Just a brief post here.  The Economist features a simple symmetric model to try to explain cycles in the financial marketsCute model, but it can’t explain booms and busts.  The key missing feature is credit that can default.  Defaults are asymmetric.  With bonds you can make a little with high certainty, or lose a lot with low certainty.  This is true of all lending, leaving aside convertibles.

In a true bust, defaults are rampant, as badly capitalized firms fail amid weakening demand.  During booms, some  firms magnify the results by levering up (borrowing more).  This is the behavior that created booms and busts, together with the momentum effects that Brad DeLong’s model demonstrates.

Modeling in default behavior and leverage should complete the model.

Apologies to readers.  I have been gone last week at my denomination’s annual meeting.  As I often say at this time of year, I never work harder than at that time, so please forgive my lack of posts.  As it is now, I am worn out, but at least I am home.  Home is my favorite place.

I am presently reading a book by Justin Fox, The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.  So far, a good book.  He has a recent blog post that impressed me as well: Dumbing Down Regulation.

Should regulation be dumb?  In one sense yes, in others, no.  It really depends on how well the regulators understand the risks involved, and how much they can encourage professionalism among marketers and risk managers.  As those two increase, regulation can be smart.  “Follow these detailed rules to calculate the capital you need to be solvent 99% of the time.”

But when either of those two aren’t true, dumb regulation may be in order:

  • Strict leverage limits, reflecting the worst outcome from underwriting poor quality loans.
  • Disallowing risky types of lending, regardless of capital level.
  • Disallowing liabilities that can run easily.
  • Disallowing products that commonly deceive buyers.
  • Disallowing certain types of contracts that fuddle accounting.

If everyone were smart, things could be different.  Deceiving people would not take place, and managements would not take undue risks.  Limits could be more loose, and products would be designed for discriminating buyers.

But, face it, we are dumber than we think, myself included.  Consumer choice is a good thing, though it implies that some will be deceived, no matter where one places the line of demarcation.  Along with that, some bank will not fit the rules and go insolvent, though it does not register so on the solvency tests.

My poster child for relatively good dumb regulation is the insurance industry in the US.  The industry is far less free-wheeling than the banking industry, and under most circumstances, the solvency margins are set high enough to have few insolvencies.  There is room for improvement, though:

  • Make risk based capital charges countercyclical.  Perhaps tinkering with the Asset Valuation Reserve would do that.
  • Have some sort of rigorous testing for capital relief from reinsurance treaties.
  • Ban surplus notes in related party transactions.
  • Ban all forms of capital stacking, especially where the transactions go both ways.  I.e., subsidiaries can’t own securities of any companies  in their corporate family.  All subsidiaries must be owned by the holding company.
  • More rigorous testing for deferred tax assets.
  • Assets as risky as equities, including limited partnerships, should be a deduction from capital.
  • Securitized bonds that are not “last loss” should have higher RBC charges than comparable rated corporates.
  • A standardized summary of cash flow testing results should be revealed.

As for the banks, they need to do that and more:

  • Insurance companies list all of their assets.  Banks should as well.
  • Intangible assets should be written to zero for regulatory capital purposes.
  • Risk-based capital standards need to be tightened to at least the level of insurance companies, if not tighter.
  • Some sorts of lending to consumers should be banned.  I am talking about complex agreements, that individuals with IQs less than 120 can’t understand.  Insurance policies have to be Flesch-tested.  Bank lending agreements should be the same.  If some argue that the poor need access to credit, I will say this: the poor need to get off of credit.  Credit is for the upper-middle-class and rich.  Poor people should not go into debt.
  • Standardized summaries of terms and fees must be created for consumer lending, with large, friendly letters, and simple language that all can read.

What I am saying is that accounting has to be more conservative, and that regulators have to require larger amounts of capital to support their business, particularly at the banks.  Financial products must be made more simple for consumers to understand.  More transparency is needed everywhere, and if the financial companies complain, tell them that they will all be in the same goldfish bowl, so no one will gain an unfair advantage.

Dumb regulation bars certain lending practices, and raises capital levels higher than is needed over the long run.  So be it.  Smart regulation is far more flexible, and trusting that companies and consumers know what they are doing.  Unfortunately, when financial firms fail, there are often larger repercussions.  It is better to limit regulated financial companies to businesses where the risks are well-understood.  Let the less understood risks be borne by those outside the safety net, and bar those inside the safety net from holding any assets in those companies.

April 2009June 2009Comments
Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract, though the pace of contraction appears to be somewhat slower.Information received since the Federal Open Market Committee met in April suggests that the pace of economic contraction is slowing. Conditions in financial markets have generally improved in recent months.The FOMC is following trends in the financial markets. The stock market is higher, and credit spreads are tighter, but what of tomorrow?
Household spending has shown signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit.Household spending has shown further signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit.The FOMC sees further signs of stabilization of household spending.
Weak sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories, fixed investment, and staffing.Businesses are cutting back on fixed investment and staffing but appear to be making progress in bringing inventory stocks into better alignment with sales.They view much of the weakness as being an inventory correction that will end soon.
Although the economic outlook has improved modestly since the March meeting, partly reflecting some easing of financial market conditions, economic activity is likely to remain weak for a time. Although economic activity is likely to remain weak for a time,They are more certain that economic conditions have improved.
Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.Materially the same.
In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. 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 prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.They trust that slack capacity will keep inflation low, despite rising commodity prices. They are less worried bout deflation. Stagflation is not a word in their vocabulary.
In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.Identical
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.They are trying to lengthen the view of the market on how long the FOMC is able to maintain a low fed funds rate.
As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year.As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year.Identical.
In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn.In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn.Identical.
The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.Identical.
The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs. The Committee will continue to carefully monitor the size and composition of the Federal Reserve’s balance sheet in light of financial and economic developments.The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.Much language change; not much substantive change.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.Identical.

Quick Hits:

  • The FOMC is following trends in the financial markets. The stock market is higher, and credit spreads are tighter, but what of tomorrow?
  • They view much of the weakness as being an inventory correction that will end soon.
  • They trust that slack capacity will keep inflation low, despite rising commodity prices. They are less worried bout deflation. Stagflation is not a word in their vocabulary.
  • They are trying to lengthen the view of the market on how long the FOMC is able to maintain a low fed funds rate.
  • They are projecting calm to all who will listen, but will inflation and the dollar cooperate?  Will economic weakness not deepen from here?  The jury is out.

One thing that I watch closely is the health of the finances of the states.  Because they don’t have a printing press, and most of them have to balance their budgets, they are a better read on the health of the economy than national statistics.

As it is, states are cutting their budgets drastically because their tax collection is down dramatically.  California is a leading example here.  Will it refuse to pay, and what of its municipalities?  How many will file for Chapter 9, like Vallejo?  My guess is that many municipalities will file Chapter 9, but that California will avoid nonpayment.

There is one more issue worth pursuing here.  Though states have to run balanced budgets (largely on a cash basis), that says nothing about pensions and other long-dated promises.  I find it fascinating that some states are still trying the gambit of pushing retiree expenses out into the future.  To me, that is a sign of desperation slightly smaller than making significant budget cuts.  It’s just playing for time at a time where delay has few advantages.

That’s one reason among many that I do not see “green shoots” at present.  During a period of debt deflation, many troubles fight prosperity as the financing bubble deflates.  If the states aren’t prospering the nation is not either, regardless of what statistics the national government might dream up.

Often when we talk about the Fed, we talk about a dual mandate — low inflation, and low labor unemployment.  But as I suggested at RealMoney many times, there is a hidden third mandate: protect the integrity of the banking system.

Often,  a tightening cycle would end with a bang, with some credit starved entity (Residential Housing, Nasdaq, LTCM, Lesser-developed Asia, Mexico, etc.) dying.  The Federal Reserve would then spring into action and say, “We must fight the threat of unemployment.”  Would they?  No, they would invoke protecting the financial system, which protects the banks.  After all, monetary policy does not work when banks are compromised, as they are today.  No wonder there is Credit Easing.

So when I hear the Fed proposed to be the systemic risk regulator, I have two thoughts:

1) You did a bad job with monetary policy and bank supervision, but you are nice guys, because you do for the US Government all of the things the Treasury Department can’t Constitutionally do.  Now let’s see if you can do better with controlling systemic risk, even though we haven’t granted you control over all the levers necessary to do so.

2)  Maybe this will make them better with monetary policy; it makes the triple mandate explicit.

My view is that the Fed is one of the major creators of systemic risk in our economy through the use of monetary policy to stimulate our way out of bad times.  The temptation that Greenspan succumbed to was to throw liquidity at problems too early, which avoided liquidation of marginal debts, and the debt levels built up.

If the  Fed has to minimize systemic risk in the economy, maybe it becomes less willing to loosen policy profligately.  I would hope it would work that way.

That said, given the lack of success for the Fed on its goals, I suspect that if it were given the task of reining in systemic risk, it would fall prey to political pressure, and fail at that as well.

I go back to my earlier proposal — the Fed would have to keep the US economy under a limit of private debts being less than 2x GDP.  But can you imagine the Fed tightening during a boom to avoid systemic risk, or raising margin requirements?  I can’t, so even though ideally the Fed would be the right player to manage systemic risk, in practice, systemic risk is unmanageable, because there are too many interests that benefit from boom times.  That’s why I don’t expect much from the proposals to manage systemic risk, regardless of who gets the power to do so.

When people look at this crisis, they look for simple answers — they want to find one or two parties to blame, not many, a la my Blame Game series.  The economic system is an interconnected web, and it is not easy to change one part without affecting many others.  Intelligent ideas for change consider second order effects at minimum.  This piece, and any that follow under the same title, will attempt to point at things that are not easily done away with.  Some of these will be controversial, others not.

1) Derivatives.  What is a derivative?  A derivative is a contract where two parties agree to exchange cash flows according to some indexes or formulas.  There are some suggesting today that all derivatives must be standardized, and/or traded on exchanges.  That might make sense for common derivatives where there are large volumes, but many derivatives are “out in the tail.”  Not common, and standardization of what is not common is a fool’s errand.

To regulate derivatives fully is to say that certain types of contracts between private parties may not exist without the consent of the government.  Thinking about it that way, what becomes of free enterprise?  Granted, there are some contracts that cannot be considered enforcable, like that of a hit man, arson for hire, etc.  Those are matters that any healthy government would oppose.

What makes more sense is to bring the derivatives “on balance sheet.”  Let the effects of the notional value play out, showing owners what is happening, rather than hiding it.

2) Rating agencies — Moody’s, S&P, and Fitch deserve some blame for what happened, but the regulators needed the rating agencies.  They still do.  The rating agencies make imperfect estimates of relative credit quality for a wide munber of instruments, which then feed into the risk-based capital formulas of the regulators.  To rate such a wide number of instruments means that the issuers must pay for the rating, because there is no general interest for most ratings.

Yes, let more rating agencies compete, but they will find that the “issuer pays” model is more compelling than the “”buyer pays” model.  The concentrated interests of issuers in a rating trumps the diffuse interests of buyers.  Bond buyers need to learn to live with this, and employ buy-side analysts that don’t take the opinion of the rating agencies blindly.  What the analysts at the rating agencies write is often more valuable than the rating itself, though it doesn’t change capital charges.

Rating agencies make the most errors with new asset classes.  Better that the regulators do their jobs and prohibit immature  asset classes where the loss experience is ill-understood.

I don’t think that rating agencies are going away any time soon.  I do think that the government and regulators contemplated this, but concluded that the changes to the system would be too drastic. (Contrary opinions: one, two)

3) Yield-seeking — the desire to seek yield is near-universal.  As a bond manager, I found it rare that a manager would do a “reduce yield, improve quality or certainty” trade.  The pattern is even more pronounced with retail accounts.  They underestimate the value of the options that they are selling, and take a modicum of yield in exchage for lower certainty of return.

Can this be banned, as some are proposing with reverse convertibles?  I don’t think so, there are too many variables to nail down, and too many people in search for a yield higher than is reasonable.  Yield-hogging is an institutional sport, not only one for retail fans to grab.  As one of my old bosses used to say, “Yield can be added to any portfolio.”  How?

  • Offer protection on CDS
  • Lower the quality of your portfolio.
  • Buy all of the dirty credits that trade cheap to rating.
  • Buy securities from securitizations — they almost always trade cheap to rating.  (Ooh! CDOs!)
  • Sell a call option on the securities you hold.
  • Buy mortgage securities with a lot of prepayment or extension risk.
  • Accept the return in a higher inflation currency, assuming that their central bank will tighten.
  • Do a currency carry trade.
  • Lever up.
  • Extend the length of your portfolio.
  • Underwrite catastrophe risk through cat bonds.

Adding yield is easy.  The transparency of that addition of yield is another matter.  Reverse convertibles have been the hot issue recently since this article.  Here is a small sample of the articles that followed: (one, two, three).  Reverse convertibles, and other instruments like them give bond-like performance if things go average-to-well, and stock-like performance if things go badly.  The inducement for this is a high yield on the bond in the average-to-good scenario.

What to do?

I have three bits of advice for readers.  First, don’t buy any financial instruments tht you don’t understand well. This especially applies when the party selling them to you has options that they can exercise against you.  Wall Street excels at products that give with the right hand and take with the left, so beware structured products sold to retail investors.

Second, don’t buy any financial product that someone appears out of the blue and says, “Have I got a deal for you!”  Stop.  Take your time, ask for literature, maybe, but say that you need a month or more to think about it.  Haste is the enemy of good financial decision-making.  Instead, do your own research, and buy what you conclude that you need.  Consult trusted advisors in either case.

Third, don’t be a yield hog.  Yield is rarely free.  There are times to take risk and accept higher yields, but those are typically scary times.  At other times, make sure you understand the portfolio of risks that you accept, and that you are being adequately paid for those risks.  Better to have a ladder of high quality noncallable debt, and take some risk with equities than to take risk in a series of yieldy and illiquid bonds that you don’t understand so well.  At least you will be able to know what risks you have, and that is an aid to asset management.

Final Question

This article began as a discussion of things that are very hard to change in the current environment.  I thought of several here:

  • The continuing need for derivatives, and the impossibility of full standardization
  • The continuing need for rating agencies
  • Human nature makes us yield hogs.
  • Wall Street builds traps for investors off of that weakness.

What other things are very hard to change in the current environment?

I have learned a lot from the late Peter Bernstein. I remember a piece of his entitled (something like), “What is Liquidity?” where he described liquidity as the ability to change your mind or request a do-over. Bright guy, and one who focused on the big issues, not minutiae.

I met Peter Bernstein in 2002 when he delivered a timely talk to the Baltimore Security Analysts Society called (something like), “The Continuing Relevance of Dividends.” I asked a question during the Q&A, and then was able to talk with him for ten minutes afterward, because few wanted to embrace such a boring topic. He was very gracious to me, and encouraged me in my research pursuits.

There were many who offered their praises of Peter Bernstein and I offer the links here:

As for his books, I offer the links here:

There may be more than this, but it was what I was able to find.  Peter Bernstein aimed for large targets, and gave broad and convincing evidence of how markets worked.  He only erred in letting Modern Portfolio Theory and Keynesianism affect him.

With that, I hail Peter Bernstein, regretting his demise.  He will be missed, as few of us had such global vision of markets as he had.

Full disclosure: if you buy anything from Amazon after entering here, I get a small commission, but your prices don’t go up.

John Reese and I share something in common: we both once wrote for RealMoney.com.  Occasionally I would question him in  the CC about what he wrote, but I never got an answer back.  He was probably a busy man.

Well, now I get to review his book, and I have to say that I like it.  It won’t be one of my favorite investment books, but it embeds many good ideas that will be useful to average investors.  Here are some of the main advantages:

1) It points people toward strategies that are valuation-conscious.  Whether investing for growth or value, the best investors pay attention to valuation.

2) Valuation is not everything.  Earnings growth and price momentum also are valuable to follow.

3)  Quality of the balance sheet matters.

One of the things that I like to say to investors is find something that fits your character, your free time, and your time horizon.   This book simplifies the strategies of ten clever investors.  Some require more time and effort, some less.  With ten good strategies to choose from, perhaps one will fit your situation well.

For the ten gurus, it describes them, their strategies, and how to implement them in a simplified way.  I knew a little about all of the gurus before reading the book, but I learned a little bit new about each one, except Buffett.  They made life choices that led them to their investment theories, and the book makes that connection.

Sell Discipline

The sell disciplines in the book are similar to mine — rebalancing, and adding stocks that the model likes better, and removing those that rank lower.  For fundamental investors, that’s a reasonable way of limiting risk, assuming that you review your thesis before adding new money.


1)  Earnings quality: leaving aside Piotorski, the rest of the gurus spend little time on earnings quality.  Particularly for value investors this component is critical for avoiding mistakes.

2)  What Reese puts forth is a simplified version of what most of these great investors do.  The actual process is more complex, and requires business judgment.  That said, his simplifed versions have done better than the market, in general.

3)  Performance calculations cut off in July 2008.  Now, he had to cut off somewhere, or he couldn’t publish.  Still, it would be interesting to know how the strategies did July 2008 through February 2009 — how did they do at risk control?

4) To be able to use this book effectively, you would need to have access to some reasonably sophisticated stock screening software.  The cheapest one that I know of would come from AAII, but you would also have to be an AAII member to buy it.  (If anyone knows a better one at a cheaper price, let me know.)

Who Would Benefit From this Book

This book would work best for people who want to follow valuation-conscious strategies, and not spend a ton of time at it, if they are willing to put in some time at the beginning setting up stock screens.


If after you have read this, you want to buy the book, you can buy it here — The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies.

Full disclosure: I get a small commission from Amazon on anything that gets bought after entering Amazon through my site.  Your price doesn’t go up, and Amazon is always happy to have additional sales, even at a lower gross margin.

This post should end the series, at least for now.  Tonight I want to talk about the limits to compounding growth.  Drawing from an old article of mine freely available at TSCM, I quote  the following regarding talking to management teams:

What single constraint on the profitable growth of your enterprise would you eliminate if you could?

Companies tend to grow very rapidly until they run into something that constrains their growth. Common constraints are:

  • insufficient demand at current prices
  • insufficient talent for some critical labor resource at current prices
  • insufficient supply from some critical resource supplier at current prices (the “commodity” in question could be iron ore, unionized labor contracts, etc.)
  • insufficient fixed capital (e.g., “We would refine more oil if we could, but our refineries are already running at 102% of rated capacity. We would build another refinery if we could, but we’re just not sure we could get the permits. Even if we could get the permits, we wonder if long-term pricing would make it profitable.”)
  • insufficient financial capital (e.g., “We’re opening new stores as fast as we can, but we don’t feel that it is prudent to borrow more at present, and raising equity would dilute current shareholders.”)

There are more, but you get the idea.

Again, the intelligent analyst has a reasonable idea of the answer before he asks the question. Part of the exercise is testing how businesslike management is, with the opportunity to learn something new in terms of the difficulties that a management team faces in raising profits.

As with biological processes, when there are unlimited resources, and no predators, growth of populations is exponential.  But there are limits to business and investment profits because of competition for customers or suppliers, and good untried ideas are scarce.  Once a company has saturated its markets, it needs a new highly successful product to keep the growth up. Perhaps international expansion will work, or maybe not?  Are there new marketing channels, alternative uses, etc?

Trying to maintain a consistently high return on equity [ROE] over a long period of time is a fools bargain and I’ll use an anecdote from a company I know well, AIG.  I was pricing a new annuity product for AIG, and I noticed the pattern for the ROE of the product was not linear — it fell through the surrender charge period, and then jumped to a high level after the surrender charge period was over.

I scratched my head, and said “How can I make a decision off of that?”  I decided to create a new measure called constant return on equity [CROE], where I adjusted for capital employed, and calculated the internal rate of return of the free cash flows.  I.e., what were we earning on capital, on average over the life of the product.

I took it to my higher-ups, hoping they would be pleased, and one said, “You don’t get it!  You don’t argue with Moses!  The commandment around here is a 15% return on average equity after-tax!  I don’t care about your new measure!  Does it give us a 15% return on average equity or not?!”

This person did not care for nuances, but I tried to explain the ROE pattern, and how this measure averaged it out.  It did not fly.  As many have commented, AIG was not a place that prized actuaries, particularly ones with principles.

As it was AIG found ways to keep its ROE high:

  • Exotic markets.
  • Be in every country.
  • Be in every market in the US.
  • Play sharp with reinsurers.
  • Increase leverage
  • Press the accounting hard, including finite reinsurance and other distortions of accounting.
  • Treat credit default swap premiums as “found money.”
  • Take on additional credit risk, like subprime lending inside the life companies through securities lending.

In the end, it was a mess, and destroyed what could have been a really good company.  Now, it won’t pay back the government in full, much less provide anything to its shareholders, common and preferred.

Even a company that is clever about acquisitions, like Assurant, where they do little tuck-in acquisitions and grow them organically, will eventually fall prey to the limits of their own growth.  That won’t happen for a while there, but for any company, it is something to watch.  Consistently high growth requires consistently increasing innovation, and that is really hard to do as the assets grow.

If True of Companies, More True of Governments

This is not only true of companies, but even nations.  After a long boom period, state and federal governments stopped treating growth in asset values as a birthright, granting them a seemingly unlimited stream of taxes from capital gains, property, and transfer taxes.  They took it a step further, borrowing in the present because they knew they would have more taxes later.  The states, most of which had to run a balanced budget, cheated in a different way — they didn’t lay aside enough cash for their pension and retiree healthcare promises.  The Federal government did both — borrowing and underfunding, because tomorrow will always be better than today.

Over a long enough period of time, things will be better in the future, absent plague, famine, rampant socialism, or war on your home soil.  But when a government makes long-dated promises, the future has to be better by a certain amount, and if not, there will be trouble. That’s why an economic downturn is so costly now, the dogs are behind the rabbit already, running backwards while the rabbit moves forwards makes it that much harder to catch up.

I’ve often said that observed economic relationships stop working when people start relying on them, or, start borrowing against them.  The system shifts in order to eliminate the “free lunch” that many thought was available.

A Final Note

Hedge funds and other aggressive investment vehicles should take note.  Just as it is impossible for corporations to compound their high profits for many decades, it is impossible to do the same as an investor.  Size catches up with you.  It’s a lot easier to manage a smaller amount — there are only so many opportunities and inefficiencies, and even fewer when you have to do so in size, like Mr. Buffett has to do.

“No tree grows to the sky.”  Wise words worth taking to heart.  Investment, Corporate, and Economic systems have limits in the intermediate-term.  Wise investors respect those limits, and look for growth in medium-sized and smaller institutions, not the growth heroes of the past, which are behemoths now.

As for governments, be skeptical of the ability of governments to “do it all,” being a savior for every problem.  Their resources are more limited than most would think. Also, look at the retreat in housing prices, because the retreat there is a display of what is happening  to tax revenues… the dearth will last as long.

Full disclosure: long AIZ

1) Why have long interest rates been rising?

  1. Increased supply.
  2. Mortgage bond/supply hedging. (also one, two)
  3. Belief in a strengthening economy.
  4. Long-term inflation expectations have been rising.
  5. Some foreign investors are selling.
  6. Flight to trash.

Number 1 is incontrovertible.  Number 2 is close.  Number three is true, though the economy is not strengthening that much in inflation adjusted terms.  As for 4, yes, TIPS inflation breakevens have been steadily rising, both short- and long-term.

The last one is the most interesting.  It is the analogue to the equity investors that are buying financials.  Since the financials have been hot, equity managers lagging in performance have encouraged the purchase of hot financials.  Same for junk bonds among broad mandate bond managers.  Many managers are buying long financial corporates for speculative gains, while selling long Treasuries to fund the purchases.

With a few exceptions, it has paid recently for bond managers to play on the riskier areas of their mandates, with the exception of high quality long duration bonds, which were the big winners last year, and the big losers this year so far.

So when you look at the rise in high-quality long rates (prices down), and the rally in junk (prices up), etc., realize that these are part of a larger phenomenon.   There is not one simple reason for the recent moves, there are many, and they are loosely related.

2)  That’s not to say that the Fed publicly understands this (one, two, three) .  When they announced their plan to buy long Treasuries, Agencies, and Mortgage bonds, there was some hope that they could keep mortgage rates down and stimulate the economy by making cheaper to finance homes.  That dream is in tatters now (one, two, three, four, contrary opinion from Paul Kasriel, who I generally respect).  The six forces listed above are bigger than the Fed’s ability to control.

3)  Will the Fed start tightening rates in 2009?  Yes or no?  When you phrase the question that way, most thoughtful observers will answer no, saying that the Fed would never start acting when a recovery is barely underway, if it is underway at all.

But maybe that’s the wrong question.  Ignoring the Fed funds futures market for a moment, ask this question instead:  Subjectively, have the odds risen recently that they might tighten sooner, and maybe even in 2009?  Certainly.  There have been other times when the Fed has acted, tightening when conditions were less than optimal.  I’ll give you two of them:

  • After the dollar tanked in 1986, with inflation still pretty benign, starting in December of 1986, the Fed began to raise rates, primarily to defend the dollar.  Not realizing all of the second order effects that would take place, the tightenings led to a bear market in bonds, and eventually the crash later that year as bonds became compelling compared to stocks.
  • From 1973 to 1982, the Fed often raised rates when the economy was less than strong.  Inflation was out of control, and it didn’t much matter whether industrial capacity or labor capacity were fully used — there was still inflation, and thus, stagflation.

It’s possible we may run into the same thing here, though if the only thing we experience is commodity price inflation because the dollar is weak, that doesn’t feed back into consumer prices that much,  because raw commodity prices play a small role in consumer prices.  Labor costs are much more important.  Would it be possible to get rising wages when unemployment is high?  Yes, look at the ’70s.

4)  But maybe the Fed can tighten without tightening.  They can begin lightening up on their credit easing programs.  Might work.  Maybe they could reverse their trade in long Treasuries, Agencies, and Mortgage bonds.  Uh, yeah, unlikely, but maybe they slow down a little.  In a case like this, moving the Fed Funds rate might be the least painful option.

So maybe a move in the Fed funds rate isn’t impossible in 2009.  The difficult part here is forecasting:

  • What conditions will be in the real economy will be like
  • How well the global economy turns
  • Whether the large amount of incremental Treasury debt and guarantees will be readily digested on favorable terms
  • Whether the financial economy won’t hit a few more roadblocks from commercial mortgages, corporate and personal insolvencies, unemployment, etc.
  • Whether there is some “bolt from the blue” like a new war, weakness in the Chinese economy, etc.

What isn’t hard is looking at the overall debt levels relative to GDP, and realizing that we have only rationalized a part of them.

5) Residential Housing is still weak, and getting weaker, but the pace of the decline has slowed.  The market still has issues in front of it:

As I said in an old CC post:

David Merkel
Hear Cody on Housing
8/24/2007 1:25 PM EDT

Much, but not all of the upset in the lending markets (which, if you look at swap spreads, the current manifestation of the crisis seems to be passing — down 4 basis points today), is from deflating values in housing. My estimate for how much further real estate has to decline on average in the US is 10-20%. We need to find owners for about 4% of the US housing stock that is vacant. The pain that has been felt in subprime and Alt-A loans will get felt in prime loans, and possibly conforming loans as well. Fannie and Freddie won’t get killed, but they will take credit losses.

So, listen to Cody. Residential real estate markets do not clear as rapidly as a futures exchange. The illiquidity and variations in lending standards tends to lead to markets that adjust slowly, and autocorrelatedly. I.e., if it went up last period, odds are it will go up next period, and vice-versa.

It will take a while for the residential real estate market to clear. When the inventory gets down to 3% it will be time to start speculating on homebuilders and mortgage lenders again, but real estate prices won’t start rising in aggregate until the inventory of unsold homes gets below 1.5-2.0%.

Position: none

In hindsight, I was way too optimistic, but I could never bring myself to write that things could be much worse, because then you get labeled a “perma-bear,” and then you get ignored.  So, if you want pessimism, here it is from T2 partners.  We may be near fair value now, but given that our housing stock is misfinanced (too much debt, terms that are too short), we will definitely go below fair value.  The only question is how much we go below fair value.

6)  Regarding the US Dollar fixed income, who is right?  The Russians, who are selling?  The Chinese, who are kvetching, but still buying?   Or the Japanese, who possess unshakable trust in US bonds?   Only time will tell.  Transitions from one currency regime to another can be messy in the absence of an anchor like gold.  There is some point where if the US keeps borrowing, and there seems to be no end in sight, that foreign creditors will finally write off their losses, and move on to some new arrangement.

In the short run, it is not in the interests of China or Japan to ditch the Dollar.  It would take something notable to get them to change, and I can’t see what that would be.  It certainly won’t be Yuan-denominated bonds from the US.

7)  Buy Corporate Bonds Now.  Aren’t we a bit late here?  The time to buy was back in the end of 2008.  Investment Grade Corporates are at fair value now, and I would reduce holdings of BBB corporates to below benchmarket levels. High yield is still a little cheap, so I would reduceallocations to high yield now to benchmark levels.  We still have significant financial stress ahead of us, and there is a lot of room for lower-rated credits to underperform.

8 ) As another example of this, consider how many junk-rated senior loans will need to be refinanced over the next five years.  Perhaps the bid from CLOs will come back, or the the banks will heal and bring it onto their balance sheets.  But absent that, there will be upward pressures on yields when refinancing senior loans.

9) I knew that I wrote something with respect to the Fed and Treasury using force to make banks take TARP funds.  I finally found it.  So, this isn’t hot news that the banks were forced to take TARP funds, (and here) but it’s nice to see that I guess right every now and then.  Barry was quite possibly right that the TARP was a ruse to protect Citi, but the bigger surprise would be how much Bank of America and Wells Fargo would need it.

10) Final note: if banks are opaque, regulators are more so.  Glad to see Matthew Goldstein continuing to put out good work on financials.  He was great at TSCM, and I’m sure will be great at Reuters.