One Dozen More Notes on the Economic Scene

1) I may as well start out the evening with some predictions. I’m not an expert on this, but Chapter 9 of the bankruptcy code applies to municipalities, but not states. Given the problems with state & municipal pensions, we will probably see chapter 9 modified over the next two decades to allows states to default. There will also be some modification to retirement funding laws as applied to municipalities, states, and maybe the US Government, to allow for retroactive negotiation of pensions and healthcare benefits for an insolvent government.

2) California will lead the parade of states in trouble.  They want the US to guarantee their municipal debt.  Schwartzenegger did all he could to try to pass the referenda that might partially close the budget gap, but from what I see now, it looks like most of the important ones have failed.  Having been a California resident for seven years, I went though my share of referenda; the referendum process makes the politicians of California lazy… they pass the tough stuff off to the electorate, who then get to decide off of voters’ guides and soundbites.

3) California is an exaggerated version of the troubles that other states are having.  Social program spending rises, while taxes on wages, corporate profits, real estate, real estate transfers, etc., all fall.  If you can’t print your own money, and must balance your budget, life is tough, kind of like it is for most Americans.

4) Another municipal issue — can financial guarantors split in two?  I have argued “no,” but who cares what I think?  We do care about those that use the courts, and banks are suing to prevent the MBIA split.  It is a simple issue of fraudulent conveyance.

5) One last municipal issue: pension placement agents.  This is very similar to what I experienced in Pennsylvania regarding municipal pensions there.  Pension consultants would gain business through campaign contributions, and the Democratic and Republican consultants would collaborate and share to control the profits jointly.  Insurance companies providing pension services would pay  compensation to the consultants in exchange for business.  It’s a dirty business, and when I raised ethical objections to it, I was told that I was naive.  Perhaps I have more company now.

Anytime you have opaqueness of compensation, politics, and uncertainty of results (investing), there is always room for corruption.

6) Asset allocation.  The belief in a large equity premium led many to overweight stocks.  I have argued against that.  Now there are many who are finding the they have to start over, after bad equity returns.  There is no magic in any asset class.  Yes, equities do better than bonds in the long run, but only by 1-2%/yr, not 5-7%.

As for the arguments of Ayres and Nalebuff, only the most emotionally dead investors can live with levering up 1.9 times perpetually.  Most people panic.  They can barely deal with the volatility of the S&P 500, much less double that.

7) Mmmm… is it time to take on Bill Miller again?  Yeh.  Overweighting financial stocks?  That is quite a bet, and probably irresponsible again.  Here is my free advice — analyze your estimates of intrinsic value with commercial real estate prices 30% lower than today.  Aside from short-tail insurers, I don’t think you want to be overweight financials.

8 ) On the same note, many small and intermediate-sized banks face troubles under stress, particularly from commercial real estate lending.

9) I think we are in the second inning for declines in prices for commercial real estate, but perhaps the seventh inning for residential real estate.  So long as residential properties sell for less than their mortgages there is downward pressure on prices, because negative events lead to foreclosures, not sales.

10) How will derivatives be regulated?  That is the question.  Will it be as transparent as TRACE?  I doubt it.  The market is not that liquid.

11) Will the US Government likely get full value back on TARP buyouts? No, because they lack expertise at analyzing these situations.  They don’t know what a warrant is worth.

12) Will low-rate mortgages rescue the economy?  No, but many middle class people with equity will breathe easier after they refinance.  Also, some will buy homes, but who will have the downpayment necessary to qualify now that underwriting has tightened?  Not many.