Brad Baldwin began be saying, “Thank you gentlemen.  This has been a hard environment for all of us, and your efforts are appreciated.  Unfortunately, at this time, we must assess what is working and what is not.  We must…”

“Brad.  Allow me.” Stan Bullard stood up and said, “Gentlemen, I am younger than all of you, but I am the chosen leader of the Bullard extended family.  My Grandfather and Father built this business, and I have no intention of letting it fail.  Times are tough, and we may need to take tough actions.”

Looking at the CFO and Corporate Actuary, he continued, “I’ve studied the history of our company, and tried to understand our culture.  I may be young, but I recognize the value of wisdom accrued of lifetimes.  Our culture has been relative decentralized and free.  We have allowed subsidiaries to set their own accounting policies and their own investment strategies.  That might be fine during boom times, but it is never acceptable during times of economic crisis.  Since we can’t predict when crises will come, that means these policies are not ever acceptable.”  Looking at Peter Farell, he said, “From now on, all investment policy will be determined by our Chief Investment Officer, Peter, in consultation with the CEO and the Board of Directors.”

Looking at the CFO, he added, “Also, accounting will be centralized as well.  Because of deviations from accepted accounting practices, we must standardize accounting across all of our subsidiary companies.”

John wondered at that statement.  “Deviations?  Huh?” he thought.

Brad picked up the conversation, and added, “There is more.  Let me introduce our guest, Caleb Matmo.  As a private stock company, our risk analyses are a little behind the rest of the industry.  We have Statutory and Tax valuation bases, but we do not do GAAP as publicly traded companies do.  Our one bow to GAAP is the debt covenants with our bankers, which thankfully we have no difficulty complying with.”

“Mr. Matmo and his firm have pored over our financials and our businesses in detail, in order to understand the risks involved, and give us a feel for whether we are taking too much risk relative to the returns that we receive.”

John wished his Chief Actuary, Greg, was with him. Greg was conservative, but not foolishly so.  It would be useful to have an independent perspective on this new consultant.

Caleb Matmo stood up and said, “For over one decade, my firm has been evaluating insurance risks and I beieve that we have a good process.  We use a rigorous actuarial risk model, and we give little credit to financial risk models as are commonly used by hedge funds.”

“Maybe Greg would like this,” thought John.

“Pass out the reports, Miss Kendall.”  A young lady passed out three reports, two from Peter Farell and one from Caleb Matmo, to each person at the meeting.

“Before I go on,” Brad Baldwin said, “I need to tell you about our defunct financial guarantee insurer.  We have put it into runoff.  Given that we have removed the manager, we will need a manager to manage the runoff, until it is so small, that we sell it off.  Marc and Henry, either one of you may manage the runoff, or you could recommend external managers to us.

John looked at the handouts, and thought, “You know, maybe I have a chance here.”

What I am about to write will sound out of character.  In writing, I often try to strike a balance between what should be, and what is possible.  In this piece, I am temporarily ignoring what should be, for what could help solve our economic problems at minimum societal cost.  Please understand that I am a principled man who hates inflation, but with the doofuses that mismanage the Fed, I am aiming for “second best” policies here.


Al McGuire, past coach of Marquette Basketball, was once asked (something like), “Would you rather have an A student or a C student at the free throw line in a tense situation?”  His answer was the C student, because he wouldn’t think about the situation, he would just act, and sink the free throws.

The current Fed is clever.  Too clever by half.  They have aimed for a trifecta of fixing short-term lending markets, not raising inflation, and stimulating the economy.  Though they may have had modest success with the first goal, the second goal has been rendered irrelevant, and the third goal is a failure.

It would have been better if the Fed had simply revved up the printing presses (virtual as most of them are), and began monetizing the government debt.  That is too crude of a strategy for our central bankers, who have delicate constitutions, and are fighting a war that ended 20 years ago.

How would higher inflation help the current situation?

  • Wages and the nominal value of collateral underlying loans would rise, reducing credit stress.
  • People and institutions would stop sitting on their savings waiting for prices to fall further before acting.
  • Inflation would cheapen the dollar, making imports more expensive and exports cheaper, stimulating the US economy.
  • Inflation would reduce the real value of debts owed to foreigners.

The Fed is wasting its time with its alphabet soup of credit easing programs.  They accomplish almost nothing for the real economy, while lavishing liquidity on markets that tangentially help financial institutions.  That is a great way to aid average Americans, not.

Far better to fire up the helicopters (that’s a figure of speech), and mail a check for $1000 to every person with a Social Security Number (or their parents if they are in their minority).  All of the complexity in the TARP and in the stimulus bills could be dispensed with, if we trusted the American people.  Give them the money, not the credit markets.  The people know better than the Fed.  After all, who is the Fed supposed to serve?

Historically, In times of extreme credit stress, the US has acted in this way, to relieve the stress of an indebted population through inflation.  (Think of bimetallism.)  Though I am not crazy about inflation (it will hurt me), nonetheless it would be good for the nation as a whole.  (Of course, with harm to those on fixed incomes.)

Mortgage rates would rise, and other interest rates would rise, harming economic activity, but the economic tempo would still increase as people would seek to use their money before it declines in value.  Inflation is a cost worth paying in order to get the economy moving again, giving debtors some breathing room.

This post is supposed to be a kind of “catch up” post, where I write about a number of small things that I thought were interesting, but weren’t worth a full post.

1) The government can’t fund everybody. The recent backup in the US treasury note market is a great example of that.  As the demands for funds now in exchange for funds later has increased, Treasury interest rates have risen.

I have several biases, but one of them is that the Government can’t unilaterally create prosperity.  It can create conditions that encourage economic activity, through predictable and fair laws, but it can’t make us immediately better off through deficit spending, or tax-and-spending.  The Government does not know what is needed to a better degree than its citizens do individually.

But let the government fund or guarantee everybody.  When they do that, there is just one overleveraged credit that matters, and it will fail, taking us with them.

2) Equity Private is one clever ladyFair value accounting primarily exists to deal with investments that are as volatile as equities. How are publicly traded equities valued?  At market.  How about volatile assets where the value is derivable from market prices?  They should be valued at pseudo-market.  If we were back in the old days, and all of our assets were bonds, we wouldn’t need fair value accounting.  Even if we did it, the values wiould not vary much.   But when you slice and dice the various pieces of bonds, the volatile bits jump around a lot.  To value them at their initial value is ridiculous, the value is too volatile.

3) Felix is rightThere needs to be more of a debate over bank nationalization. I’ve written my pieces there, influenced by the better regulations of the insurance industry, and how they deal with insolvencies.  Mark assets to market.  Do the triage.  Send insolvent institutions to RTC 2, and take stakes in some marginal institutions.  That is where the money will do the most good.

4) “We have to buy up assets that are selling at fire sale prices.  We will even make money for the taxpayers.” So go the arguments of those that want to create a “bad bank”.  Oh, please.  Profits are rare in bailouts.  They happen by happy accidents, a la Chrysler (80s, not now), which possibly could have made it without a bailout.

Assets are at fire sale prices because there is not enough balance sheet capacity to buy and hold them over a period where the realization of value is likely.  I’ve seen structured assets rated AAA where the collateral is okay, and the likely realization of value is in the 90s, if you can hold it for 5 years.  Where does it trade?  Around $60.  Another asset, which would likely be worth $35 if it could be held for 15 years, where does it trade?  It doesn’t trade, but you could get rid of it to a broker for zero.

Strong balance sheets can’t be created out of thin air, though.  Remember how formidable Fannie and Freddie used to be, or many of the FHLBs?  Strong balance sheets only exist through investments where the cash flows will not be needed for decades, like pension and endowment plans.

5) Some commentators complain that the current crisis destroys the concept of efficient markets, because a trust in markets led us to failure. Oh please.  First, all of our markets were by no means free from government mismanagement, and many of the distortions came from poor regulation.  Our dear government had many lending programs pre-crisis, and even more post-crisis.  They further encouraged the increase in debt through the tax code.

Why is debt finance tax deductible, and equity finance not?  What might the system have been like if interest payments could not be deducted on taxable income, but dividends could be?  Leverage would have been a lot lower, and the system would be a lot more stable.

Market efficiency means many things.  In the short run, it means that no one can do better than the current situation. In the intermediate-to-long term, markets are efficient in a different way.  They reveal problems that need to be solved.  Some might call those market failures but they aren’t.  In the present crisis, the invisible hand is saying to us: reduce debt levels; your economic system in too inflexible.  The visible hand, the government, says: “Have some more of the hair of the dog that bit you.  We need lower mortgage rates.  We need more consumer lending.  We’re going to borrow more than ever before in an effort to create prosperity.”  Caroline Baum takes a similar view, and as usual, she expresses it well.

Market efficiency does not mean things are trouble-free, but it gives us sharper incentives to solve our problems.  Some things become revealed as truly public goods that the government needs to regulate.  But that is not the majority of human actions.

6) AIG is one black hole for cash.  Selling or IPO-ing units during the bust phase, when valuations are compressed does not seem to be an optimal strategy here.  If all of the assets were sold, would there be enough for the junior debt or preferred shareholders to get paid?  (Forget the common.)  So, in the face of it, do they IPO partial stakes in enterprises, with an eventual end of IPO-ing or selling the whole thing later?  If so, there is little free cash flow being generated to pay down debt.

What this implies to me is that the huge loans that the government made to AIG will likely hang out there for a long time.  Is this the best use of the government’s credit?  I think not.  If there are still systemic risk issues, wall those off separately, and send the rest of AIG into liquidation.  The insurance units are intact; let others buy and manage them.  Speculating on a future boom in asset prices is not a reaonable government policy.  Hope is not a strategy.

7) It is simple to blame the US for the current global crisis.  Simple and wrong. The US deserves blame, true, but not even the majority of the blame, just a slightly larger than proportionate amount for its size.

But when China blames the US, it goes too far.  In the era of neo-mercantilism, China had political goals to achieve.  Industrialize the country.  Get surplus workers off of the farms and into the cities.  Keep the currency undervalued to support export-led growth.  Force savings through restrictions on imports.  As a result, suck in developed country debts and companies where strategically desirable and possible.  Do these deals in their currencies because of the need to keep the Yuan cheap.

China made its bed, let it sleep in it.  They knew that they were lending to the US in its own currency; it was a necessary part of the bargain to achieve their own goals.  Just as the mercantilists sucked in gold, and then found it to be less valuable than they imagined when they had to draw on it, so it will be when nations want to draw on the US dollar assets that they have hoarded.


My phrase, “the humility of realism” is meant to get us thinking about the system as a whole, and about the long-term consequences of societal actions, whether by the government or private parties.  Humility says that sometimes we have to say, “No, we can’t.”  It also says that we should think carefully about major policy actions, and not let ourselves get bullied by those who rush, shouting “crisis, crisis,” while quietly angling for their favored pet projects to get swept in while no one is looking.  Realism sometimes means the government has no good solutions, so it should inform the public that they aren’t omnipotent, and humbly say the crisis must be borne with grace.

The problems generated by the short-termism of the past three decades will not get solved by more short-term thinking.  The present rush to assure prosperity will not end well, in my opinion.

How do you create a Black Swan? It’s not that hard.  Start with something that you know is seemingly useful, true or good.  Then slavishly rely on that idea until it fails.  I’ll toss out a few here:

  • The more people that live in houses that they own, the better.  The government should encourage home ownership.  You should own the biggest house you can afford.  (In 1986, a Realtor pitched me with that idea, and I thought it was dumb then.)  Residential housing is an investment for the masses; the prices never go down for the nation as a whole.
  • Continually maximizing return on equity will maximize stock prices.  Optimal capital structures and all times.
  • We all want high, smooth returns from our investments — high Sharpe Ratios, everyone!
  • Proper central banking practice can lead to near-permanent prosperity with moderate volatility.
  • Our government can borrow without limit to promote or common prosperity.  Our central bank can cleverly intervene in markets with their assets, and fix things without getting stuck, or creating inflation.

Many ideas that are good marginally aren’t so good if pressed to their logical absurd.  By duping marginal homebuyers into buying what they could not afford, we create a black swan — I remember commentators who were saying as late as 2006 year end, that home prices never went down across the nation as a whole.  It wasn’t true if you looked at the Great Depression or episodes in the 19th century, but people beieved that housing prices could not go down, so they piled into it creating a boom, a glut, and now a bust and a glut.  Behold the Black Swan!  Rapidly falling housing prices across the nation as a whole.

Consider the buyback craze, now deflated.  Was it good to buy back like mad in 2004-2006?  I would tell insurance management teams to leave more of a buffer for adverse deviations.  But it was always easier in the short run for insurance CFOs to buy back more stock, and earnings would rise.  Stock prices would improve as well, and that’s fine during the boom cycle, for then, but many would issue expensive hybrid junior debt with an accelerated stock repurchase.  Short term smart, long term dumb.

The insurance industry is my example here, but it went on elsewhere.  How many acquiring CFOs wish they had used stock rather than cash for the last major acquisition that they did?  Most, I’m sure.

There is always a boom-bust cycle, and there is ordinary trouble during a normal bust phase.  But when the boom phase has parties abandoning all caution, possibly with government acquiesence, the boom gets huge, and the bust too, where the Black Swan appears — things you thought could never happen.

The craze for smooth, high, uncorrelated returns led to a boom in alternative strategies in the investment business.  Return correlations change not only due to cash flows on the underlying investments, but also due to investor demand.  Not so amazingly, as alternative investments go mainstream, the returns fall and become more correlated.  When an alternative is new, typically only the best ideas get done.  When it is near maturity, only the marginal ideas get done.  Alternative asset prices get bid up along with the boom in conventional assets.

Now we get a Black Swan — all risk assets do badly at the same time.  Investors in private equity don’t want to fund their commitments.  Some venture capital backed firms will fail (here and here).  Many hedge funds raise their gates, all at the same time, because investors want out.  Liquidity is scarce.  Companies pay in kind where they can, whether it is on “covenant lite” loans, REIT dividends, etc.  The era of buying back at high prices gives way to equity issuance at low prices.

Now for my final Black Swan, and perhaps the most controversial.  Monetary policy is “optimal” when it follows the Taylor Rule.  A good central banker, applying the rule, should minimize inflation and macroeconomic volatility.

My argument here, which seems intuitively correct to me, but I can’t yet prove, is that continuous application of the Taylor Rule will eventually lead us into a liquidity trap.  That might be more due to the human nature of sloppy central bankers like Greenspan, who want adulation, and err on the side of monetary lenience.  Or, it might be that the central banker overestimates the productive capacity of the economy.  Whatever the reason, we followed something pretty close to the Taylor rule for 15 years, and now we are in a liquidity trap of sorts.  I’ve suggested it before, but perhaps monetary policy should not focus on (at least solely) price inflation or unemployment, but on the level of total debt relative to GDP.

As with so many things in a complex capitalist economy with fiat money, there may not be a right answer.  Optimizing for one set of variables often leads to unforseen pessimizing (a new word!) another set of variables.  What works in the short run often does not work in the long run.

In closing, consider a Black Swan of the future.  Governments globally nationalize financial institutions, run huge deficits and borrow a lot of money to do so.  They “stimulate” the economy through targeted spending, and ignore the future consequences of the debts incurred.  They do it in the face of the coming demographic bust for the developed nations plus China.  My expectation is that these “solutions” will not do much to deal with the economic weakness induced by the debt overhang.

As Walter Wriston famously said, “A country does not go bankrupt.”  Perhaps what he should have said was the country remains in place, only the creditors get stiffed.  Short of war, it is tough to reorganize or liquidate a country.  But I’lltake the sentiment a different way and say that most people believe “A developed country does not go bankrupt.”  That is the black swan that will be displayed here, and Iceland is the harbinger of what might be a future trend of developed country sovereign defaults, or their close cousin, high inflation.

I’m tracking three FOIA lawsuits involving the TARP (using Bloomberg Law, and Googlebots):

    1. Bloomberg L.P. v. Board of Governors of the Federal Reserve System
    2. Fox News Network, LLC v. Board of Governors of the Federal Reserve System
    3. Fox News Network, LLC v. United States Department of the Treasury

      In the first case, there is a motion for summary judgment — this might come to an amicable end, itf the parties can compromise on terms of disclosure.

      The second case has the Fed writing out Vaughn Indexes — explaining what they can’t tell the plaintiff.

      The third case has the Treasury Department saying that they are in the process of complying with the original request, but that they are backed up now, and there are many sub-departments to co-ordinate.  Just wait your turn, and there will be many blacked-out documents for Fox News Network to review.

      I write this partly because I wonder whether the Obama Administration will create an open culture with respect to disclosure of data from the Federal Reserve and the Treasury.  My guess is no, because once someone is in power, they tend to reflect the interests of those who were in power.  But, I can hope, and remember, hope is audacious!

      I will continue to track these cases, and will report as biggish things happen.

      I didn’t think I’d see a proposal like this one which would (seemingly) bar investors from purchasing default protection via the credit default swaps [CDS] on corporations without owning the underlying bonds.  But here it is.  (It would also force the creation of a clearinghouse for CDS, something I have been more dubious about — it will work for large liquid exposures, but not others.)  This is more restrictive than I would recommend; consider my earlier piece, Rethinking Insurable Interest.

      My basic idea is that people, even artificial people like corporations have a right to restrict who takes life insurance out on them, aside from those that already have a financial interest in the well being of the company.  Also, gambling should be opposed on public policy grounds.  Most of the CDS market is just a series of side bets, with little or no true hedging going on.

      Now, what I am suggesting is controversial, though less so than the proposed bill.  There is a very good blog called Derivative Dribble, that took issue with what I wrote in my piece.  The author, Charles Davi, asked me to comment on it, and I ran short of time, and never did.  This proposed bill gives me a chance to comment on his piece, and for you to read his logic.  It is a clear statement of what those that have an economic interest in the size of the CDS business will say.

      My argument with Derivative Dribble is this: he brushes past my moral arguments and focuses on the right of two parties to be able to contract freely.  (Also, his argument about incentivizing illness is just weird, and does not apply to the discussion at hand.)  Merely because a life insurance company has an economic interest in not selling insurance to someone who might harm the insured, does not mean that the insurable interest argument relies on the self-interest of the insurer.  It is a statement of public policy that we don’t allow parties with no insurable interest to make bets on the lives of others.  It arose out of many incidents where insured parties got murdered.  Innocent people have a right to not be concerned that someone has an incentive to kill them.

      In the same way, corporations have a right to not have to worry about being harmed by those that might have an economic interest in their demise.  This is not just for the good of the management, many laborers, suppliers, pensioners, and other stakeholders lose when a firm goes bust.  There are situations where parties controlling the financing of a firm in trouble have acquired CDS protection greater than that of their likely economic loss.  Given that the ability of the firm to refinance in such a situation is limited, this virtually guarantees the demise of the firm.

      The right to free contract is limited in our culture, and in most cultures.  Even an economic libertarian like me knows that.  This is one of the areas where the right to contract should be limited, so that corporations do not have to be looking over their back to see if someone has an interest in their demise.

      The Federal Open Market Committee decided today to establish akeep its target range for the federal funds rate ofat 0 to 1/4 percent.

      Since the Committee’s last meeting, labor market The Committee continues to anticipate that economic conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined.  Financial markets remain quite strained and credit conditions tight.  Overall, the outlook for economic activity has weakened furtherare likely to warrant exceptionally low levels of the federal funds rate for some time.

      Meanwhile, inflationary pressures have diminished appreciably. Information received since the Committee met in December suggests that the economy has weakened further. Industrial production, housing starts, and employment have continued to decline steeply, as consumers and businesses have cut back spending. Furthermore, global demand appears to be slowing significantly. Conditions in some financial markets have improved, in part reflecting government efforts to provide liquidity and strengthen financial institutions; nevertheless, credit conditions for households and firms remain extremely tight. The Committee anticipates that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant.

      In light of the declines in the prices of energy and other commodities in recent months and the weaker prospects for considerable economic activityslack, the Committee expects that inflation to moderate furtherpressures will remain subdued in coming quarters. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

      The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.  In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

      The focus of the Committee’s policy going forward will beis to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustainare likely to keep the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the The Federal Reserve willcontinues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand itsthe quantity of such purchases of agency debt and mortgage-backed securitiesthe duration of the purchase program as conditions warrant.  The Committee is also evaluating the potential benefits of purchasingis prepared to purchase longer-term Treasury securities.  Early next year, the if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets. The Federal Reserve will also implementbe implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal ReserveCommittee will continue to consider waysmonitor carefully the size and composition of using itsthe Federal Reserve’s balance sheet in light of evolving financial market developments and to assess whether expansions of or modifications to lending facilities would serve to further support credit markets and economic activity and help to preserve price stability.

      Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. CummingWilliam C. Dudley, Vice Chairman; Elizabeth A. Duke; Richard W. FisherCharles L. Evans; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Dennis P. Lockhart; Kevin M. Warsh. and Janet L. Yellen.  Voting against was Jeffrey M. Lacker, who preferred to expand monetary base at this time by purchasing U.S. Treasury securities rather than through targeted credit programs.

      Quick Hits

      • The ZIRP will continue for a long time, like Greenspan’s ill-considered 1% policy.
      • Credit easing will persist.  Lacker seems to want the less complex quantitative easing.
      • The Fed will purchase longer duration debt than is ordinarily done.  I will continue to buy mortgages and agencies.
      • They are hoping for recovery to begin in late 2009.
      • We will not see a normal Fed balance sheet for a long time.

      Smiling, John showed how Wonderful Life had been executing better than othe companies with similar product mixes.  Internally, he knew it was a weak argument.  In the back of his mind he could hear, “Why didn’t you enter other lines of business?”  He pointed out the relatively low cost nature of the dedicated field force, and how surrenders were lower and mortality ratios as well.

      As he talked about industry conditions, he looked around the room.  Goldsmith, Farell, and Blitztein were giving him full attention, but Baldwin and Bullard looked bored.  Brent Fowler sat there, playing with his Blackberry.

      He thought to himself, “Okay, time to take the bull by the horns,” and then said, “Peter prepared these final exhibits for me at my request.  If you don’t like what I have to say here, blame me, not Peter.”  He looked at Peter, who gave a small smile, then Baldwin and Bullard, who looked vaguely puzzled.

      “In early 2007, we began making our asset portfolio more conservative.  We felt we were not getting compensated for taking risks on lower investment grade bonds, junk bonds, and even commercial mortgages.  We further emphasized industrial and utility bonds over financials, difficult as that was to do.  We accelerated that process in early 2008.  This cost us yield, be we aimed for safety in what we thought was a bad environment.  We do not think it is time to begin taking risk in a major way now, but we do believe we are ready to make more money when the bond markets reliquefy.  We have begun edging back into junk bonds and low investment grade corporates.”

      “The bad news from this is our spreads on investments were pinched to the point where we will not be able to pay as big of a dividend in 2009 that we paid in 2008.  Nonetheless, we believe we are better positioned for long term growth.”

      As he sat down, he prayed.  “That was my best shot,” he thought.  Baldwin simply said, “And now you, Fowler, finish up.”

      Brent Fowler took a very different tack from John Davidson.  He pointed to the considerable growth in premiums — indeed, he was near the top in the industry in percentage terms.  He talked about new products that were gaining market share, and the considerable profits they were gaining from new and existing business.  Fowler concluded by saying, “There are always opportunities in Life Insurance and Annuity marketing if one simply opens his eyes and grabs hold of them.”

      John noticed that much of the growth came from new variable annuity products with secondary guarantees, and EIAs, but aside from that he thought, “I’m sunk.  His profits are up and mine are down.  He’s the successful risk-taker, and I’m just a stodgy loser.”  He waited to hear what would come next from Baldwin and Bullard.

      There have been a lot of posts on the power of the momentum anomaly lately.  To mention two, there was my post, A Different Look at Industry Momentum, and a post by Mebane Faber at his excellent blog World Beta, Quantitative Strategies for Achieving Alpha.  I know there have been more recently, but somehow I did not bookmark them.

      Tonight’s note considers whether the strength of the momentum effect might not be waning.  Consider this:

      This graph shows the excess returns of my industry momentum model over the past twelve years.  Momentum has worked over that time period, but deceasingly so, with a few wipeouts along the way.  Many will remember the worst of them in August 2007, when quantitative investing was decidedly crowded.

      Remember, I view investment strategies using an ecological framework.  There are many strategies that work on average, but often many of them are overpursued, and the excess returns have been competed away.  Or, a strategy has been forgotten, relatively speaking, and now it might have some punch.

      I am guessing that momentum as a factor is overplayed at present, and it might be wise to leave it to the side until the next wipeout.  If that were to apply in the present market, it would mean the failure of the more stable parts of the market to retain value: consumer staples, utilities, health care, other cash flow spinning industries.

      There are two ways that could happen: 1) a resurgence of the cyclicals, and 2) market collapse, where investors give up on all stocks, even stable ones.  I’m not going to bet on either of those, but either is possible in this environment.  If demand begins to rise in the world due to falling commodity prices, #1 is possible, and #2 would come from a continuing collapse in consumer demand.

      Food for thought in this ugly environment. Invest carefully, the need for a margin of safety is more critical than ever.

      Barry posted a link w/commentary to this Bob Woodward piece in the Washington Post.  I thought it was a good piece, but said to myself, “Wait.  He also wrote Maestro : Greenspan’s Fed and the American Boom. There would certainly be a good parallel piece there.”

      So, though I am nowhere near as good a writer as Mr. Woodward, perhaps my knowledge of the markets might give me a good perspective on what Ben Bernanke should try to understand from his predecessor’s tenure.  With Greenspan, since monetary policy works with a lag, we have a better perspective today on what the true effects of his tenure were.

      1) How you accept contributions from lesser players has an effect on policy.

      Dr. Laurence Meyer gave a speech once, called Come with Me to the FOMC.  He explained how Alan Greenspan ran FOMC meetings, among other things.  When Greenspan wanted to assure a certain result, he would vote first.  If he was certain of the outcome, he would vote last.

      Greenspan also enforced message discipline on FOMC members — there was a party line.  Give Bernanke credit, he lets the main players of the FOMC speak their own minds.

      Because Greenspan had quite a reputation for promoting prosperity, this led to groupthink at the highest levels of the Fed.

      2) A willingness to throw liquidity at every market fire creates the Greenspan Put.  The promise of liquidity is not free, because economic actors become more aggressive as bad debts are rescued rather than liquidated.

      It began with the crash in 1987.  Greenspan was more than willing to throw liquidity at the crisis. Better he should have been silent, and let the market work its way out of the crisis.  He did the same thing with Mexico and RMBS in 1994, Commercial Real Estate in the early 90s, LTCM/Asia/Russia in 1998, Y2K in 1999-2000, and the aftermath of the tech bubble in 2001-2002.

      Throughout his tenure the debt/GDP ratio grew, exceeding levels last seen during the Great Depression.  Bad debts grew, leading to our eventual crisis today.

      3) Monetary policy should consider asset prices.

      Greenspan was unwilling to consider the effect of asset prices on monetary policy in any major way until the end of his term.  Consider this CC post:

      David Merkel
      When Alan Greenspan Talks, the Market Listens (Apologies to E.F. Hutton)
      8/26/2005 10:32 AM EDT

      As Alan Greenspan does his “Farewell Tour,” today in Jackson Hole, Wyo., he said the following in his speech:

      The structure of our economy will doubtless change in the years ahead. In particular, our analysis of economic developments almost surely will need to deal in greater detail with balance sheet considerations than was the case in the earlier decades of the postwar period. The determination of global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities that finance them. Our forecasts and hence policy are becoming increasingly driven by asset price changes.

      The steep rise in the ratio of household net worth to disposable income in the mid-1990s, after a half-century of stability, is a case in point. Although the ratio fell with the collapse of equity prices in 2000, it has rebounded noticeably over the past couple of years, reflecting the rise in the prices of equities and houses.

      Whether the currently elevated level of the wealth-to-income ratio will be sustained in the longer run remains to be seen. But arguably, the growing stability of the world economy over the past decade may have encouraged investors to accept increasingly lower levels of compensation for risk. They are exhibiting a seeming willingness to project stability and commit over an ever more extended time horizon.

      The lowered risk premiums–the apparent consequence of a long period of economic stability–coupled with greater productivity growth have propelled asset prices higher.5 The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions.6 The conversions have been markedly facilitated by the financial innovation that has greatly reduced the cost of such transactions.

      Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums. In short:

    • Greenspan is factoring asset prices more into FOMC decisions.
    • Greenspan sees market players as more willing to take risk than before, and thus “risk premiums” are low. (Low credit spreads, investor-owned housing has negative carry, flat yield curve, etc.)
    • The stability engendering the willingness to take more risk has allowed financial institutions to lever up more.
    • Greenspan thinks this won’t work out well in the long run.
    • No one can tell what Greenspan’s successor will do, but rhetoric like this indicates an inverted curve until excesses (real or imagined) can be wrung out of the system.

      The market reacted badly when his speech hit the wires. It will do worse if the FOMC carries through on the logical implications of what he has said. (Leaving aside for a moment the friendly foreigners that are more than undoing the FOMC’s tightening actions…)


      Now this had little effect for most of his term, but at the end he was worried.  Reality was catching up with neoclassical dogmatism.

      4) Greater length of monetary tightness is a good thing, as is shorter lengths of monetary looseness.

      Greenspan had a willingness to loosen for too long, and an unwillingness to let monetary tightness really bite.  This was another part of the Greenspan Put.  He was never willing to disappoint the asset markets for too long.  There is some evidence that he used Fed funds futures to set policy; during the Greenspan years, it was a very good predictor of policy.  I began to wonder whether the tail was wagging the dog.  Fed funds was such a good predictor of Fed behavior one month in advance of FOMC meetings that one did not have to consider much else.

      5) Don’t tolerate bad bank loan underwriting.

      The Federal Reserve leads bank regulation in the US, and they encourage bank examiners to be tough or loose.  There was a long period of encouraging looseness in bank regulation, and it has led to significant loan losses in our banking system.

      In a fiat money system, control of credit is the key thing.  Allowing the banking system to run amok is not helpful to free market economics, because of the resultant depressions.  The ability of banks to extend credit should be limited; without limits, or with loose limits, banks encourage the economy to overexpand, leading to recessions, and occasional depressions.

      6) Don’t allow banks to own any assets that you don’t understand, or can’t be valued in tough market environments.

      Regulators must bar regulated entities from buying financial instruments that cannot easily be valued.  Regulated entities must be safe institutions even if it hurts their ROEs.  Greenspan encouraged a simple-minded approach to derivative instruments, without considering the systemic effect from their use.

      Securitization was another tough concept.  Banks and pseudo-banks originated loans that they would not have if they had to retain them themselves.  That created more systemic risk.

      Banks should have been barred from holding assets that were new.  By new, I mean any class of assets that has not suffered market failure, so that the loss potential and illiquidity during a bear market could be estimated fairly, and the proper risk-based capital level set.

      By encouraging banks to use their own internal risk models, Greenspan and those that favored the Basel II framework encouraged banks to make aggressive assumptions, and do more business than their capital could bear.

      7) Don’t become a tool of the Executive branch, nor of Congress

      Greenspan happily sat beside First Ladies during State of the Union Addresses.  He met with the executive branch more than any other Fed Chairman.  He facilitated the economic politics of the government, regardless of who was there.  Consider the plunge protection team during the LTCM era, or his statements after Black Monday in 1987.

      Better Fed Chairmen dissed both Congress and the executive, and did their duty.  Consider Volcker during the hard times, William McChesney Martin, or Thomas McCabe.  They opposed the political establishment, and left monetary policy tighter than the politicians would have liked.

      8 ) The Fed Chairman should not be the Chief Economist of the US

      Perhaps it is another way of running down the shot clock when in front of Congress, but the Fed Chairman is not supposed to be a political figure.  Questions not pertaining to maonetary policy should be ignored.  Score a few points for Ben Bernanke.

      Aside from that, Greenspan had many dumb comments over — Irrational Exuberance, ARMs, and Derivatives including Credit Derivatives.

      9) Obfuscation pays, but jawboning the markets only works in the short run.

      From an old CC post:

      David Merkel
      Greenspeak: A Foreign Language to All
      4/21/04 12:53 PM ET
      Adam, your question is very applicable. My view on Greenspan is that he tries to get the market to do his bidding, rather than always using the explicit policy tools that the Fed has. He speaks ambiguously for a number of reasons:1. If he speaks too clearly, the market will immediately adjust to what the Fed is going to do, and the actual use of their policy instruments will have little impact.

      2. He genuinely tries to express the degree of uncertainty inherent in the data and theory underlying economics, as well as the political backdrop.

      3. If he answers too quickly and directly, he will get more questions. In basketball, this is called “running down the shot clock.”

      4. I think he uses obfuscation tactically to make it easier to adjust market expectations. He can give occasional clear statements to bump the bond market where he wants it tactically to go in the short run, which may be different than where he thinks it has to go in the long run.

      5. I think he enjoys it.

      At present, I think Greenspan wants to keep things near where they are, which allows the economy to grow fairly rapidly to absorb labor market slack. To me, that means targeting the 10-year Treasury between 4% and 4.50% or so. Unless there is a marked pickup in his favored inflation gauge, or a huge decline in the dollar, I don’t see the FOMC being compelled to raise the fed funds rate. To raise rates for the abstract reason of reducing leverage in the fixed income market will not play well politically, particularly in an election year.

      All my opinions, but I have been watching the Fed for 20 years…

      No stocks mentioned

      In addition, because Greenspan had such a good reputation during his time as Fed Chairman, obscure comments would be reinterpreted to favor the the views of the one questioning Greenspan.

      We are currently in an era where jawboning does not work well, because of the overleverage in the financial system. Jawboning works when economic actors are unafraid of systemic worries, and are only concerned with relative performance in the own local markets.

      But it led market players to think”Hey, the Fed has my back,” and so they could take more risks on average.

      10) Merely because measured employment is strong, and measured inflation is low, does not mean monetary policy is being conducted properly.

      There are three factors that led to monetary policy to be more asset-inflationary, leading the more credit-sensitive monetary aggregates to expand more aggressively while measured consumer price inflation remained low.

      First, foreigners were willing to stimulate the US economy in excess of the Fed in order to build up their own manufacturing bases. As such, foreign central banks bought in our debt, financiang our current account deficit, helping our interest rates go below where they would have been in their absence. Bernanke and Greenspan called it the “savings glut,” but they should have tightened policy to compensate.

      Second, demographics favored high employment and low inflation, as the Baby Boomers entered the prime of life. Through their institutional agents, pension plans, and their own private actions, a greater amount of risk was taken to finance the future cash flow needs of the Baby Boomers. P/Es were bid up, and interest rates bid down through the 80s, 90s, and 2000s.

      Credit spreads were bid down as well, culminating in three major credit boom-busts, which peaked in 1989, 2000, and 2006, respectively. Monetary policy facilitated those cycles by being too aggressive in providing liquidity, creating the boom. The punchbowl should have been taken away sooner. At least, margin requirements should have been raised.

      Third, through securitization, more credit was extended than in previous periods relative to the Fed’s ability to control it. Some securitization went on outside of the banks, so it was outside of the Fed’s direct control. Some went on through the banks, but the banks bought many of the securitized debts, the creditworthiness of which is presently suspect. As I argued above, the Fed should have not allowed the banks to invest in asset classes that had not been through a failure cycle.

      The Fed should have leaned against the wind on all of these factors to slow down the aggressive growth of debt that now paralyzes our economy. To the extent that that is not in their charter, blame should be laid at the door of Congress. But since the Fed has responsibility for the health of the banking system, they should have addressed these three factors, and considered monetary policy in broader terms.

      Instead, Greenspan aided every boom, and never let the busts clear away marginal investments by coming to the rescue too soon. That is his legacy, and we are living with it now.