1) I have said it before, but what are the limits of the US Government borrowing money?  Aside from God, everything has a limit.  I appreciate finem respice as she says:

Of course, the next bubble (and perhaps the last for a while) is government. The state government bubble is beginning to burst even as you read this. The federal government bubble is next. You might want to open your mouth and plug your ears.

I view the current rise in Treasury yields as an expression of concern over being paid back in the same purchasing power terms.  The further in time you go out, the lower confidence in the US Government gets.  Given the huge deficits, debts, and unfunded liabilities, how could it be otherwise?

2) So what of the Treasury yield curve then?  Does it threaten Obama’s agenda?  Maybe, if it gets materially worse.  At present, no.  I appreciate what Lacy Hunt said to Barron’s:

But, says Lacy Hunt, chief economist of Hoisington Investment Management, an Austin, Texas, manager of $4 billion in assets, “The sharp rise in Treasury yields isn’t a result of an economic recovery. That occurs when income, production, employment and sales, simultaneously, turn higher. Presently, these indicators merely show a lessened rate of decline.”

There are several possibilities here:

  1. The rise in long Treasury yields is just an overshoot of the mortgage market.
  2. Fears of eventual US underpayment in terms of current purchasing power.
  3. A strengthening economy.
  4. Some combination thereof.

I favor a combination of 1 and 2.  I don’t see any significant strength here.  I do see worry, but not panic.  The more one wants to borrow, the higher the yield that will be paid.

3) When I was 14, my brother (then 12) wrote Howard Baker, Senator from Tennessee, to ask him about whether a Value Added Tax [VAT] would make sense for the US.  I read the reply letter once, and I remember much of it.  I was impressed with the erudite response; I am even more impressed today, given the facile answers often given by politicians to constituents.  Baker made three main points:

  • The revenue raising power of a VAT was tremendous.
  • The VAT was “insidious,” in that it took a little here and took a little there, and no one really felt how much was taken.
  • He felt that it would slow the US economy down considerably, and so, it wasn’t an idea worth pursuing.

Now we are seeing articles reopening/opposing the idea of having a VAT:

I agree with Howard Baker — a VAT is insidious.  Taxes should be obvious, and hurt, such that people have an interest in the level of taxation.  Let the government decide what to eliminate in spending, but don’t overtax us.

4) So maybe we get a single regulator for banks?  That will improve consistency of regulation, but will it be consistently good, or will it be a greater regulatory capture?

5) I agree with Felix.  Personally, I don’t think the government should insure anything, even bank deposits, but insuring the senior tranches of securitizations is ridiculous.  It would put the government in charge of subordination levels.  What public interest reason is there for this?  There will always be some sort of relatively safe assets outside of a government guarantee.  If they fail, should the government guarantee them?  Sorry, but AAA, AA, A bonds sometimes fail within a year of issuance.  Not often, mind you, but that’s the way it is.  To do otherwise is to create a flaccid group of creditors that is unwilling  to take modest risks unless they are government-guaranteed.

6) I grew up as a quant, and from my past Pastor who was a Ph. D. in History I learned to appreciate qualitative arguments.  So what value is economic history?  I’m going to stick my neck out here, but I will argue that intelligence is the ability to use analogies validly.  With math, the analogies used are simple, because of the abstraction.  To a lesser extent, the same is true of science.  But by the time we get down to the social “sciences,” the analogies are much more open to question.

Thus all of the articles alleging that the current troubles are akin to: 2001-2, 1994, 1987, 1979-82, 1973-74, 1969, 1962, 1937, 1929-32, etc.  It is easy to make such arguments, and most of them are wrong.  That said, there is a richness in understanding all of the arguments, but not buying them fully.  Listen to Samuel Clemens, “History may not repeat itself, but it sure does rhyme.”  Looking for exactness in analogies fails; analogies are never meant to be exact, just as the parables of Jesus teach one main truth, and subsidiary matters are more questionable.

7) What of inflation?

It boils down to this: how easily can the Fed reduce policy accommodation with out derailing the recovery, and will it take less time than it did/will Japan (they are into two lost decades now, are they trying for three?).  There is no free lunch, leaving aside seniorage from being the world’s reserve currency.  The implicit subsidies that the Fed created will leak their way into the money stock, and inflation, eventually.

8)  Remember 2008, long T-bonds were the rage and high yield was trash.  2009, those two are flipped.  Personally, I would take at least half of my high yield ( and BBB) trade off the table and leave it in cash.

In early 1994, after the Fed’s first rate hike in what would be annus horribilis for the bond market, I was behind in my quota for selling Guaranteed Investment Contracts [GICs] at Provident Mutual.  Worse, my liabilities were running off faster than my assets.  My bosses gently nudged me about sales, and I told them that spreads were not justifying sales at present.  They let me be; they did not want to compromise underwriting in order to get sales.

But as my cash position got worse, and went negative, I eventually got a call from the Treasurer, one of the few people at Provident Mutual who could have worked at AIG and thrived.

“What are you doing?”

“What do you mean?”

“We are into the banks [DM — borrowing money] because your GIC separate account is forcing us to borrow money!  What are you going to do about it?!”

“I’ll sell some GICs, and soon.”

“You better, or the CEO will hear of it.”

“You got it.”

After that, I reviewed my options, and looked for the cheapest way to raise cash.  The stable value industry at that time had yield illusion when the yield curve was steep.  GICs the would mature half in one year and half in five years were considered the equivalent of a three year GIC, even though the 1-5 had a forty basis point advantage in funding over the 3.

So, I called up a new client in Boston that I had been cultivating, and offered him a “special.”  A 1-5 GIC at 40 bps over the 3-yr GIC rate.

“That’s one special rate.”

“It is a special rate.”

“How much can you do?”

Thinking of the amount of debt I was in, I said “Six Million.”

“Sweeten it by another basis point, and we are done.”

I replied, “Done.”

My present problem solved, as the investment actuary, I looked at the situation, and with the mortgage market falling apart, and rates being forced up, I drew the conclusion that we were in a self-reinforcing situation where interest rates were going to rise.  I began to sell GICs with abandon, telling the investment department not to hedge my sales, and not to stretch for yield.  I sold my entire year’s quota in the next six months, and the investment department upgraded the credit quality of the portfolio as rates rose.  By the time Confederation announced its insolvency, I had almost finished my year.  Good thing, given that the Confederation insolvency would kill of my line of business two ways: 1) charges from the guaranty funds.  2) Provident Mutual’s credit rating was now too low to sell GICs.  I ended up closing the line of business two years later.

Now, as a note to risk managers, it is probably a bad idea to give control of hedging policy over to the line of business actuary, even though it worked out for the pension division of Provident Mutual.  We were special, not because of me, but because we stayed in close touch with the investment department, and hired actuaries that understood investments, which was rare at that time.

So, out of the horrible year 1994, we came out of it better off, while many were licking their wounds, and three of our competitors had blown up.  That wouldn’t keep the business from being eliminated two years later, but it did protect the interests of our dividend receiving policyholders.

The First Priority of Risk Control

This brings me to the main idea of this piece.  What is the first priority of risk control?  It is to make sure that the company/individual in question is never forced to take action at an adverse moment.  Consider all of the financial companies that are being forced to dilute common sharholders in order to survive.  Consider the universities that entered into illiquid investment programs with the promise of earning higher returns.  Many of them are choking on a lack of liquidity at present, as the fall in the markets has driven:

  • the endowment down
  • giving is down
  • willingness of parents to send children to expensive universities is down
  • what’s worse, illiquid investments have suffered worse than liquid investments.  Very tough to sell in the secondary markets — akin to consorting with guys who wear “panky rangs,” as they say down south.  (Loan sharks.)

The first priority of the risk manager is to make sure that there is never a call on cash (or any other resource) that he can’t meet on favorable terms.  It means running at a lower ROE, and having more surplus assets to cushion the company.  It also means doing stress-testing beyond what is imaginable to most of your peers.  My interest rate scenarios for cash flow testing went up 9%, and went all the way down to zero.  We made sure that we could survive.  If you can’t survive, you can’t play for the next round, no matter how good the last few rounds were.

David Swensen is a bright guy, as are many of his peers in similarly tough situations.  Yes, they enjoyed the boom as the leverage built up, but now what do you do when faced with demands for liquidity, and precious little liquid assets to deliver?  You estimate the duration of the crisis, and if it is longer than your liquid assets can finance, you sell some of your best illiquid assets now, and play for time.  If the duration is shorter, sell liquid assets.

Most life insurance companies that died in the 90s died from a liquidity mismatch.  Liquid liabilities, and illiquid assets.  Works great in a bull cycle, and lousy in a bear cycle.  That is true for any institution, though, so if you manage risk, be careful of the illiquidity of your assets.  Even owning a home that requires two incomes to pay the mortgage is not a risk worth taking.

Ask yourself, for your firm, and for your household, are there any conceivable situations where you will not be able to meet your obligations on favorable terms?  If not, you are placing those that you care for at risk.  Take action now to reduce that risk while you still can.

1) I made the point last week when I talked about my experiences in the pension division of Provident Mutual.  The investment choices of 90% of individuals follows recent performance.  This is another factor in why markets overshoot, and why mean-reversion is a weak tendency.  Thus when I see many leaving the stock market for absolute return, bonds, cash, commodities, it makes me incrementally more bullish, though I am slightly bearish at present.

2) Has this been a “suckers rally?”  That’s too severe, but there is some truth to it. Many of the large financials may be safe, but at a cost of higher taxes and inflation.  Also, the losses on commercial real estate have not been felt yet on the balance sheets of banks.  I think we will break the recent lows on the S&P 500 before this is all done.  Debt deflation and dilution continues on.  We have an overhang in residential housing that will require prices to go below equilibrium in order to clear.  Global growth is anemic, even if some of the emerging markets are doing well.

3) When writing for RealMoney, I was usually diffident about buybacks, because I liked to see strong balance sheets.  Now in this era, those that bought back a lot in the past are paying the price.  Buy high, dilute low is a recipe for big underperformance, and we are seeing it in financials now.  (The comments about pension design in the article are spot-on as well.)

4) Behavioral economics does justice to what man is really like, both individually and collectively.  We are prone to laziness, greed and fear.  There is a weak tendency for a minority of individuals to break free from the fads and fashions of men, and pursue profit exclusively.  Remember, thinking hurts, so people conserve on it, unless the reward for thinking exceeds the pain.

5) Quantitative managers have gotten whacked, and few more than Cliff Asness of AQR.  It doesn’t help that you are outspoken, or that you took time away to aid the CFA Institute.  When the business goes south, thereare no excuses that work.  In times like this, be quiet, analyze  failure, and stick to your knitting.

6)  Ken Fisher made an argument like this in his book The Wall Street Waltz.  Eddy’s argument is ordinarily right; buy during bad times.  The only time that is not true is when you are in a depression, and there is much more debt to be liquidated, and more jobs to be lost.

7)  From Quantifiable Edges, there is some evidence that the ratio of the Nasdaq Composite to the S&P 500 can be used as a timing indicator.  Nasdaq Composite outperformance presages more positive returns in the S&P.

8 )  I read the article on the “purified VIX” and other “purified” indicators, and I get it.  Adam is still correct that periods where the VIX and SPX move in the same direction tall you something about future SPX performance.  If both are up, then the trend for the SPX tends to be up.   Vice-versa if both are down.

9) Regarding this article on David Rosenberg, I think the earnings  are too optimistic, but the P/E multiple is too pessimistic.  Things may be ugly for a while, but I can see an S&P 500 above 1000 in 2011.  (That may be inflation.)

This phrase is problematic “As for the multiple, Rosie believes the P/E should approximate a Baa bond yield, leading to an “appropriate” multiple of 12x.”  E/P on average should be equal to a Baa bond average less 4%, making a fair P/E at 20+.

10) Beta stinks.  You knew that.  Here’s more ammo for the gun.  I have doubted the CAPM for almost 30 years.  It’s only value is to confuse other wise intelligent comptetitors.

11) Is small cap value still relevant?  Is winning relevant?  Please ignore the studies that use betas that adjust for small cap, value, and momentum — using each of those is a management choice, and those of us that choose to be smart take credit for following research, not that research should discount our actions.

12) Yes, the Q-ratio works.  Don’t tell anyone about it, though.  Shh…

13) Dow 36,000.  Yes, in 2030.  Glassman and Hassett were sensationalists that pushed an idea of rationality too hard, suggesting that people could accept a near-zero risk premium to invest in stocks, versus treasury bonds.  Bad idea.  The E/P of stocks averages near the Baa bond yield less 4%.  Stocks need 4% earnings growth to compete with bonds on average.

14) Homes are for living in; they are only secondarily investments, if you know what you are doing.  Compared to TIPS, gains in homeowning, less expenses, are comparable.

15)  As this post points out, and I have said it before, “The vast majority of currency ETFs represent stakes in an interest-bearing bank account denominated in a foreign currency. They derive all their return from two sources: the cash yield of the foreign currency over the expense ratio of the fund and changes in the exchange rate against the dollar.”  Be careful with foreign currency funds; they often embed financial credit risk.

Longtime readers know that my investing interests are broad.  I almost decided to name this blog, “The Investment Omnivore,” but took the name of the investment fund that I deeply considered creating in the 90s, and used that.

So, when notable things happen, I tend to switch to where the action is.  On a day like today, that means the high quality, long duration band markets, because they are falling dramatically.  Now, there are other high quality observers following this phenomenon, including:

Let me give you my perspective. Big moves in Treasury, Interest Rate Swap, and Mortgage rates tend to persist.  Why?  Three reasons:

  • Mortgage originators hedge their pipelines.  As rates rise/fall, they receive floating/pay fixed in order to lower their exposure to changes in interest rates.  As mortgage rates rise, mortgages get longer, because fewer people refinance.  Vice-versa for when mortgage rates fall.  Receiving a short rate like LIBOR, and paying fixed rates makes money when LIBOR rates are rising, which hedges those originating mortgages.
  • Those managing mortgage bond portfolios against a benchmark find themselves in the same situation.  As mortgage rates rise, mortgage bonds get longer versus their benchmark, and managers sell longer assets in order to adjust, sending the yields on longer-dated assets higher.
  • Speculators pile on when they sense that the first two factors are in play.

That’s why big moves in Treasury, Interest Rate Swap, and Mortgage rates tend to persist.  Thus for those who trade those markets, it is best to stand aside, or follow during big moves, and let the momentum run.

Wednesday we experienced what I would call a phase change, where the losses in the bond market since its apex in mid-to-late December have been consolidated.  Consider this graph of the yield curve as it has progressed over the last five months:

Short end stays firm because of confidence that the FOMC is on hold.  Long end runs because of new high borrowing needs of the US government, both recent and future issues.

Now what is this doing to the mortgage market?

That’s a graph of 10-year swap yields, which correlate closely (under ordinary circumstances) with 30-year mortgage yields.  The yellow line is the 18-month trailing moving average.  When rates are above that level, refinancing tends to slow; when rates are below that level, refinancing tends to speed up.

So how is the move in the yield curve affecting mortgage rates?

Rates have gone up considerably, but with the government interventions in the bank lending and residential mortgage markets, ordinarily stable market relationships got out of kilter.  This graph has the difference between 10-year swap yields and Fannie 30-year mortgage yields:

An ordinarily stable showed a lot of stress from the end of 2007 until now.  Present levels are close to “normal” over the the life of the series over the past 20 years where excluding the stress period, the difference was typically 0.60%, and we are at 0.67% now.

One more graph.  What period in the recent past is the current yield curve shaped like?  September 2003.

What was the economy like in September 2003?  Accelerating growth with little goods price inflation — it would be neat if that were the scenario ahead.  What is different this time is that the banks still have problems to work through, not the least of which are losses from commercial real estate lending.


  • What a rapid move in the long end yield curve over the past five months, with most of the moves concentrated in January and May.
  • This move may go further, but not much further, because we are at historic levels of steepness for the yield curve.
  • Refinancing opportunities should dry up.
  • The Fed would have to do a lot in order to bring mortgage rates lower versus swaps because we are close to the normal relationship of swaps versus mortgage yields.
  • The yield curve is very steep, which usually foreshadows rapid growth in the economy, but we have issues in the financial system that may resist that stimulus.  Liquidity in private hands is tight, so opportunities to make money borrowing short and lending long are limited.

1) Last night I started out with the concept of a “housing mismatch.”  Today, with a hat tip to Calculated Risk, I can make my case better.  The low end of the market is humming, as new buyers come in.  Makes sense.  Who get the capital together for a downpayment?  New homebuyers for homes on the lower end.  But homeowners that want to upgrade are stuck, because the buying power of the equity of their current home has deflated.  Thus few upgrading buyers, and they are typically a large part of the housing scene.  Good article — helps point out why this cycle in residential real estate may have prices drop below equilibrium levels.  We are close to equilibrium now, but nowhere near reversing.

2) How should bank solvency be regulated?  If sticking with the existing model, the bank examiners must be more rigorous, and they should consider some stressful scenarios, such as we are experiencing now, or worse.  Perhaps a market-based solution would help, such as that which former Fed Governor Poole has proposed.

His objective is the toobig to fail institutions, but he says that all banks would have to issue subordinated debt.  This would be difficult to implement for small banks. Small issue sizes in the debt market are tough to place, and rolling over 1% each year makes the sizes smaller still. The sub debt would have to be at the operating bank subsidiaries, which are smaller than the holding companies.

I like the idea, though. Maybe a market would develop for small bank sub debt… maybe even funds specializing in it. The yields could be significant, and even protected to some degree, given the need to roll it over to stay operating.

That said, loss incidence might be infrequent, but loss severity and correlation would be high. That’s true of losses on unsecured financial debt generally, but it would be worse with sub debt.

This idea is not new, but it is worth a try. The financial analysis of banks by regulators who have little economic incentive to be right, and hampered by politics has not worked well. It would be replaced by profit-seeking analysts who do have an incentive in the health of the bank in question.

3) Given the fall in global trade, export-driven nations are getting hit hard.  Maybe that can help explain why Treasuries are selling off on the long end — aside from excess supply due to the humongous deficit, there is less need to recycle excess dollars by buying Treasuries.

4) Okay, I was wrong about the Indiana Pension System winning in the short run regarding secured Chrysler debt.  Given the time pressures, the suit was rejected.  Maybe they will win on appeal, but how that works out after the deal is done is messy.

5) GM bondholders have rejected a settlement, and so the company will likely go through chapter 11.  I do not get the large amount of financing that the US government is putting up.  What? Do they want to repeat the losses they will experience through AIG?

6) With the shrinkage in market capitalizations, the number of sell side analysts declines.  No surprise here.  The number of sell side analysts is proportional to the money that can be made by investment banks off of underwriting and trading.  As market capitalizations fall, so do revenues for investment banks.

7) Yesterday, I said that if California defaulted, we would face a constitutional crisis.  I still think that is true.  I ran across Felix’s thoughts on the matter today, though they are one month dated.  The upshot to me is that there are no ways of enforcing payment if a state won’t pay on their municipal debts.  This is a hole in the system, and one that could pinch many in the US, not just Californians.

8 ) Federal Reserve Transparency act of 2009?  Bring it on.  Yea, Ron Paul, one of the few economically literate memebers of Congress.  The Fed gets away with a lot because they aren’t purely private or public.  They use their dual status to hide — when it is more useful to be a government institution, they are that.  Vice versa, when being private allows the avoidance of FOIAs.

9) This is one long article.  How sunk are we regarding peak oil/hydrocarbons?  I have revised my estimates of oil production downward, and will buy more energy related stocks at my next rebalancing.

10) Though I am not a dollar bull, there is no easy replacement for the US Dollar on the global scene.  Euro, too experimental.  Yen, too small.  I have not advocated that the Chinese currency could replace the Dollar (as some have), because their economy would have to become far more open.  They aren’t willing to do that.

11) It’s tough being a corporate director. 😉 No, it’s altogether too easy, which leads to complacency.  Consider the situation at the banks, or at the FHLBs.  Years of leverage expansion, where the livin’ was easy, made them lazy, and unwilling to challenge their managements.  No surprise that their reasons for existence are being chalenged now.

12) Though Samuelson misses the point that trust fund exhaustion is not the trouble point, his article is a welcome addition to the discussion.  Time is not on the side of the social insurance programs of the US Government, but as I have stated, that trouble comes when revenues are less than expenses, because the trust funds, invested in Treasuries, are a farce.  The only way the US government can pay off on those is through taxation, borrowing, or inflation.

13) What are implied breakeven levels of inflation implying from TIPS?  That many people fear that inflation will run out of control, given the reckless actions of the Fed and the US Government.

I didn’t talk much about it at the time, but I had a hard drive crash around February 1st of this year, and it wiped out my main industry rotation model, and many other things as well. My last backup of the model was eight months earlier — I resolved to become better at backing up my data.

To do that, I back up my main files using a free service from Microsoft, mesh.com, in a way they didn’t intend.  Mesh is a way of synchronizing files across computers painlessly.  Well, almost painlessly; it is a bit of a bandwidth hog.  I turn it on for fifteen minutes each day, and updated and new files are replicated in cyberspace.  If I accidentally destroy a file, I can restore it.

Back to my dilemma in February — if I didn’t have my main model, at least I had my secondary model.  The secondary model was derived from a set of pieces written here (one, two), about four months ago, about the time that the momentum anomaly began to become overused (and right prior to the hard drive crash — I need to rebuild that model as well — I know its main result, but my proof is gone).

Fortunately, the two models give fairly similar results, although the secondary model predicts monthly performance, and my main model, annual performance.  The choice becomes what mode to use the model in — value/mean-reversion mode (cool-green), or momentum mode (red-hot).  Typically, I work in value mode, but recently I have been taking ideas from both the red and green zones.

There are two ways to do industry rotation.  In the green zone, the question is “Where has hope been abandoned?”  Buy the financially strongest companies there, and when the cycle turns (it always does, except for buggy whip industries like newspapers), you will do well.  In the red zone, the question to ask is, where have trends been underdiscounted?  In that case, buy companies of reasonable strength that will benefit from the persistence of the trend.

I have highlighted a few areas that I would consider at the top of the graphic, where it reads “dig through.”  You may see other opportunities that I don’t.  Either way, be careful as you select industries to invest in.  Careful selection pays off.

1) I don’t think that residential real estate prices are turning in general.  But even if residential housing recovers, and demand returns, there will be a “housing mismatch.”  There will be too many high end homes relative to buyers.  Financing for high end homes is sparse, and too many expensive homes were built during the boom years.

2) Inflation.  What a debate.  In the short-run, deflationary pressures are favored, but what can you expect when so many dollar claims are being created by the Fed?  The output gap may indicate inflation is impossible, but stagflation is possible when monetary policy exceeds the need for dollar claims amid a collapsing economy, as in the 70s.

3) At the time, I suggested that the banks forced to take TARP funds had been coerced because the regulations could be lightly or tightly enforced.  Looks like that was true.  Why does this matter?  The TARP was supposed to be stigma-free because all major banks were taking it.  Coercion should make the government more lenient on payback terms.

4) I never did all that much with the cramdown that the Obama administration did with Chrysler secured creditors.  All that said:

5) Can global trade patterns be changed to avoid the dollar?  Some are trying.  In the long run, if the US is only a capital importer, the US Dollar will lose its reserve status, and weaken considerably.

6) Union jobs are magic.  They provide these incredible benefits, but with one small problem: they kill the companies that are forced into them.  GM may be sold to the government, but unless the burden of total compensation being above productivity is lifted, there will be no substantive change.

7) Dilution.  I was never a fan of McClatchy, but this seals the story on the newspapers.  Sell equity interests cheaply, so that you can survive.  The same is happening with many banks, and it is forcing the share prices of the industry lower.

8 ) Commercial real esate is the final shoe to drop in our credit bust.  Prices are 20% below the peak.  Refinancing will prove tough.  There are no sectors in commercial real estate that are not overbuilt.

9) The PBGC is taking its share  of losses at present.  This is no surprise here, given all I wrote about the PBGC at RealMoney.  The losses on a market value basis are even greater, because firms with underfunded pensions are more likely to default.

10) Residential real estate has not stabilized yet.  The bottom will come after the resets on Alt-A lending.

11) Are there difficulties with lending in the farm belt?  To a greater degree than I expected, yes.

12) Will California survive?  We can only hope.  Given that there is no bankruptcy code for states, California could prompt a Constitutional crisis if it defaults.

13) Should the Fed regulate systemic riskPerhaps when it stops creating it.  My position was, and continues to be that the Fed has been incompetent with monetary policy, bringing us to where we are today.  We need to eliminate the Fed and its bureaucracy, which produces little value for the US.  Monetary policy could be conducted with a far smaller staff; it might even be better.  Remember, bureaucries hit economies of scale rather rapidly.  Small is beautiful with bureaucracies.

14) In the recent slowdown, there has been inventory decumulation.  Those at the end of the supply chain have been hit the hardest.  Welcome to the cyclical world when it has to slow down.  The tail always gets it the worst in a game of “crack-the-whip.”

15) Ending with inflation, John Hussmann makes the case that the current economic policy must result in inflation.  If you are reading this, John, given that we live in the same city, perhaps we could have lunch someday?

No, this isn’t another discussion of SFAS 157, though there are some similarities.  There has been a bit of a brouhaha over repayment of TARP options.  Isn’t the government getting shortchanged?

Maybe.  Maybe not.  This one is tough to answer, because at least as yet, there is no active market available for really long-dated call options.  Let me give you an example from my own experience.

I used to run a reasonably large options hedging program for a large writer of Equity Indexed Annuities [EIAs].  Much as I did not like the product, still I had to do my job faithfully, and when we were audited by a third party, they commended us having an efficient hedging program.

But here was our problem:  the EIAs lasted for ten years, but paid off in annual installments, based on average returns over each year.  Implied volatility might be low today, and the annual options that we purchased to hedge this year might be cheap, but the product had many years to go.  What if implied volatility rose dramatically, making future annual hedges so expensive that the company would lose a lot of money?

Maybe there could be another way.  What if we purchased the future hedges today?  A few problems with that:

  1. We don’t know how much we need to purchase for the future — the amount needed varies with how much the prior options would finish in the money.
  2. But the bigger problem is once you get outside of three years, the market for options, even on something as liquid as the S&P 500, is decidedly thin.  There’s a reason for that.  The longer-dated the option, the harder it is to hedge.  There are no natural sellers of long dated options, and relatively few Buffetts in the world who are willing to speculate, however intelligently, in selling long-dated options.

There is an odd ending to my story which is tangential to my point, but I may as well share it.  Eventually, the insurance company wanted to make more money, and felt they could do it by hiring an outside manager (a quality firm in my opinion — I liked the outside manager).  But then they told them not to do a total hedge, which was against the insurance regs, given their reserving practices.  Not hedging in full bit them hard, and they lost a lot of money.  Penny wise, pound foolish.

So what about the TARP options?  Did the US Government get taken to the cleaners on Old National Bank?  Is Linus Wilson correct in his allegations and calculations?  Or is jck at Alea correct to be a skeptic?

It all boils down to what the correct long term implied volatility assumption is.  Given that there is is no active market for long-dated implied volatility / long-dated options for something as liquid as the S&P 500, much less a mid-sized bank in southern Indiana, the exercise is problematic.

In quantitative finance, one of the dirty secrets is that common parameters like realized volatility and beta are not the same if calculated  over different intervals.  Also, past is not prologue; just because realized or implied volatility has been high/low does not mean it will remain so.  It tends to revert to mean.  With the S&P 500, implied volatility tends to move 20% of the distance between the current reading and the long term average each month.  That’s pretty strong mean reversion, though admittedly, noise is always stronger in the short run.

Let’s look at a few graphs:

Daily Volatility for ONB:

Or weekly:

or monthly:

or quarterly?

Here’s my quick summary: the longer the time period one chooses, the lower the volatility estimate gets.  Price changes tend to mean revert, so estimates of annualized realized volatility drop as the length of the period rises.  Here’s one more graphic:

I’m not sure I got everything exactly right here, but I did my best to estimate what volatility level would price out the options at the level that the US government bought them.  I had several assumptions more conservative than Mr. Wilson:

  • In place of a low T-bill rate for the risk-free rate, I used the 10-year Treasury yield.  (Which isn’t conservative enough, I should have used the Feb-19 zero coupon strip, at a yield of 3.79%.)
  • I set dividends at their current level, and assumed they would increase at 5% per year.
  • I modeled in the dilution from warrant issuance.

But I was more liberal in one area.  I assumed that ONB would do an equity issuance sufficient to cut the warrants in half.  If the warrants were outstanding, the incentive to raise the capital would be compelling, and it would get done.

The result of my calculation implied that a 21% implied volatility assumption would justify the purchase price of the warrants.  That’s nice, but what’s the right assumption?

There is no right assumption.  Short-frequency estimates are much higher, even assuming mean reversion.  Longer frequency estimates are higher if one takes the present reading, but lower if one looks at the average reading .  After all, Old National is a boring southern Indiana bank.  This is not a growth business.  If it survives, growth will be modest, and the same for price appreciation.

The Solution

It would be a lot better for the US Treasury to get itself out of the warrant pricing business, and into the auction business, where it can be a neutral third party.  Let them auction off their warrants to the highest bidder, allowing banks to bid on their own warrants.  I’ll give the Treasury a tweak that will make them more money: give the warrants to the winning bidder at the second place price.

By now you are telling me that I am nuts — giving it to the winner at the second place price will reduce proceeds, not increase them.  Wrong!  We tell the bidders that we want aggressive bids, and that they will get some of it back if they win.  I’ve done it many times before — it makes them overbid.

So, with no market for these warrants, I am suggesting that the Treasury creates their own market for the warrants in order to realize fair value.  Is it more work?  Yeah, you bet it is more work, but it will realize better value, and indeed, it will be more fair.

Note to readers: for this review, I read the first chapter, and skimmed the rest of the book. (full disclosure)  I usually read the entirety of every book I review, but I did not this time.  Why?  Chapter 1 is the backbone of the book, and tells the whole story in a nutshell.  The remaining chapters flesh out Chapter 1.  Most of my writings over the past five years shadow what Mr. Zandi has written, and he has created an integrated description that covers every major area of the crisis, with particular attention to mortgages, and the huge effect that the speculative mania in real estate had on the financial economy.

This is a serious book, one that explains the roots of our crisis.  If you haven’t understood it in a systematic way from reading my blog, or those that I recommend, this book will give you a coherent explanation of how we got here.

I do have some quibbles with the book.  When he describes residential mortgage securitization on page 117, the mezzanine and subordinated tranches are too large, even for subprime.  Also, his recommendations in the last chapter — I can agree with most of them, but not with mark-to-market, and the uptick rule.

This edition of the book takes us up to the first quarter of 2009, allowing Zandi to comment on the initial actions of the Obama administration.

All in all a very good book.  If you have a relative that doesn’t understand the crisis, this will explain it to him in a simple way.  If you want to buy it, you can buy it here:

Financial Shock (Updated Edition), (Paperback): Global Panic and Government Bailouts–How We Got Here and What Must Be Done to Fix It

As with all of my reviews, if you buy something through Amazon after entering through my site, I get a small commission, and you don’t pay anything more.  Don’t buy anything that you don’t want to buy on my account, though.

“So when are we coming out with a tasset fund?”

“A tactical asset allocation fund?” I replied. “Mmm, it’s worth a thought, but you know what it takes to add a new product.  How much demand would there be for this?”

“Are you kidding? In a bear market, people still want to make money.  We need someone smart who can decide when to be in the market and when to take shelter in cash.”

“If it were only that easy,” I replied, “Tell me, who is so reliably brilliant at market timing, and willing to trade for anything other than his own account?”

“You got me there, Dr. Merkel, but we really need a product like this.  It would sell like crazy.”  (Note: they called me Doctor there regularly.  I did not encourage it; I am not a Ph. D.)

“No doubt.  I will consider it, and get back to you.”


I had that conversation back in 1994 with one of the better pension representatives of Provident Mutual.  As one of the actuaries there, I quickly realized that I had to boil any investment ideas down into very simple terms for the field force.  The best explanations were rich and simple, like a fairy tale, one of Aesop’s fables, or one of the parables of Jesus Christ.  That is a challenge — one worthy of the best investment minds.

The thing is, there is a constant war between two views of the market:

  • Buy and Hold — Bull Market
  • Trade, trade, trade — Bear Market

I don’t think either view has permanent validity.  Of course in a bull market the buy and holders will crow; they are making money.  And in a bear market, those with less exposure to the market will crow.  Big deal.  Those that are accidentally correct boast while their strategy is in favor.

So, when I read this NY Times article about diversification, I yawn.  After a bear market, you decide to reduce equity exposure?  That’s just fear expressing itself in stupidity.  Even worse is this WSJ article, where the author is giving into his fears, and reducing equity exposure.

My point here is a simple one.  Don’t confuse brilliance with a bull market.  Don’t confuse stupidity with a bear market.

Very few people are good traders, such that they can manuever the pulses of the market.  For those that understand how the market works in the long run and on average, the best thing to do is to ride bear markets out.  Own the best companies you can find, and adjust your asset allocation such that you can survive something worse than a bad recession.  Many people over-own stocks, implicitly trusting in the naive view that they always outperform bonds.  Stocks do outperform bonds, but by much less than advertised, say 1-2%/year.


When I look at the risk cycle now, I am inclined to reduce risk, and add to safe investments.  That said, I might wait a while to see if the positive momentum persists.  I am gratified by the rally in lower-rated corporate bonds, but think that the risk there is growing.  I am presently inclined to do an “up in quality” trade, sacrificing yield for safety.  There.  That is the way to go now.  Reduce risk, and take the loss in yield.