I ordinarily like the writings of Jason Zweig, so this post is not meant as a criticism of him.  He wrote an interesting article suggesting that US investors may suffer reduced performance because they invest too much in US stocks.  Ideally, shouldn’t investors seek out the stocks that are likely to perform the best, regardless of where they are located in our world?

Ideally, yes.  Practically, there are difficulties.  I write this as one who has always allocated more than the average to international stocks.  Investing internationally assumes several significant things:

  • There will be no war that changes the amount or terms of commerce.
  • There will be no legal changes that affect property rights abroad.  This includes exchange controls.
  • I will get the same flow of news that an investor in the target country will get.
  • I understand the differences in the accounting rules, and will not get tripped up if they are more liberal than in the US.
  • I understand that regulations are different in foreign countries as well.
  • Transacting in non-ADR foreign stocks from the US can be expensive for retail accounts.  Buying mutual funds that invest in foreign stocks carries expensive management fees.
  • Economic policy will remain rational in the target country, or at least, better than that of the US.
  • I understand the trading nuances of the target country.

Home bias is normal, around the globe.  We understand the business dynamics of our own countries far better than foreign countries, together with our understandings of accounting, regulation, exchange controls, information disclosure, legal systems, economic policy, etc.

Even within the US, there is home bias among investors to the extent that we tend to invest more in companies that are near to us — perhaps it is a greater flow of informal information.

I would encourage all of my readers to invest abroad but to do it selectively.  Does the country allow for relatively free capital flows?  Do they honor the rule of law?  Is their accounting as good as that in the US?  Are there war risks?

There are risks in investing abroad that do not exist locally.  Make sure you minimize those risks if you invest abroad.

Ordinarily, I don’t think much of video on the web.  Writing is usually a more concise way to get a view across.  But video can be more effective if it gets past the genre of “talking heads,” in which case, one is usually better off reading a transcript.  Consider the State of the Union message as an example: regardless of who is president, would you rather spend an hour on it, of five minutes?  And, it would be five minutes where you are not distracted by the crowd, and can dissect things rationally.  I pick reading.

There are places where video can be useful, but it has to be well thought out.  I first saw the above video over at “The Big Picture,” which has enough readership to kick up a video’s viewings.  I thought it was clever, representing the economist’s views in a short catchy way, and capturing their philosophies  as well.  The next day, I showed it to three of my boys — they thought it was interesting, and mentioned it the next night at dinner.  My wife, incredulous at the idea of an economics rap video, then watched it the next night with all of the kids, while I cleaned up the dinner dishes.

Then the surprise happened.  “Dad, what are animal spirits?”  “Are animal spirits the bull and the bear?”

Interesting.  The video prompted questions from the children for me to answer.  I’ve written on Animal Spirits before, at least twice.  Animal spirits attributes irrational risk taking and avoidance to businessmen, as if they are irrational animals.

I told my children that businessmen are generally rational, and they make their decisions off of their own balance sheets, and the general willingness of the market to spend, which is related to balance sheets in aggregate.

The contrasts of the video are considerable:

  • Keynes is known, Hayek is unknown.  Desk clerk immediately knows Keynes.
  • The two men are hybrid in what they portray.  To some degree they represent the schools of thought that each was a leader of, and to degree the men themselves.
  • Hayek reaches into the hotel room drawer, and rather than finding the Bible, finds the General Theory. Similarly, Keynes says, “I am the agenda.”  This is a statement of the dominance of Keynesian thought in modern macroeconomics.  Keynes was important, but not as dominant while he lived.
  • Hayek assumes they will go via the subway.  Keynes hires a limo.  Keynes is worldly wise, having a great time, and Hayek is uncomfortable.  Keynes has alcohol; if Hayek is having alcohol, he is sipping it through a thin straw.
  • Alcohol is an allusion through the whole piece.  Stimulus is just more of “the hair of the dog that bit you.”  The boom is a good time where we drink freely, and the bust is where we deal with our hangover.  It was no surprise to see that the Bartenders were named “Ben” and “Tim” and that they were serving up alcohol for as long as the patrons would survive.  Even the pyramiding of the glasses had meaning — building up to a stuporous, unsustainable level.
  • Keynes holds money as he begins his rap, and throws it midway through.  It is an aspect of how incentives from the government or central bank can lead behavior for a time.
  • Keynes ends his rap with “We’re all Keynesians now.”  Keynes himself did not live to hear that comment uttered by Friedman in the ’70s.
  • Keynes and Hayek had different views on spending and savings.  On spending, Keynes didn’t think what money was spent on mattered, only that it was spent.  Hayek felt that intelligent spending would grow the economy more.  On savings, Keynes was negative, whereas Hayek said that moderate savings were valuable, and would facilitate future investment.
  • As for animal spirits, businessmen only get bold when they have sufficient free capital to act.  When interest rates are artificially low some businessmen invest, trusting that good times will continue.  Alas, those good times never last; avoid long commitments when times are good.
  • There are liquidity traps, but they occur when banking systems are broken due to misregulation.
  • “In the long run we are all dead.”  Well, Keynes, way to care for our progeny.  You had no kids, for a variety of reasons, but some of us care for how our children, and the nation that we love will do after we have died.

The video portrays a Goliath and David situation.  Keynes is dominant, and totally assured of his position in the world.  Hayek is less certain of himself, but certain in his message.

My wife and my kids have a better understanding of the current economic situation now than they did before the video came out.  I am grateful that the video was made.

I once wrote a post on university endowment investing that I thought was one of my better ones, but drew little attention.  It helped to inform another piece I wrote that was better received, The Forever Fund.  Okay, two more if you are a glutton for this kind of stuff: Liquidity Management is the First Priority of Risk Management, and The First Priority of Risk Control. (Note: university endowments had a lousy year ending in June of 2009.  Things may be looking better now, but with interest rates so low, university endowments are even more reliant on outperformance of equities and other risky assets.)

The key idea is this: understand what you are trying to fund before you begin investing.  When will the money be needed?  How much?  How realistic is the implied rate of return?  What if everyone with needs like yours tried to do this?  Would it work then?  Is the demand for investments that are optimal for entities with your liability structure greater than the available investments to be had?  Do you have some sustainable competitive advantage that few others have?

When I look at ideas like pension plans employing leverage (also here), I think they don’t know what they are doing.  Anybody remember how New Jersey decided to sell pension bonds and lever up their pension investments in risky assets?

That last article is timely, published today.  What began as borrowing $2.7 billion to plug a gap became a $34 billion gap.  Risky assets, particularly equities, did not perform.  Not only did they not earn enough to earn the actuarial rate needed to fund the defined benefit plan, they also had to pay interest on the pension bonds.

Trying to fill a funding gap via a more aggressive strategy is usually foolish.  If that were the best strategy, you should have been employing it already.

But consider the leverage angle more closely.  A defined benefit plan is by its nature a plan to pay out a stream of benefits over time to beneficiaries.   Typically they invest some of their assets in bonds that are shorter than the length of the stream of benefits they will have to pay.  Those bonds typically don’t earn enough to cover the actuarial funding rate, so they invest the rest in risky assets that they think that blended with the return on the bonds, will earn the actuarial funding rate or better.

There are at least three problems here:

  • It would be ideal to invest entirely in super-safe debt instruments that match the expected liability cash flows, but that would require too much in taxes from the citizenry.
  • But the moment that you move to funding some of the assets into stocks you open up two risks: 1) funding risk — what if the risky assets don’t perform to the degree needed? and, 2) Interest rate risk — the moment you are not matched there are risks if interest rates move against you.  This is usually a risk if rates move down.  It is rare for a defined benefit plan to buy enough long debt such that the value of bonds rises as much or more than the present value of the liabilities rise when interest rates fall.
  • Pension bonds, or any sort of investments with internal leverage have the potential to increase funding risk, and they increase interest rate risk as well.  Pension bonds add another fixed claim to the existing semi-fixed claim of the benefit stream.

Are we the double-down society as far as investing goes?  It sure seems like it, and if many entities do this as a group the failure of the idea will be spectacular.  Risk premiums are not high now; take a look at Jeremy Grantham’s forecasts on page 4 of this PDF (which has many other useful bits that you can learn from).  Borrowing money to invest when risk premiums are small is playing the exact same game as we were doing with CDOs from 2005 to 2007.  If the spreads are thin, pile on more leverage!  That will get us to our earnings target.

It’s sad to see this phenomenon reappearing.  Don’t we ever learn? :(


December 2009January 2010Comments
Information received since the Federal Open Market Committee met in November suggests that economic activity has continued to pick up and that the deterioration in the labor market is abating.Information received since the Federal Open Market Committee met in December suggests that economic activity has continued to strengthen and that the deterioration in the labor market is abating.No real change; they shade their views up a bit on economic activity.
The housing sector has shown some signs of improvement over recent months. Sentence dropped.  Area moved two sections down.
Household spending appears to be expanding at a moderate rate, though it remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit.Household spending is expanding at a moderate rate but remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit.No real change, though they shade up their certainty level.
Businesses are still cutting back on fixed investment, though at a slower pace, and remain reluctant to add to payrolls; they continue to make progress in bringing inventory stocks into better alignment with sales. Business spending on equipment and software appears to be picking up, but investment in structures is still contracting and employers remain reluctant to add to payrolls. Firms have brought inventory stocks into better alignment with sales. Unemployment unchanged.   They think they see more business activity in equipment and software.  Housing and CRE markets are getting worse, as opposed to the optimism expressed two sections above.  They think the inventory adjustment is done.
Financial market conditions have become more supportive of economic growth.While bank lending continues to contract, financial market conditions remain supportive of economic growth.Banks aren’t lending much, but corporate debt spreads have tightened.
Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.Shifts their overall view of economic activity upward.

Implies that no further actions are needed on a monetary, fiscal, or market basis in order to keep the recovery going.  So, why no greater change?

With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.With substantial resource slack continuing to restrain cost pressures and with longer-term inflation expectations stable, inflation is likely to be subdued for some time.Shades their certainty up on goods and services inflation remaining low.
The Committee will maintain the target range for the federal funds rate at 0 to ¼ percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, 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 ¼  percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.No change.  This gives you the trigger for when they will raise the Fed Funds rate.  As I said last month, watch capacity utilization, unemployment, inflation trends, and inflation expectations.
To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt.To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt.No change.
In order to promote a smooth transition in markets, the Committee is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter of 2010. 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.In order to promote a smooth transition in markets, the Committee is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter. The Committee will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets.No real change.  The end is in sight for purchases, which will be a new beginning.
In light of ongoing improvements in the functioning of financial markets, the Committee and the Board of Governors anticipate that most of the Federal Reserve’s special liquidity facilities will expire on February 1, 2010, consistent with the Federal Reserve’s announcement of June 25, 2009. These facilities include the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility. The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements by February 1. The Federal Reserve expects that amounts provided under the Term Auction Facility will continue to be scaled back in early 2010. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and March 31, 2010, for loans backed by all other types of collateral.In light of improved functioning of financial markets, the Federal Reserve will be closing the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility on February 1, as previously announced. In addition, the temporary liquidity swap arrangements between the Federal Reserve and other central banks will expire on February 1. The Federal Reserve is in the process of winding down its Term Auction Facility: $50 billion in 28-day credit will be offered on February 8 and $25 billion in 28-day credit wil be offered at the final auction on March 8. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30 for loans backed by new-issue commercial mortgage-backed securities and March 31 for loans backed by all other types of collateral.No real change.  This was all known in advance, though not in such detail.
The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth.The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth.No change.  A useless sentence.
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; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh. Voting against the policy action was Thomas M. Hoenig, who believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted.The regional bank governors change since it is a new year.  Hoenig has the guts to dissent.


  • Hoenig’s dissent is interesting, but not significant.  The regional bank presidents have lost a lot of effective authority since unconventional lending came into existence.
  • As has the Fed funds rate – so long as the Fed is buying long dated paper such as agency MBS, the Fed funds rate is not the pinnacle of monetary policy.
  • Watch capacity utilization, unemployment, inflation trends, and inflation expectations.
  • The FOMC shades up its certainty level on almost everything except real estate, where they seem to express more doubt.
  • They think the recovery has begun, and they are definite about it.

Before I begin, I want to tell all of my friends in Japan that I have a great love for their country.  I have not traveled much, but if I were to travel abroad, Japan would be my first choice.  Plus, I have many friends in Kobe, Japan.

Japan is at the leading edge of the demographic wave where many developed countries have a shrinking population.  But beyond that, Japan has high government budget deficits and a very high government debt.  Consider this graph from Bill Gross’ latest missive:

Japan is in the awkward spot of having high government debt, though much is internally funded, and is still running high government budget deficits.

What a mess.  I happened across a blog I had never seen before today, and it gave a simple formula for when government debts would tend to become unsustainable.  It was analyzing Greece, but I looked at it and said to myself: “What about Japan?”

The main upshot of the equation in the article about Greece is that you don’t want the rate your government finances at to get above the rate of GDP growth.  If so, your debt will increase as a fraction of GDP, even if your deficits drop to zero.

So, what about Japan?  Can we say two lost decades?

Oooch! 0.2%/yr average growth of nominal GDP?!  That stinks.  But here is what is worse.  The Japanese government  finances itself at an average  rate of 0.6%.  The debt is walking backward on them unless GDP growth improves.  No wonder S&P has put Japan on negative outlook.

Japanese interest rates could rise.  Like the US. Japan has an average debt maturity around 5.5 years.  Unlike the US, 23% of its debt reprices every year, which makes them more vulnerable to a run on their creditworthiness.

Here are three more links on the Pimco piece, before I move on:

We can think of central banks as equivalent to a margin desk inside an investment bank in the present situation.  Though I can’t find the data on the web, what I remember from the scandal at Salomon Brothers that led Buffett to take control, there was a brief loss of confidence that led the investment banks margin desk to raise the internal borrowing rate by 3-4% or so. Within a day or so, the trades expected to be less profitable of Salomon were liquidated, and Salomon had more than enough liquidity to meet demands.

But this is the opposite situation: what if the margin desk were to drop the internal lending rate to near zero?  Risk control would be hard to do.  Lines of business and people get used to used to cheap financing fast.  If it were just one firm that had the cheap finance, say, they sold a huge batch of structured notes to some unaware parties, it would be one thing, because after the easy money was used up, the margin rate would revert to normal, and so would business activities.

But let’s expand the paradigm, and think of the Central Bank as a margin desk for the nation as a whole.  Pre-2008, before the Fed moved to less orthodox money market policies, this would have been a more difficult claim to make, but the claim could still be made.

Pre-2008, the Fed controlled only the short end of the yield curve, which, with time, is a pretty powerful tool for making the economy rise and fall.  Short, high-quality interest rates move virtually in tandem with the Fed funds rate, but during good times, with the Fed funds rate falling, economic players seek to clip interest spreads off of longer and lower quality fixed claims, causing their interest rates to fall as well, with an uncertain timing, but it eventually happens.

And when Fed funds are rising, the opposite happens — funding rates for those clipping interest spreads rise, and the expectation of further rises gets built in, leading some to exit their trades into longer and riskier debts, which makes those yields rise as well, with uncertain timing, but eventually it happens.

I like to say that every tightening cycle ends with a crisis.  Let’s see it from an old RealMoney CC post:

David Merkel
1/31/2006 1:38 PM EST

One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

  • 2000 — Nasdaq
  • 1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed
  • 1994 — Mortgages/Mexico
  • 1989 — Banks/Commercial Real Estate
  • 1987 — Stock Market
  • 1984 — Continental Illinois
  • Early ’80s — LDC debt crisis
  • So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.

    But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it.

    Position: None

    Or, these two posts, which you can look at if you want… one suggested that housing was the next bubble (in 2004), and the other critiqued Bernanke’s reasoning on monetary policy.  (Aaron Task has an interesting rejoinder to the latter of these.)

    Things are a little different now, because the Fed is not limited to the Fed funds rate any more.  They have a wider array of tools, and the Treasury is in the act as well through the TLG program.  The Fed owns over $1.5 Trillion of longer dated debts, mostly residential MBS.  The Fed as the margin desk has itself become involved in clipping interest spreads, using its cheap short-term funding to buy longer dated paper, directly forcing long rates down.  The Fed may innovate in other ways as well, offering/receiving term financing as well as overnight financing via Fed funds.

    But, here’s the rub.  If the Fed brings the margin rate down to near zero and leaves it there, while actively creating expectations that it will stay there “for a considerable period,” and does so in a lesser way for long-dated paper as well, it can manufacture lower interests rates seemingly everywhere for a time.  It’s amazing how fast bond managers can shift from fear to yield lust.  (I leave aside the effects of foreign players for now.)

    But as I pointed out in my visit to the US Treasury, you can change the financing rate, but the underlying cash flows don’t change.  The margin desk drops the financing rate, and prior good trades look better, marginal trades look doable, but there are investments that are still losers at a discount rate of zero.  No way to help those.

    So what happens when the next crisis arises?  It could be commercial real estate, inflation, a war, a sovereign default (e.g., Greece, Japan, UK, Italy), another wave of corporate defaults, or, a very weak economy, with banks that are willing to clip spreads, but not take any significant financing risks.

    Back to Japan.  Two lost decades.  Debt walking backwards on them.  All of the Keynesian remedies they applied.  Government spending and deficits ultrahigh.  Interest rates ultralow.  Start with a government with little debt; end with a government that is the most indebted among developed nations.

    This developed world in Bill Gross’s “ring of fire” is pursuing the same strategies that Japan did over the last two decades.  They should expect the same results, until sovereign defaults begin.  Then the game will change — mercantilists like China will see their strategies blow up, and the nations that default will see their living standards decline.

    This has gotten too long, but one thing that I will try over the next few days is estimate Nominal GDP growth rates for nations in the “ring of fire,” and their Government’s financing rates.  If I find anything interesting, I will let you know.

    Final note: Ben Franklin at the Constitutional convention in 1787 commented that the half-sun on Washington’s chair was a rising sun, not a setting sun.  Though my title plays on a name for Japan, all nations in this predicament may find that their sun is setting as well.  Unwillingness to take short run pain in trading leads to failure in trading — even so, it is the same for nations.

    Insurance is probably the most complex industry as far as accounting goes.  Why?  When you sell the policy, you have a vague  idea of what the costs will be, and when those cash flows will occur.

    That leaves room for a wide variety of games as far as the accounting goes.  Because hitting operating return on equity targets is often the “be all” and “end all” of management reporting, one of the holy grails was taking capital losses and turning them into operating income.  Net result on income is zero, but it looks like you are making a lot of returns off of operations.

    At one company that I worked for, the new CEO want to great pains to declare how ethical the new CFO was.  I murmured to my boss, “Not ethical, but clever.”  He gave me a smile.  She had pulled that very trick, and if one reconciled the Statutory and GAAP accounting, the chicanery was obvious.

    At AIG, my managers were quite concerned about what went above the line and below the line.  If an accounting item didn’t figure into net income my managers didn’t care about it, even if it diminished shareholders equity.

    As an investor, this made me skeptical about income statements.  But if you don’t have an income statement, what do you do to estimate profitability?

    Well, you could look at the change in tangible net worth due to common shareholders, and add back dividends, including the value of spinoffs, and net money spent on buybacks.  That is what a shareholder earns, in book value terms.  Back when I was an analyst of the insurance industry, there were companies run by value investors that would present their returns that way showing the the growth in fully converted book value over time.  In a sense , Berkshire Hathaway does that as well, but it doesn’t pay a dividend, so it is simply the increase in book value.

    In the short run the market is influenced by net income due to common shareholders.  But there is a difference between the two measures of income, and I call the difference “cram.”  Cram is the amount of extra income reported through the income statements that does not makes its way through the balance sheet.

    That said, I have another measure that I nickname “jam.”  Jam is the amount of money gained/lost from buying back stock.  In general, when companies buy back stock they dilute value for investors.  Better to retain and reinvest.

    How do I know this?  I have been working on an accounting quality model, which is still a work in progress.  An aside, I have had my share of calls from consultants who tell me they have an earnings quality model that covers the whole market.  When they call me I ask them how they analyze financial companies.  I get the intelligent equivalent of a shrug.  The reason is that accruals on the financial statements of industrials and utilities are quite similar, but for financials, they are quite different.

    Here are some of the results of my model on the S&P 100:

    The data covers the last 4 3/4 fiscal years.  Why did I use fiscal years? Because data capture with companies is most complete at fiscal year ends, when they file their 10Ks.

    What did I find?  In general, most companies lose money off of buybacks, whether it is 24% of cumulative net income, or 32% of final tangible net worth.  Individual company performance varies a great deal.  More surprising to me was that cram on average was only 1% of cumulative net income.  Maybe GAAP isn’t so bad on average after all.  But averages conceal a lot of variation — I would not want to own companies that lose a lot of money off of buybacks, or those that inflate net income versus growth in tangible book.

    If buybacks ceased, companies might have a lot of slack assets on hand.  I know that companies keep themselves slim to avoid takeovers,  A large amount of slack assets invites others to come in and buy the assets to manage them.  Still, it seems that most buybacks waste the money of shareholders.  This seems to be another example of the agency problem, wheremanagers take an action that benefits them, but harms shareholders.

    I would be negative on both cram and jam.  Good companies don’t report earnings in excess of what shareholders obtain, and they don’t buy back stock except when it is cheap.

    Full disclosure: long ALL COP CVX ORCL PEP

    There seems to be some confusion over what threatened to cause major banks to fail.  Let me go over my list of the risks:

    • Many relied on AIG to insure their subprime and other structured lending risks.  Note: initially, when an insurer underprices a product dramatically and attracts a lot of business, the sellers of risk chortle, and say, “Sell away to the brain-dead.”  After it has gone on for a long time, a sea change hits, where they think — oh no, we’re the patsies — the industry now relies on the solvency of AIG!  Alas for risk control, and the illusion of the strength of companies merely because they are big.
    • As an aside, though I have defended the rating agencies in the past, please fault the rating agencies for one thing: the idea that large companies are more creditworthy than small ones.  Big companies may have more liquidity options, but they also take advantage of cheap financing to bloat in bull markets.  When the tide goes out — oh well,  GE Capital might not have survived without the TLGP program.  Another reason why I sold all my GE Capital debt when I was a bond manager.  Big companies can make big mistakes.  Instead, I bought the debt of well-run smaller companies with better balance sheets, lower ratings, and more spread.
    • Most of the real risks came from badly underwritten home mortgage debt, whether conventional (bye Fannie and Freddie), Alt-A and Jumbo, or subprime.  Underwriting standards slipped everywhere.
    • Commercial mortgage lending hasn’t yet left its marks — there is a lot of hope that banks can extend maturing loans rather than foreclose and take losses.
    • In general, banks ran with leverage ratios that were too high.  Risk-based capital formulas did not properly account for added risks from: securitized assets, home equity loans, construction loans, overconcentration in a single area of lending, the possibility that the GSEs could fail, etc.  Beyond that, there was a dearth of true equity, and a surfeit of preferred stock, junior debt, trust preferreds, etc.
    • The high leverage particularly applies to the investment banks, which asked for a change from the SEC and got it in 2004.  The only bank to not lever up was Goldman; Morgan Stanley did it only a little bit.  Guess who survived?
    • The Fed encouraged risk-taking by the banks by not allowing recessions to damage them.  They tightened too late, and loosened too early, and that pushed us into a liquidity trap.
    • Residential mortgage servicers priced their product in a way that could only work if few borrowers were delinquent.
    • Financial insurers took advantage of loose accounting rules, and insured more than they could afford.
    • State and local governments came to depend on increased taxes off of inflated asset values.

    What I don’t see is problems from private equity or proprietary trading.  These were not big problems in the current crisis, but the Obama Administration is focusing on these as if they are the enemy.

    Look, my view is that banks should be able to invest in equity-like investments up to the level of their surplus, and no more.  By this, I mean real common equity, not hybrid equity-debt financing vehicles.

    I believe that bank risk-based capital structures need to be strengthened.  I don’t care if it means that lending diminishes for a few years.  Far better tht we have a sound lending base than that we head into a Japanese-style liquidity trap, which Dr. Bernanke is sailing us into.  (He criticized the Japanese, and he does not see that he is doing the same thing.)

    President Obama can demagogue all he wants, and make the banks to be villains.  In the long run, what makes economic sense will prevail, not what scores political points.

    A senior aide to a Congressman emailed me regarding the debate on Capitol Hill.  I responded:

    Nell Minow knows what she is talking about, but this paragraph on page 5 is the money shot:

    But the key is the board. It is unfathomable to me that many of the very same directors who approved the outrageous pay packages that led to the financial crisis continue to serve on boards. We speak of this company or that company paying the executives but it is really the boards and especially their compensation committees and until we change the way they are selected, informed, paid, and replaced we will continue to have the same result. Until we remove the impediments to shareholder oversight of the board, we cannot hope for an efficient, market-based system of executive compensation.

    Pay can’t be reformed unless corporate governance is reformed.  Her suggestions above that are “mom-and-apple pie,” but they never get implented because boards are captured by their executives.  What she says on board reform after the aforementioned paragraph is crucial.

    Away from that, anyone structuring incentives quickly learns:

    1. Short-term incentives motivate more.
    2. Incentives based on what the employee can control motivate more than those he can’t.
    3. Cash now is preferred to anything else — it motivates more, unless there is tax deferral as a goal, or, inflation of apparent corporate profits, because the issuance of stock does not hit the income statement as a cost.
    4. Some incentives are near-guaranteed because there are goals of not destroying the firm through taking too much risk — those should disappear during a crisis.  In this case, they didn’t but they should have disappeared.

    That’s why Wall Street’s incentives were designed the way they were — they motivate to a high degree; that is the culture of Wall Street.  They should have cancelled bonuses because of the crisis — they would have if they had not been bailed out, which the Government stupidly did, and even then did it stupidly.

    If the government had merely backstopped the derivatives counterparties, while sending losses to the holding companies until they were insolvent, and running an RTC 2, rather than just handing cash to holding companies, this all could have been avoided.  The systemic risk would have passed — most firms on Wall Street would be in insolvency, and bonuses would not have been paid.

    The fault belongs mainly to the Fed and Treasury; they botched their jobs.

    Back to incentives — the four points above work best for companies when revenues and expenses of the business are short term in nature.  But when the results of business take a while to develop, like selling a life insurance policy, the accounting gets complex.  So do the incentives.  Life insurance companies typically pay agents most of their compensation in a lump at the sale.  There are limited clawbacks.  Other methods of compensating agents more gradually have been tried, and generally, they don’t work so well with making sales.

    But management aren’t salesmen — they should be bright and motivated on their own, or they shouldn’t have their jobs at all.  They shouldn’t need the “immediate gratification” incentives, and should be able to live with the eight reforms that Nell Minow suggests.  This is particularly true for financial companies, the the true results of activity will not be known for years.  Creating longer-term incentive structures will aid stability and improve managment of the firms.  The firms will be less aggressive, and that is good.  Aggressive financials almost always blow up.

    To close, if you want to see this happen, corporate governance should be changed, where boards cannot so easily be captured by their managements.  Otherwise, this issue will return.


    I am no fan of Ben Bernanke, longtime readers know.  There are many reasons to find fault with him:

    • His actions on the Fed while Greenspan was Chairman provided the intellectual support for over-providing liquidity to the market.  Dropping the Fed funds rate below 2% was indefensible.  All the economy needs is a small positive slope to the yield curve, and after a few years, the economy will normalize.  Steep yield curves work faster, but they encourage bad investments because when the yield curve is steep, many people will try to clip free income.
    • Rather than encouraging liquidation of broken financial institutions, he gave money to holding companies in exchange for ownership, with few strings attached.  The Fed should not have power to bail out any financial institutions; that power should belong to Congress or the Treasury directly, so that we can hold them accountable.
    • He resisted giving information regarding the bailouts by denying FOIA requests.  There is no good reason to avoid those requests.  The insurance industry has to reveal every asset, and material liabilities in aggregate.  The is no reason why the banks could not do the some thing.
    • He has been intellectually certain that the Great Depression occurred because monetary and fiscal policies were too tight, and a trade war disrupted commerce, rather than the more likely hypothesis that loose monetary policy led to an increase  in debts financing an asset bubble, and the Depression only ended when enough of the debts were extinguished (around 1941).

    To any Senator that might be listening (I dream), I would simply say this — it doesn’t matter whether Bernanke is reappointed or not because the greater question is reforming the Fed.  The Fed has a self-perpetuating nature, and resists real change.  The faces change, but it remains business as usual.  Would Congress consider:

    • adding Governors that are not neoclassical economists?  Bring real diversity of thought to the Fed?
    • slimming down the Fed so that it does not dominate research on monetary policy?  Employment of economists at the Fed is too big, and not justified by their output.  You could fire half of the people at the Fed, and there would be no effect on its effectiveness.
    • making the Fed solely responsible for all depositary institutions?  Note: I don’t like the Fed, but I do like accountability.  Let there be one institution responsible for credit, and one institution responsible for creating bubbles.  The Fed has created bubbles, and denies it.  No.  Let the Fed take care of credit, and when they blow it, hold them accountable.  Either fire those that made the bad decisions, or, move back to a commodity/gold standard.  It would constrain our government that attempts to mandate prosperity with out the power to do so and fails.

    Senators, if you need to vote down Bernanke for political reasons, there is no reason not to do so.  The American people will not think the worse of you for doing so, and while the markets may blip down, they will recover once a new Chairman is appointed.  Among conventional candidates, I would favor John Taylor, who formulated the Taylor Rule of monetary policy, which Greenspan and Bernanke violated.  Unconventional candidates?  Elizabeth Warren, Sheila Barr, Ron Paul, Barry Ritholtz, jck at Alea, and I could name many more people who understand our crisis better than Bernanke.

    PS — the same logic applies to Timothy Geithner; he is dispensable as well.  We think that the institution will change if we change the person at the top, but structural change is needed, refocusing or reducing the institution as a whole.  I could generate another list of complaints against Mr. Geithner, but truly, if he were gone. without structural reform, the Treasury would not change.

    I read Reminiscences of a Stock Operator around ten years ago.  I was trying to understand trading dynamics in the market, and the book was mentioned frequently.

    It is a classic.  But can a classic be made better?  In this case yes.  Jon Markman, an able financial writer, has written notes around the narrative, with pictures and graphs that illustrate many things that would be obscure to the reader of the book.  Markman brings forgotten people to life, and motivates the events that transpired.

    It was an exciting era, one where the common law of contracts played a greater role, and statutory law played a lesser role.  It wasn’t no-holds-barred, but it was close.

    We are experiencing our own era of leverage that is too high, and what happens when it breaks.  The protagonist of the book, Jesse Livermore, aims for best advantage, and learns as he goes along, going broke several times in the process, and dying broke as well.  Leverage cuts two ways.  Live by leverage; die by leverage.

    Paul Tudor Jones II writes an appendix to the volume, as well as a foreword.  Being a trading billionaire who started from scratch and went broke a few times, he is an excellent man to get into the mind of Livermore on a modern basis.

    Who would benefit from this book: Historians would benefit, as would those interested in trading.  Economists wanting to get a look at market microstructure would also benefit.  Livermore, more than most, gives a full view of technical analysis, because he lays bare the motivations of players, and how other players attempt to devine those motivations.

    If you want to buy this book you can buy it here: Reminiscences of a Stock Operator Annotated Edition.

    Full disclosure: Publishers send me books.  I review some of them.  I try to review the best of them, but I promise the publishers nothing.  If you click on a link that leads you to Amazon through my website, and you buy something, I get a small commission.  My view is that you should buy what you want.  Don’t reward me for something that you don’t like.  Rather, enter Amazon through my website and buy what you want; it will cost you nothing more.