a sale. Most businesses and farms were passed on to their children, or dissolved at the death of the proprietor.

In the modern world we have more options for when we get old – at least, it seems like we have more options. In retirement, we have three ways to support ourselves: we have government security programs, corporate security programs, and personal savings.

Quoting from an earlier article of mine, Many Will Not Retire; What About You?:

Think of this a different way, and ignore markets for a moment.  How do we take care of those that do not work in society?  Resources must be diverted from those that do work, directly or indirectly, or, we don’t take care of some that do not work.

Back to markets: Social Security derives its ways of supporting those that no longer work from the wages of those that do work.  That’s one reason to watch the ratio of workers to retired.  When that ratio gets too low, the system won’t work, no matter what.  The same applies to Medicare.  With a population where growth is slowing, the ratio will get lower. If the working population is shrinking, there is no way that benefits for those retiring will be maintained.

Pensions tap a different sort of funding.  They tap the profit and debt servicing streams of corporations and other entities.  Indirectly, they sometimes tap the taxpayer, because of the Pension Benefit Guaranty Corporation, which guarantees defined benefit pensions up to a limit.  There is no explicit taxpayer backstop, but in this era of bailouts, who can tell what will be guaranteed by the government in a crisis?

That said, not many people today have access to Defined-Benefit pensions. Those are typically the province of government workers and well-funded corporations. That leaves savings as the major way that most people fund retirement aside from Social Security.

One of the reasons why the present generations are less secure than prior generations with respect retirement is that the forebears who originally set up defined-benefit pensions and Social Security system set up in such a way that they gave benefits that were too generous to early participants, defrauding those who would come later. Though the baby boomers are not blameless here, it is their parents that are the most blameworthy. If I could go back in time and set things right, I would’ve set the defined-benefit pension funding rules to set aside considerably more assets so that funding levels would’ve been adequate, and not subject to termination as the labor force aged.

I also would’ve required the US government to set benefits at a level equal to that contributed by each generation, and given no subsidy to the generations at the beginning of the system. Truth, I would eliminate the Social Security system and Medicare if I could. I think it is a bad idea to have collective support programs. There are many reasons for that, but a leading reason is that it removes the incentive to marry and have children. Another reason is that it politicizes generational affairs, which will become obvious to the average US citizen over the next 10 to 15 years.

Back to Savings

As for personal savings today we have more options than our great-great-great-grandparents did 150 years ago. We can still buy land and we can still store precious metals – both of those have a great ability to retain value. But, we can buy shares in businesses and we can buy the debt claims of others. We can also build businesses which we can sell to other people in order to fund our retirement.

But investing is tricky. With respect to lending, default is a significant risk. Also, at the end of the term of lending, what will the money be worth? We have to be aware of the risks of inflation and deflation.

In evaluating businesses more generally, it is difficult to determine what is a fair price to pay. In a time of technological change, what businesses will survive? Will the business managers be clever enough to make the right changes such that the business thrives?

You have an advantage that your parents did not have, though. You can invest in the average business and debt of public companies in the US, and around the world through index funds. This is not foolproof; in fact, this is a pretty new idea that has not been tested out. But at least this offers the capability of opening a fraction of the productive assets in our world, diversified in such a way that it would be difficult that you end up with nothing, unless the governments of the world steal from the custodians of the assets.

With that, I leave you to read my answers to some of the questions that were posed to me regarding retirement:

What is a safe withdrawal rate?

A safe withdrawal rate is the lesser of the yield on the 10 year treasury +1%, or 7%. The long-term increase in value of assets is roughly proportional to something a little higher than where the US government can borrow for 10 years. That’s the reason for the formula. Capping it at 7% is there because if rates get really high, people feel uncomfortable taking so much from their assets when their present value is diminished.

How should you handle a significant financial windfall?

If you have debt, and that debt is at interest rates higher than the 10 year treasury yield +2%, you should use the windfall to reduce your debt. If the windfall is still greater than that, treat it as an endowment fund, invest it wisely, and only take money out via the safe withdrawal rate formula.

What are some ways to learn to embrace frugality?

This is a question of the heart. You have to master your desires to have goods and services today that are discretionary in nature. Life is not about happiness in the short term but happiness and long-term. Embrace the concept of deferred gratification that your great-grandparents did and recognize that work and savings provide for a secure and happy future.

How can the average worker start earning passive income?

Passive income is a shibboleth. People look at that as a substitute for investing, because they can’t control investment returns, and they think they can control income.

Income comes from debt or a business. If from debt, it is subject to prepayment or default; it is not certain. Also, income that comes from debt is typically fixed. That income may be sufficient today, but it may not be so if inflation rises. Also your capital is tied up until the debt matures. When the debt matures, reinvestment opportunities may be better or worse than they were when you started.

If income comes from a business, it is subject to all the randomness of that business; it is not certain. It is subject to all of the same problems that an investment in the stock market is subject to, except that you have to oversee the business.

There is no such thing as a truly passive income. Get used to the fact that you will be investing and working to earn an income.

What can those workers who are not employed by a large company or the public sector do to maximize their retirement savings?

You can start an IRA. Until the rules change, you can create healthcare savings account, not use it, and let it accrue tax-free until you’re 59 1/2. Oh, you get an immediate income deduction for that too.

If you are a little more enterprising, you can start your own business. If your business succeeds, there are a lot of ways to put together a pension, deferring more income than an individual can. By the time you get there, the rules will have changed, so I won’t tell you how to do it today; at the time, get a good pension consultant.

Why is calculating how much you’ll need for retirement an important exercise?

You have to understand that retirement is a new concept. In the ancient world, retirement meant continued work at a slower pace on your farm, living off of savings (what little was storable then – gold, silver, etc.), and help from your children whom you helped previously as you raised them.

Today’s society is far more personal, far less family centered, and far more reliant on corporate and governmental structures. Few of us produce most of the goods and services that we need. We rely on the division of labor to do this.  Older people will still rely on younger people to deliver goods and services, as the older people hand over their accumulated assets in exchange for that.

Practically, modern retirement is an exercise in compromise. You will have to trade off:

  • How long you will work
  • At what you will work
  • What corporate and governmental income plans you participate in
  • How much income with safety your assets can deliver, with an allowance for inflation
  • How much you will help your children
  • How much your children will help you

As such, calculating a simple figure how much your assets should be may be useful, but that one variable is not enough to help you figure out how you should conduct your retirement.

Why don’t more people consult investment professionals? What keeps them from doing so?

There are two reasons: first, most people don’t have enough income or assets for investment professionals to have value to them. Second, people don’t understand what investment professionals can do for them, which is:

  • They can keep you from panicking or getting greedy
  • They can find ways to reduce your tax burdens
  • They can diversify your assets so that you are less subject to large drawdowns in the value of your assets

Other than maximizing your annual contribution, what other things can you do to get the most out of your IRA and 401(k)?

Diversify your investments into safe and risky buckets. The safe bucket should contain high quality bonds. The risky bucket should contain stocks, tilted toward value investing, and smaller stocks. New contributions should mostly feed investments that have been doing less well, because investments tend to mean-revert.

Stocks are clearly risky and investors have emotional reactions to that. How can investors rationally manage their stock investments so that they are less likely to regret their decisions?

When I was a young investor, I had to learn not to panic. I also had to learn not to get greedy. That means tuning out the news, and focusing on the long run. That may mean not looking at your financial statements so frequently.

As for me as a financial professional, I look at the assets that I manage for my clients and me every day, but I have rules that limit trading. I do almost all trading once per quarter, at mid-quarter, when the market tends to be sleepy, and not a lot of news is coming out. When I trade, I am making business decisions that reflect my long-term estimates of business prospects.

Closing

And if that is not enough for you, please consult my piece The Retirement Bubble.  You can retire if you put enough away for it, but it is an awful lot of money given that present investments yield so little.

Redacted Version of the September 2014 FOMC Statement

July 2014September 2014Comments
Information received since the Federal Open Market Committee met in June indicates that growth in economic activity rebounded in the second quarter.Information received since the Federal Open Market Committee met in July suggests that economic activity is expanding at a moderate pace.This is another overestimate by the FOMC.
Labor market conditions improved, with the unemployment rate declining further. However, a range of labor market indicators suggests that there remains significant underutilization of labor resources.On balance, labor market conditions improved somewhat further; however, the unemployment rate is little changed and a range of labor market indicators suggests that there remains significant underutilization of labor resources.More people working some amount of time, but many discouraged workers, part-time workers, lower paid positions, etc.
Household spending appears to be rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.Household spending appears to be rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.No change

 

Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.No change.  Funny that they don’t call their tapering a “restraint.”
Inflation has moved somewhat closer to the Committee’s longer-run objective. Longer-term inflation expectations have remained stable.Inflation has been running below the Committee’s longer-run objective. Longer-term inflation expectations have remained stable.TIPS are showing slightly lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.52%, down 0.08% from July.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators and inflation moving toward levels the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators and inflation moving toward levels the Committee judges consistent with its dual mandate.No change.  They can’t truly affect the labor markets in any effective way.
The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced and judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat.The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced and judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year.CPI is at 1.7% now, yoy.  They shade up their view down on inflation’s amount and persistence.
The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.No change.
In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in August, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $10 billion per month rather than $15 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $15 billion per month rather than $20 billion per month.In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in October, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $5 billion per month rather than $10 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $10 billion per month rather than $15 billion per month.Reduces the purchase rate by $5 billion each on Treasuries and MBS.  No big deal.

 

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.No change
The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.No change.  But it has almost no impact on interest rates on the long end, which are rallying into a weakening global economy.
The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.No change. Useless paragraph.
If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will end its current program of asset purchases at its next meeting.Finally the end of QE is in sight.  For now.
However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.No change.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.No change.
In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.No change.  Monetary policy is like jazz; we make it up as we go.  Also note that progress can be expected progress – presumably that means looking at the change in forward expectations for inflation, etc.
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.No change.  Its standards for raising Fed funds are arbitrary.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.No change.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No change.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Narayana Kocherlakota; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Narayana Kocherlakota; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo.Fisher and Plosser dissent.  Finally some with a little courage.
Voting against was Charles I. Plosser who objected to the guidance indicating that it likely will be appropriate to maintain the current target range for the federal funds rate for “a considerable time after the asset purchase program ends,” because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee’s goals.Voting against the action were Richard W. Fisher and Charles I. Plosser. President Fisher believed that the continued strengthening of the real economy, improved outlook for labor utilization and for general price stability, and continued signs of financial market excess, will likely warrant an earlier reduction in monetary accommodation than is suggested by the Committee’s stated forward guidance. President Plosser objected to the guidance indicating that it likely will be appropriate to maintain the current target range for the federal funds rate for “a considerable time after the asset purchase program ends,” because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee’s goals.Thank you, Messrs. Plosser and Fisher.  But what happens when the economy weakens?

 

Comments

  • Pretty much a nothing-burger. Few significant changes, if any.
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Small $10 B/month taper. Equities rise and long bonds fall.  Commodity prices are flat.  The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The FOMC needs to chop the “dead wood” out of its statement. Brief communication is clear communication.  If a sentence doesn’t change often, remove it.
  • In the past I have said, “When [holding down longer-term rates on the highest-quality debt] doesn’t work, what will they do? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.  The Fed is playing with forces bigger than themselves, and it isn’t dawning on them yet.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.

Making Systematic Risk Disappear, Not

Yesterday I was at a conference for Registered Investment Advisors. There were about 11 of us in the room, and a variety of different parties pitched us on their services. Some of the pitches were harder, most were softer.

Two of the presentations I felt were deceptive, though I don’t believe the presenters intended to be deceptive. The idea was, you need to provide alternative investments to your clients, because clients can’t earn what they need to in stocks and bonds. Private equity investments and real estate outperform stocks, and we have new durable income vehicles that outperform bonds. What’s more, we can remove a lot of volatility from the portfolio.

Imagine for a moment that you’re investing in two private companies that after you buy them, you will have to own them for 10 years. The money is committed, and you have no way to get liquidity from the companies until the 10 years are up. One of the companies will leverage up a little bit, and invest in stocks. The other company will leverage up a great deal, and invest in bonds; it will behave like a shadow bank.

Now imagine on your brokerage statement, that your broker does not have to mark the positions to market.  After all, the corporations are not publicly traded and so the companies are valued at the amount of your investment until they dissolve and pay out their proceeds at the end of 10 years.

Does this method of investing limit volatility? It looks like it does, but it really doesn’t. Your investments are subject to all of the vicissitudes of the stock and bond markets, and then some, because the private companies took on some leverage. Though the values may be constant on the accounting statements, the volatility of the investing will be delivered in full at the end of the 10 years.

That’s the way some of these alternatives work, except they get applied not to public stocks and bonds, but private companies, real estate, mortgages, etc.  They are subject to the same economic forces as the public stocks and bonds, and once you strip out the effect of the additional leverage they perform about the same.

The story was told that this is the way that the wealthy got wealthy, by investing in private corporations, and investing in real estate. This is true as far as it goes except that the wealthy concentrated their investments in a few real estate projects and a few corporations that they themselves actively managed. Those offering alternative products investing in private equity and real estate are investing far more broadly in order to reduce risk. Even if the investments do well, you won’t get wealthy off them, though you might do well.

What is also not mentioned is that many more people who try to become wealthy by concentrating their investments fail. If this were easy, everyone would be doing it. The volatility is not eliminated; far from it, the volatility is amplified, and for those wealthy that succeed, that was the road to wealth for them.

As with public equity and bond investments, you will find that there are talented managers who can outperform the rest. Many of the talented managers in private investments limit the amount they manage, and money from new investors is not welcome.  The best managers of alternative investments are not open to the public, and not to these private investment middlemen as the conference.

The same logic applies to hedge funds. There are many different types of hedge funds, and performance data for them is dirty. Some managers are good, some are bad, and on average they’re about as good as markets they invest in. As for some of the data abnormalities, the good ones get into the databases before they’re actually taking money from outside clients which overstates the returns to clients. The bad ones exit the databases early, so the returns on their failure do not get reported.

Though some notable managers will do well, average managers will not outperform investments in public stocks and bonds. This is another case where the actual underlying investments matter more than the legal form that the investments take. Private and public investments exist in the same economy and get roughly the same returns. This should be no surprise.

The upshot of what I’m trying to say is that if you are not investing in alternatives, don’t feel bad because you’re not missing anything on average. Just beware slick marketing pitches designed to make you feel inferior because you’re not one of the “cool kids” investing in illiquid private securities.  After the next bear market, many “cool kids” will find that they lost a lot of money along with everyone else, if their alternatives mature in the bear market.

A Final Note — Fixed Income or Banking Income?

I also believe that income investors in some of these new approaches will be the most disappointed in the next bear market. When I was a portfolio manager managing mortgage bonds, we had a rule: don’t buy mortgages on operating properties like hotels, marinas, casinos, theaters, etc. When you do that, you cease to be a lender, because the underlying cash flows of the property are not stable enough to support a loan. If you do such a loan, you have a smaller loan that is real, and the rest is an equity investment.  In a bear market, that “equity investment” could prove worthless.

People will find out this same thing with durable income products, they will prove far more risky than ordinary fixed income investments in the next bear market because they are running a levered lending business. And in the few cases where the business is not levered, the riskiness of the investments is higher than what would commonly expect.

And thus my counsel is focus on the return of your money, rather than the return on your money. Play it safe with your fixed-income investments.

End the “Code of Silence”

I was asked to contribute to a survey recently, and one question made me think.  It was a question about why don’t more people consult investment professionals, and What keeps them from doing so.  I gave a fairly standard answer for me:

There are two reasons: first, most people don’t have enough income or assets for investment professionals to have value to them. Second, people don’t understand what investment professionals can do for them, which is:

  • They can keep you from panicking or getting greedy

  • They can find ways to reduce your tax burdens

  • They can diversify your assets so that you are less subject to large drawdowns in the value of your assets

After I wrote it, I submitted it for publication, but I wasn’t really happy with my answer.  The thing that left me less than happy are the various tales that I hear where investment advice is subpar, communicated poorly, etc.  Personally, I expect the real reason many people don’t consult investment professionals is fear of a bad experience, which may often stem from a a bad experience that they have had or a friend my have had.

I sympathize with the goals of the CFA Institute’s Future of Finance Initiative.  That said, I think it is a nice-sounding idea that won’t get far.  I have four main reasons why:

  • We don’t have a financial system where all financial professionals have to be under a common ethics code, with additional ethics code sections for areas of specialization.
  • We don’t have a culture among investment professionals that really wants to clean up the system, and talk about abusive practices, such that they become well-known and go away.
  • We don’t have enough of a culture among investment professionals that wants to genuinely educate the investors that want it, and in ways that don’t directly benefit us.
  • Because we don’t have one unified theory of investing, there will be enough gray areas where people will still get hurt by professionals.

On the first point, I would note a recent article of mine on self-regulation financial markets, where I said:

The guy from the National Futures Association emphasized the idea that mandatory membership in the association as a requirement to do business was paramount for an SRO and I can see that.  The SRO then has the “death penalty” hanging over the heads of those they regulate.  That said, consider this: the CFA Institute may dream of the day when all involved in investing *must* hold a CFA Charter.

I have no doubt that this would be a good thing.  Ethics codes are good for the industry, and to kick out bad apples would be a good thing.

On the second point, it would be worthwhile for financial writers and some larger firms to take on common practices that are abusive.  This will be controversial, because not everyone will agree on every item, but even getting a stoplight list where red is bad practices, green is good practices, and yellow means be careful would be a good start.

On the third point, we need to advocate for the best practices even where it doesn’t exactly fit where our businesses make profits.  Think of it this way: it often helps in home repair when someone who comes to fix one thing gives me some free advice on another matter that he doesn’t do, but sees it and tells me.  That builds goodwill for a later date, because I know that person cares about me, and not just what I pay him.

On the last point, my earlier article went over many of the disagreements:

Ethics aren’t neutral; people disagree about what is right and wrong to a high degree.  Even in finance, there are considerable disagreements in what is the correct behavior:

  • Active vs Passive mangement
  • Value vs Growth
  • Does Technical Analysis work?  (Is there truly a single discipline there?  I don’t think so.)

That’s a considerable reason why it would be difficult to enforce the views of the CFA Institute over the markets.  There is no commonly agreed-upon view of how the markets work.  The views of the academics are ridiculous, and do not reflect market realities. But many asset allocators trust them, even though their results are poor.

But even if this results in some squabbles, at least people can be aware that there are differences of opinion, and maybe that can inform the way we talk to clients.  Long only managers should tell their clients to buckle in, because they do not time the markets.  Traders should tell clients that they won’t do well in choppy markets, and that methods to limit losses and let gains run have their limitations.  Time horizons for investment decisions should be clearly identified, so that investors can set their expectations reasonably.

And that could be the best part of this: if investors have a good idea up front of how an investment will likely perform in a variety of scenarios, there will be fewer negative surprises, and hopefully, happy clients.

Anyway, that’s what I think the goals should be.  Now, who else wants to make them practical, and be willing to speak up about this?

Post 2600

Every 100 posts or so, I take a step back and think about where I have been, and maybe, where things are heading.  This time, things are a little different.

It started when there was a series of articles published where they were measuring the amount of social media influence various RIAs that blog have.  The early ones placed me twelfth, and then one placed me fourth, without making a big thing that the group was limited to RIAs.  At present (thanks Michael Kitces!), I may be ranked fifth, for what it is worth.

That said, I don’t blog to be at or near the top of anyone’s rankings.  I’ve learned over the years that blogging is a fickle thing.  It’s one reason why I keep a wide variety of topics on hand, because those that specialize in one area (such as scandal or crisis) get put out to pasture when everything normalizes.

After that, I decided to write one post to explain my blog to those who were new readers, because there were a lot of them.  Okay, that was the last century post.  For what it is worth, that one was around 2530, and this one around 2615.

In the middle of this, I decided to update the WordPress software at my blog, and improve the ability of people to comment here using Jetpack, enhance social sharing, and allow people to log in using WordPress, among other things.  If the ability to use my blog as a reader hasn’t improved, please let me know.

Then another weird thing happened.  Yahoo Finance finally decided to cleanse the shire, and tossed out what I felt were a number of subpar content providers.  That’s when I noticed the replacement which was Yahoo Finance Contributors.  I asked to be admitted, and I was happily waved in.

What I didn’t expect was that it would roughly double the readers coming to my blog natively.  Email and RSS are up also.  I suspect that there will be some fall-off from these levels, but it is interesting to see this happen after 7.5 years of blogging and a relatively stable audience over the last five years.

About the only change long time readers should see is a picture at the top of almost all of my pieces from now on, unless like this post, I am not sending it onto Yahoo Finance via my intermediary tumblr blog.  Additional note: if you want to comment at my blog using DISQUS, it is operational on the tumblr site.

I don’t intend on changing anything else at this blog — not topics, style, etc.  I remain happy to answer questions via blog posts, and I have a number of book reviews coming, but the one thing I don’t have any more of are long series of posts on a related topic.  I think all of those are out of my system.

As I end many of these memorial posts, I thank you for spending time on my blog reading my musings.  I hope you always find it valuable, but I realize there are seasons in life, so if you eventually find me not as useful, well, that’s normal for many.  My topics change over time, usually in sync with the markets.  Phrasing it another way, if you find me less useful, you might want to check back in when market events change, because you might find me relevant again (or not).

One final note: if anyone knows a cartoonist that might like to work with me, let me know.  No guarantee that I will do anything there, but I have been musing about a few ideas.  Bye for now!