October 2008 – Page 3 – The Aleph Blog

IFRS: Incomparable Flexible Reporting Standards.

Posted on 11 October 200812 October 2008 by David Merkel

One housekeeping note before I start.? I made a small enhancement to the blog today.? I added a little link on the upper right, just below the banner that reads “Aleph Blog.”? If you click it, it brings you back to the home page.? I know that is how my banner is supposed to work, but I have not been able to get it to do that.

My first topic this evening is the SEC’s move to IFRS.? If you would like to protest this, the form is here.? Here is what I am submitting to the SEC:

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Sirs,

I strongly oppose adopting IFRS in place of US GAAP.? I am not an accountant, but something more important, a user of financial statements.? I am a life actuary and a financial analyst.? I have been on both the preparation and use sides of accounting statements over the last 20+ years.

My first critique is that there is nothing that is that big of an improvement over US GAAP in IFRS, and many areas that seem less accurate.? I will handle those later.? My point here is that in order to justify the costs of retraining accountants and financial analysts, what ever is put into place needs to be a large improvement over GAAP.? IFRS is not that.? It will impose big costs on US corporations to re-tool their accounting, and the small corporations will be disproportionately affected.? In the end, I don’t think we will have materially better financial statements.

Perhaps accounting consulting fees will rise in the short run from the conversion, but that it not a reason to put the rest of us through the wringer.? Just as laws are too important to be left to lawyers only, in the same way, accounting standards are too important to be left to accountants only.

Second, there have been a number of studies done that show that US GAAP confers an advantage of lower capital costs on companies that use it versus IFRS.? Why raise capital costs on US corporations?

Third, IFRS will not unify accounting standards around the world, because the national implementations of IFRS are significantly different.? Here’s an idea, though:? Call US GAAP an implementation of IFRS.? WHo knows, it might become the preferred IFRS because of its relative strictness.

Fourth, IFRS is more squishy than GAAP because it is “principles-based.”? We use rules-based systems in the US because they offer legal protection regarding fraud in securities laws.? I would argue that IFRS is actually rules-based also, but with a less-tested set of rules.? The rules of US GAAP are large because they have grown to meet the complexities of accounting in the modern economy.? More below.

Fifth, the additional squishiness/flexibility will make it more difficult to compare results across companies, making the job of securities analysts more difficult.

Sixth, US GAAP is more investor-focused than IFRS. That’s why it lowers capital costs.

Seventh, value investors will benefit from IFRS because the income statements and balance sheets will be less reliable, which will force more investors to the cash flow statement, which is harder to fuddle.? Average investors will have a harder time investing, to the extent that they look at financial statements.

Eighth, does Congress really want to give up its sovereignty over US accounting rules?? I think not; all it will take is one significant scandal, and Congress will move away from IFRS.? The pressure toward globalization is weaker than most think.

Ninth, IFRS is weaker when it comes to revenue recognition, joint ventures, and accounting for fixed assets and intangibles.? In general, the ability to revise asset valuations up should be limited or nonexistent.? The ability to be flexible in recognizing revenue should be similarly limited.

In the American context, where we have dispersed ownership, we need conservative accounting rules that are comparable across companies.? The proposed move from US GAAP to IFRS is a step backward.? Please do not sacrifice our relatively good accounting standards for something less accurate and applicable to the needs of our nation and its securities markets.

Sincerely,

David J. Merkel, CFA, FSA

Blame Game, Redux

Posted on 11 October 2008 by David Merkel

When I write, I don’t always know what will be popular, and what won’t.? Personally, I thought my article
Rethinking Insurable Interest was the more innovative of my two articles last night, but Blame Game made the splash.? Well, perhaps no surprise, the crisis has the attention of all of us.? I just have broader interests; I want to write about a wide number of things.

My readers took me up on my request, and gave me more targets to blame.? Let me expand on them:

21) The Rating Agencies — that was a popular choice.? Yes, the rating agencies messed up.? They always do.? Their job is an impossible one.? Should they be proactive or reactive?? Should they rate over the cycle, or be instantaneous?? Should they care about systemic risk issues?

Where they did err?? They competed for business, leading underwriting standards lower in structured finance.? They overrated the financial guarantors, who were their major clients.? Away from that, they made mistakes, but every firm offereing opinions makes mistakes.? I make mistakes regularly here.

22) Matt give me another party to blame, and I will let him speak for himself: I have one more to add – the Office of the Comptroller of the Currency. Not only did they fail to regulate the national banks, they also stone-walled State and local governments from bringing suit (claiming jurisdiction, but never following up on claims).

Add to that the divided regulatory structures that encouraged regulatory arbitrage.? That encouraged diminished underwriting standards.

23) Investment banks.? They asked the SEC to waive their leverage limts, and now none of the big guys are left as standalone publicly traded institutions.? They made a lot for a while, and then lost more.

24) Then there were the carry traders who have now gotten carried out on their shields. There were too many players trying to clip uncertain interest spreads, from hedge funds to Japanese housewives?

25) House flippers — whenever investors get to be more than 10% of a real estate market, beware.? Sad, but I heard an ad on the radio for buying residential real estate in order to rent it out.? It is not time for that yet.

26) The quants — they enabled models that gave a false sense of security.? They did not take into account decreased lending standards, and assumed that housing prices would continue to go up, albeit slowly.

They also assumed that various classes of risky business would be less correlated, but when hedge funds and fund-of-funds take many risks, returns become correlated because of investoors enter ing and exiting sectors.

27) The tax havens and hedge funds.? Hedge funds are weak holding structures for assets.? In a crisis they can be sellers, because they want to lower leverage.

28) Mainstream financial media — CNBC, etc.? They were relentless cheerleaders for the bull markets in stock and housing.? This isn’t a compliment, but financial radio makes CNBC sound cautious.? FInancial radio seems to be a home for hucksters.

And, that’s all for now.? If you have more parties to blame, feel free to respond.? One final note on my point 16, diversification, from the prior post: many quants did us wrong by focusing on correlations stemming from only boom periods.? There are many problems with correlation statistics in finance, but the big problem is that correlations are not stable even during boom times, much less between booms and busts.? In a bust, all risky assets become highly correlated with each other, invalidating ideas of risk control through diversification.

My view of diversification is holding safe assets and risky assets.? High quality short-term debt does wonders to reduce the volatility of results.? Other hedges are less certain.? Nothing beats cash, even when money market funds are open to question.

Blame Game

Posted on 10 October 200810 October 2008 by David Merkel

Some people don’t like the concept of blame.? They view it as useless because it wastes time in looking for a solution.? I will tell you differently.? Blame is useful because it identifies offenders, which is the first step in eliminating the problem.? The trouble is that few have the stomach to get rid of the offenders.

So, as I traveled home from prayer meeting with my children last night, we listened to a radio show discussing the current credit crisis.? This was a good discussion, unlike many that I hear.? But the discussion (on NPR) eventually focused on “who should we blame?”? Okay, here is my incomplete version of who we should blame:

1) The Federal Reserve, especially Alan Greenspan.? For the past 20 years, we couldn’t let the economy have a severe, much less a moderate recession.? Rates were reduced before significant pain was felt by those who had borrowed too much.? The 1% Fed funds rate in 2003 was the pinnacle of that effort.? It created the ultimate bubble; there is nothing left to reflate in 2008 from easy monetary policy.

2) Congress and the Presidency — they encouraged undue leverage in a variety of ways:

a) Fannie, Freddie, the FHLB, and more: Everyone has gotta live in a single family home.? Gotta do that.? Thomas Jefferson’s ideal was that we should encumber future generations so that marginal buyers could live in houses beyond their means.? They compromised lending standards more and more, along with private lenders as the boom went on.

b) The SEC: in a fiat currency world, controlling the currency means controlling leverage of financial institutions.? The SEC waived leverage restrictions on the investment banks in 2004, leading to a boom, and a bust. Big bust.? Ginormous bust — how many large standalone investment banks are left?

c) Particularly the Democrats in Congress defended the GSEs as their own pet project.? I am not bashing the CRA here; I am bashing the goal of having everyone live in a house beyond their means.

d) We offered a tax deduction on mortgage interest, and a limited exemption on capital gains from selling a home.? There is no good reason for these measures.

e) And, the Republicans in Congress who favored deregulation in areas for which it was foolish to deregulate.? Much as I favor deregulation, you can’t do it if you have fiat money (unbacked paper money).? In that case you must restrain the growth of credit.

f) The Bush Jr. Administration — they did not enforce regulations over financial institutions the way that the law would demand on a fair reading.? Again, I’m not crazy about regulation, but unless you have a gold standard, or something like it, you have to regulate the issuance of credit.

g) Their unfunded programs with promises to the future; the states and Federal Government always promise today, and don’t fund it.? Hucksters.

3) Lenders steered borrowers to bad loans.? There was often implicit fraud, and in some cases, fraud.? The lenders paid their staff to do it.

4) Borrowers were lazy and greedy.? What? You’re going to enter into a transaction many times your income or net worth, and you haven’t engaged helpers or friends to advise you?? Regardless of the housing price mania, you should have gone slower, and done more homework.? Caveat emptor — you neglected that.

5) Appraisers were slaves of the lenders who wanted to originate and sell.

6) Those that originated MBS did not check the creditworthiness adequately.? They just sold it away.? Investment banks did not care where a profit was coming from in the short run.

7) Servicers did not demand a high price for their services, making it hard for them to service anything but solvent borrowers.

8) Realtors steered people into buying more than they could rationally afford; I’m not saying they did that on purpose, but their nature was to sell to get the highest commissions.

9) Mortgage insurers and financial guarantee insurers — because of the laxness of accounting rules, they were able to offer guarantees significantly in excess of what they could pay in the deepest crisis.

10) Hedge funds, investment banks and their investors — they demanded returns that were higher than what was sustainable.? They entered into businesses that would not survive difficult times.

11) Regulators let themselves be compromised by those following the profit motive.? Many hoped to make money after joining private industry later.

12) America.? We let ourselves become short-term as a culture, encouraging short-term prosperity, regardless of the cost.

13) Neomercantilists — they lent us money, because they wanted they export sectors to grow for political reasons.? This made our interest rates too low, encouraging overinvestment and overconsumption.

14) Average people who voted in Congress, and demanded perpetual prosperity — face it, we elect those that govern us, and there is the tendency in America to love the representative that brings home the pork, while hating Congress as a whole.? Also, we need to bear with recessions, and let them do their work, and not force our government to deal with them.

15) Auditors that did a cursory job auditing financial entities.? As the boom went on, standards got lower.

16) Academics who encouraged a naive view of diversification, and their followers who believe in uncorrelated returns.? In a bad economy, everything is correlated, and your statistics from a good economy don’t matter.

17) Pension and other funds that believed the academics.? It is amazing what institutional investors will fund, given the mistaken idea that correlation coefficients are stable.? Capitalistic economies are unstable by nature!? Why should we expect certain strategies to workallo the time?

18) Governmental entities that happily expanded government programs as the boom went on.? Now they are talking about increased taxes, rather than eliminating programs that are of marginal value to society.? Governments should not rely on increased taxes from capital gains, or real estate tax assessments.

19) Those that twitted “doom-and-gloomers,” and investors who only cared if markets went up.? It is hard to write about what could go wrong in the markets.? Many call you a wet blanket, spoiling their fun, and alleging that you are a short, or some sort of misanthrope.? The system is biased in favor of happy talk.? Just watch CNBC.

20) Me, and others who warned about the current crisis. Perhaps we weren’t clear enough.? Maybe our financial interests made us look like we were talking our books.? I know that I spent a lot of time on these issues, but in the short run, I was still an investor, trying to make money in the markets, hoping that what I feared would not occur.? Now I am getting my just desserts.

This is an incomplete list.? I invite you to add others to the list in your comments.

Rethinking Insurable Interest

Posted on 10 October 200820 June 2017 by David Merkel

Let’s take a short break from “all credit crisis, all the time.”? I want to talk about an issue that troubles us in a number of ways.? The legal doctrine of “insurable interest” [II] is critical to the life insurance industry.? II states that only those with a direct economic or (sometimes) sentimental interest can seek to buy life insurance on another person.? The sentimental interest is limited to close family, and sometimes friends, if approved by the insured.

This protection exists for several reasons:

Insurance exists to reduce risk, not promote gambling.
The tax-favored nature of life insurance relies on the idea that it is helping people who would be harmed by the death of the insured.? Absent that, the IRS will eliminate those favors.
We don’t want to raise the risk of murder by allowing anyone to take out insurance on another person.? Even though murder by the policyholder would invalidate the claim, that can be hard to catch.

Now, those who know me as a life actuary know where I am going next.? I’m going to complain about stranger-owned life insurance, viatical settlements, premium financing and the like.? Good guess; I’ve written about those before.? I’ve turned down job offers in that area for ethical reasons.? You only get one reputation in the business, so you better guard it carefully.

But, that’s not what I am going to write about, much as I think that many of those practices should be outlawed.? I’m going to write about credit default swaps.

Wait.? What do credit default swaps have to do with insurable interest?? Legally, nothing at present.? This article will suggest that there should be a link.

Insurable interest exists to protect the insured, a natural person, against increased risk of death from policyholders seeking to do him harm.? Corporations are corporate persons under the legal code.? Should they not get the same protection?

Credit default swaps pay off when a corporation “dies.”? I know there are additional complexities here, but play along with me for now.? There are parties that get hurt when a corporation dies:

Suppliers
Employees
Sponsored pension funds
Debt/loan holders
Stockholders
And maybe more…

They have an insurable interest in the continued well-being of the corporation.? They should be allowed to issue credit default swaps to the degree that it allows them to hedge their exposure, and no more.? Any excess exposure is gambling, not insurance, and should be forbidden by law.

Yes, like Charlie Munger, I believe that gambling should not be legal on public policy grounds.? Credit default swaps are not insurance as the regulators define today, but they should be regulated as insurance, and only financial guarantee insurers should be allowed to insure it, and those seeking insurance should prove insurable interest, or the contract is null and void.

Now, if you see my logic, forward this article to your Senators and Congressmen.? Let’s change the dynamic that has introduced so much speculation into the bond markets, where there is more credit default swaps than there are bonds available.

At a time like this, when many things are coming unhinged, this is just one more thing to set right, so that we can have a more stable financial system.

A Note on the Greenspan Legacy

Posted on 9 October 200820 June 2017 by David Merkel

Check out this article from the New York Times on the Greenspan legacy.? In my time at RealMoney, I took some heat for being a critic of Greenspan.? I won’t list all of it, but I will echo this one post:

		Aaron Task
		Speaking of Permabears…
		7/26/2006 1:27 PM EDT

Thanks for the response, Rev.

Meanwhile, Merrill’s Rich Bernstein has an interesting note out arguing that the Fed’s 450 basis points of tightening “has not yet severely impacted the U.S. economy” because the expanded use of credit derivatives has created an alternative source of liquidity.

“Whereas the majority of Wall Street is focused on the traditional growth/inflation trade-off, we hope Mr. Bernanke is also considering this new and expanding form of credit creation,” Bernstein writes. “Our belief is that he is indeed quite concerned, and that despite current dovish jawboning, he will ultimately tighten more than investors currently expect.”

Position: Awaiting the Beige Book.

		David Merkel
		By Default, No Credit Where It Is Not Due
		7/26/2006 2:23 PM EDT

Aaron, I read the Rich Bernstein piece. I usually agree with what he writes, but not this time. The amount of yield compression created by credit default swaps is 50 basis points at best, which doesn’t even come close to the 450 basis points that the FOMC tightened. Now, if someone makes the argument that the rates on corporate bonds 10 years and longer haven’t increased significantly over the past 27 months, I would agree with that, but that has little to do with credit default swaps, which are a short maturity phenomenon for the most part.

I thought of writing a note on the article cited in Bernstein’s piece, but ran out of time yesterday. It is a horrendously optimistic article, and too short-sighted. Credit derivatives, as I have noted before, have induced two anomalies into the credit markets. First, they make spreads artificially tight on the short end. Second, they create demand for bonds after they default.

Both of these are “tail wagging the dog” phenomena. When the market for making side bets gets bigger than the main business of financing corporate credit, something weird is going on. The real test will come when we get the next spike in investment grade defaults. When we had the last spike, the credit default swap market had notional amounts smaller than the corporate bond market. Now the credit default swap market is more than four times the size of the corporate bond market in nominal terms. When it happens, all of the negative effect of too much insurance chasing too few bonds to be insured will be revealed.

One more aside, the idea that the low default rates since 2003 is unusual is wrong. We had a longer period in the mid-90s. The effect of credit default swaps and collateralized debt obligations on default in the short run is modest at best (even the article says CDOs lower borrowing costs by 3-5 basis points).

In the long run, it may make the default problem worse. Whenever you lend a debtor money, he immediately looks more creditworthy because of the liquidity. When the liquidity goes away, as it always does for some minority of corporate borrowers, the debt problem is worse not better.

Position: none, but my bet is that Buffett is right on credit derivatives, and Greenspan wrong (why does that seem like an easy bet?)

I’ve always been a skeptic on the macro-level of derivatives, because they don’t change anything for the system as a whole, unless the losing party is undercapitalized.? The seeming calm that derivatives helped to induce merely shifted volatility to parties that could not bear losses under significant stress.? Talking about a “Great Moderation” during a bull market is hooey.? It’s a Great Moderation if lending terms are stable in a bear market.

Greenspan is a bright guy, but like many bright guys who become beholden to the DC establishment, they circumscribe their reasoning to the politics that they live in.? Few of us have the stomach to speak truth to power; I wonder what I would do under the same cirumstances, though my constitution says I would be a short-lived creature in DC, which does not want to hear the truth.

My guess is that Greenspan will fare badly in history books one century from now.? The inflation that he induced, and the false confidence he engendered will be villified.

Industry Ranks for the Reshaping

Posted on 9 October 2008 by David Merkel

There has been only one other time in my life where I felt so skittish about my methods: June-September 2002.? I got whacked hard by the market then, harder than at present, but I bounced back October 2002 – January 2004, making it up and then some.

I don’t count on that now, but I will give you may industry ranks as of this week:

Running my usual screens, I get a bunch of new tickers to consider:

ABD ??? ABG ??? ACE??? ACGL??? ADCT??? AEG??? AEL??? AFG??? AFSI??? AGII??? AHL AIG??? ?AIZ??? ALL??? ALU??? AMPH??? AMSF??? AN??? ANEN??? ARRS??? ASI??? AWH??? AXA??? AXS??? AZ??? CB??? CBG??? CHEUY??? CIEN??? CINF??? CMVT??? CNA??? ?CNO CPHL??? CPII??? CRMT??? CRNT??? CTV??? DFG??? DSITY??? EBF??? EIHI??? EJ??? ENH??? ENTG??? FFG??? FMR??? FNSR??? FSR??? GBE??? GCOM??? GILT??? GLRE??? GLW??? GNW??? GPI??? GSIG??? HALL??? HCC??? HIG??? HMC??? HMN??? HYSNY IHC INDM ING IPCR IRS JDSU JLL KGFHY L LGGNY LNC LTXC MET MHLD MIG MIGP MRH MRVC MXGL NDVLY NSANY NVTL OB OPLK OPXT PAG PEUGY PFG PL PMACA PNX PRE PRU PTP PUK PWAV RE RFMD RGA/A RNR RTEC RUSHA RUSHB SAFT SAH SAIA SEAB SUR SWCEY SYMM TER THG TLAB TM TMK TRH TRV TTM UAM UFCS UNM UTR VOD VR VTIV WRB XL YRCW ZFSVY

Some of these are on the last list, and some of them I own.? Personally, my “green zone” methods are making me queasy at present because in a credit crisis, trends tend to persist a lot longer, so I will be more likely to look at names that are stalwarts in this crisis.? My investment methods are not purely quantitative.? I use quantitative methods to assist my qualitative reasoning.

As such, I have a few more tickers to toss into the hopper, many of which are safe names, or, names in the red zone that seem cheap:

AA??? ABX??? ALL??? ALOG??? BGP??? BHI??? BKS??? BRNC??? CAG??? CNI??? CP??? DD??? DLX??? DOW??? DPS??? EOG??? FCX??? HAR??? HCC??? HOLX??? HPQ??? IBM??? ITW??? ITW??? MCF??? MET??? MMM??? MSFT??? NBR??? NYX??? ORCL??? PBR??? PFG??? POT??? PRU??? RDC??? REXI??? RTI??? SII??? TAP??? TEL??? TIE??? TM??? VEIC??? WMT??? XTO

Together with my last post, these are the tickers that I will compare against my existing portfolio to choose new names for my portfolio.? As for where I got the batch of tickers for my last post on this topic, my method is to take every idea that I hear over a quarter that I think is interesting, and I note it down, or print it out.? It is eclectic in that sense, but when I analyze the ideas at the end of the quarter, I try to forget where I got the ideas, so that I can analyze them fresh.? I am the main analyst here, and I try to avoid believing the arguments of others when I do my final analysis.

Industries Don’t Learn From Each Other on Credit Issues

Posted on 8 October 2008 by David Merkel

As usual, my friend Caroline Baum wrote another good piece on the credit crisis called Anatomy of Crisis Starts With Skewed Incentives.? I want to take her idea, and run with it a little, because the insurance industry has faced similar problems.

In the P&C insurance industry, there has often been the problem of “giving away the pen.”? For those not familiar, that means letting someone else make the underwriting decision, while you accept the policy onto your books.? Why might a company do that?? Simple — they see opportunity in some neglected market where an experienced Managing General Agent says he has a program that is very effective.? Unfortunately in the old days, the MGA would get compensated on sales, and modestly on underwriting results.? As Caroline put it: skewed incentives.

Anytime you offer significant money for sales without some significant underwriting check, you are asking for trouble.? The agents will write all that they can.? One of my greatest successes in business was designing a compensation formula for pension representatives that aligned their incentives with the company’s profitability.? Worked well for four years, and that was a lifetime in this business.

On another level, we can consider the issue of credit triggers.? Credit triggers are designed to deal with small issues, not large ones.? Anytime credit triggers can be so big as to bring a company down, the company should refuse to enter into such a course of business.? But where have we seen this before?

Life Insurers with fixed rate GICs (early 90s)
Life Insurers with floating rate GICs (late 90s)
Utilities in the early 2000s (think Enron-like structures)
P/C reinsurers in the early-to-mid 2000s

With respect to the last of those, the representative from S&P and I lectured the World Insurance Forum in Bermuda in 2004 that it would not work.? Sadly, a few companies had to fail because no one changed.

Both AIG and Lehman went down because of capital calls from derivative agreements.? Anytime one puts a clause onto an agreement where more capital has to be posted on a downgrade, it sets up a cliff, and wise companies don’t set up the cliff.? Normal companies stay away from the cliff.? Dumb companies get pushed over the cliff, and complain about shorts before the failure, and creditors after the failure.

Our current credit crisis boils down to two factors: excessive leverage, and lousy underwriting standards.? Those resulted from a system that rewarded mortgage origination without much adjustment for credit quality.? Now we suffer for it, while bad debts get liquidated, or inflated away.

Entering the Endgame for Monetary Policy, Part II

Posted on 8 October 2008 by David Merkel

Here’s my updated graph of the composition of the Fed’s balance sheet, with modifications as suggested by some of my readers:

As you can see, the percentage of the Fed’s balance sheet containing Treasuries, whether held for itself, or together with the government is declining.? Let’s look at it another way that contains some editorializing by me:

By lower quality assets, I simply mean assets less creditworthy than the US Government or its agencies.? That’s an estimate on my part.? Why does balance sheet quality at the Fed matter?? If the Fed wants to extend credit, it can more easily do so by having higher quality assets, like Treasuries.? Now, the Fed can lose money, and it means that seniorage profits that go to the US Treasury get reduced, or go negative, which implies increased borrowing or taxation.

I can’t remember which Greek philosopher said something like, “Democracy is doomed when people learn that they can vote to get money for themselves from the public treasury.”? I know Tyler and de Tocqueville said something like that as well.? At a time like this there are a lot of demands on the public treasury, and they are growing:

There is a trouble here.? In the absence of a functioning market, how can the bureaucrats at the Fed figure out the right prices/yields to charge?? This is the same problem as valuing level 3 assets, but without a profit motive to aid in focusing the efforts of the businessman.

Now, the little graph above (from The Economist) describes the real cause of the problems.? As in the Great Depression, there was too much debt financing of assets.? The debt was more liquid than the assets, as well.? Borrow short, lend long.? Oh, and remember, the graph above does not contain the hidden debts of the Federal Government (Medicare, Social Security, and old unfunded DB plans), the states (low funded DB plans and unfunded retiree medical plans), and corporations (poorly funded DB plans).? Nor does it take account of the synthetic leverage from derivatives.

What we are seeing at present is not a reduction of the debt structure of the economy, but a shift from public to private hands.? That can lead to four results, when the debt of the US Treasury is so large that it cannot be serviced:

Inflation when the Fed monetizes the debt,
Depression from vastly increased taxes,
Debt repudiation (whether internal, external, or both), or
Japan-style malaise for a long time.

Japan-style malaise is sounding pretty good. ;)? No growth for several decades while the government debt bloats, and financial balance sheets slowly normalize.? Trouble is, we don’t internally fund our debts.? At some point, our creditors will tire of throwing good money after bad, and then the next cycle can begin in earnest, when the neomercantilistic nations give up, and accept that their investments in the US are worth a lot less than they had thought, and allow their currencies to come to a fairer level against the US dollar.

Financial intermediation has limits.? Financial and economic systems function better at lower levels of leverage if you want it to be sustainable.? Granted, you can have big boom phases if you pile on the leverage, but they will be followed by big bust phases, where the deleveraging is painful.

All of the government’s/Fed’s choices are bad here.? Dr. Bernanke is on a hopeless task, and his theories, borne out his academic studies of the Great Depression, means that we will get a new sort of Great Depression.? There is no easy solution; it is merely a situation where we choose which poison we want to take while the deleveraging goes on.? My guess is that we see some combination of malaise plus inflation.

As Martina McBride said in her song “Love’s the Only House,” “Yeah, the pain’s gotta go someplace.”? The pain is going somewhere; our policymakers are merely determining where.

PS — I am by nature a moderate optimist.? I invest in equities, and many of my sub-theories of the world, i.e., how well will the life insurance business fare, and how well will global demand fare versus that of the US, are being tested now, and I am finding myself the loser on both counts.? Yeah, the pain’s gotta go someplace

Setting a New Speed Record for Being Wrong

Posted on 7 October 2008 by David Merkel

Okay, so 16 minutes after my last post, Ben Bernanke says he will consider more rate cuts.? Nice, and toss in the commentary that sound like the Fed is taking signals from the TIPS market on inflation, as well as the commentary in the minutes that some members were leaning toward cuts in the Fed funds rate.

The key here is how much of the loosening they allow to work its way into the banking system, versus how much they put into the intervention programs.? So far, it hasn’t been much.

Bound for the Zero Bound, or, Will They Accept Dollars in Exchange for Helicopter Fuel?

Posted on 7 October 2008 by David Merkel

These are the times that try my soul as a portfolio manager.? During crises, I am forced to make tradeoffs of the short-, intermediate-, and long-terms.

Short-term: technical oversold/overbought-ness.
Intermediate-term: valuation levels.
Long-term: what industries benefit from economic change?

This is a difficult balancing act.? What makes matters more complex here is trying to understand what impact the actions of the Fed/Treasury are likely to have on the Dollar.? I hope to have another post up on the balance sheet of the Fed, for now, here’s the graph that Ron Smith called “the hockey stick.”

As I note in the graph above, the changes are even larger than the change in the weekly average figures.? Now, this isn’t presently going to be inflationary, because the Fed is (sort of) acting as an agent for the US Treasury in bailing out lending markets.? The US Treasury creates T-bills or notes, gives them to the Fed, and the Fed uses them as collateral in their collateralized lending programs.

The difficulty comes here: it’s easy to create these programs, but hard to shut them down.? Now the Fed will buy commercial paper.? Talk about unbacked paper money, CP is unsecured by any assets of the company receiving the loan.? jck at Alea rightly calls this not-so-wee beastie the Super-SIV.? As I commented there:

# 1 David Merkel Says:
October 7th, 2008 at 9:58 am I think you pegged it calling it the Super-SIV. As I commented in late 2007 as the Fed began this series of interventions in lending markets, it is easier to start these actions than to complete them. It is hard to estimate all of the consequences.Just as I think George Bush, Jr., started to go wrong when he concluded that he had found his mission (fight terrorism, without boundaries), Ben Bernanke faces a similar problem (do whatever it takes to stop the Second Great Depression, without boundaries).

History is being made here, and it will be volatile?

And jck responded:

# 2 jck Says:
October 7th, 2008 at 10:14 am one thing we know for sure, is that the policy of ?promoting? liquidity appears to have backfired, no reasonable person would claim that markets are functioning better now than when they started?in fact some people would say they are a lot worse.
as you say David, very hard to get out of this, I don?t expect to see a normal Fed balance sheet, i.e treasuries_t-bills in my lifetime.
I will pop in for a comment on your euro piece a bit later?busy???

The question is: what are the endgames for these programs… TAF, CPFF. PDCF, TSLF, TARP, the bailouts of Bear and AIG, etc?? Once a market gets a taste of cheap credit, it is difficult to get them to give it up; they begin to depend on it.

And there are more demands for use of the credit of the US Government.? Bill Gross wants Fed funds at 1%, and wants the Fed to guarantee that institutional transactions clear.? Sounds simple, but the devil is in the details.? The essentially means that the Fed takes short term risk of financial firms failing while securities are in the course of settlement.? The losses could be significant in a crisis, but so could the calming effect.

The Treasury/Fed hopes that if they can calm the markets, eliminating fear of cascading defaults, eventually the markets will regain a tolerance for risk, and they can slowly eliminate the new lending programs.? My sense is that is the Japanese solution, and we are still waiting after two decades to see if it works.? Other “solutions” include:

Inflating away the value of the promises made. (I.e., monetizing some of the T-securities that have been printed and given to the Fed.)
Increasing taxation to pay for the credit losses from the bailouts.
Creating a two-tier currency system, where foreign lenders get paid back in a cheaper currency, but domestic lenders don’t get so badly affected.
Or, a combination of the above four.? Like jazz, I think policymakers are making it up as they go along, and will use a wide variety of solutions.

And, all of this hinges on the willingness of those who buy Treasury and Agency securities to continue to do so.? On the bright side, the disarray in Europe is making the US Dollar and Japanese Yen more attractive, giving the US the opportunity to issue more debt at a time when it will be needed for the TARP.

I come down on the side of an eventual inflation, monetizing the debts of the US Treasury, though that is a minority opinion at present.? It certainly isn’t showing in the TIPS market.? Take a look at one of Greenspan’s favorite graphs, five year inflation, five years forward:

After six years of stability in this statistic, expected inflation has gone over Niagra in a barrel.? Call me a nut, but I like TIPS even more here.? Very cheap inflation insurance, which I think we will need when this comes into its endgame.

Most of the pressure is toward a lower Fed funds target rate, but given that the Fed has sterilized their prior cuts, I don’t see what great good it will do.? It just gets us closer to the zero bound, after which, Japanese quantitative easing exists, and the infamous helicopters of Friedman and Bernanke.? As it stands now, I don’t put much credibility in a Fed funds rate cut.? The Fed seems committed to using its balance sheet to intervene in lending markets, not the more traditional stimulus of the economy as done in the past.

Truth, I am not sure where this ends, but from my recent discussions with Ron Smith and Dr. Jeff Miller, the solutions aren’t easy or pretty.? The time to have acted was 5-15 years ago, and we don’t have a wayback machine.