## Trillusions

My article on Dr. Shiller’s idea of Trills was warmly received in some quarters, and not in others.  Though I think Trills are a very bad idea for financing the US Government (though I think the US Government is not creative enough in its financing plans), there is one thing that I do agree with Dr. Shiller on — the price of Trills.  He says they would trade near \$1400 — a 1% initial yield.  My view of a 1.06% initial yield largely agrees — the bond math is the bond math; we can argue about assumptions, but given the assumptions, there is only one answer.  Comments about risk premium miss the point.  Yes, we don’t know the future growth of the economy, but pricing assumes a growth path.  Also, these are US Treasury securities — default risk is nonexistent in dollar terms, right? 😉

Why are Trills a bad idea?  First, they seem cheap because of the low initial yield, but they aren’t cheap because the interest rate grows exponentially.  Assuming 3.4% average nominal GDP growth, the coupon doubles every 21 years, forever.  Suppose we issue a Trill in 2010, and we get a 1% coupon like Schiller suggests.  What will future coupons be?

• 2031 — 2%
• 2052 — 4%
• 2073 — 8%
• 2094 — 16%
• 2115 — 32%
• 2136 — 64%
• 2157 — 128%

And so on.  Unlike ordinary bonds, the price for calling the issue grows along with the coupon, so there is no escape.  The best that can be said is that Trills would guarantee the default of the US Government if issued widely enough.

But now for the illusion of Trills.  Because they pay one one-trillionth of GDP each year, some deem them to be the equivalent of owning one one-trillionth of the US economy.  Oh no, they are far more valuable than that.

The US economy is subject to all manner of risks, risks that are higher than that of the US Government paying on its debts.  Whether thinking of all the producers in aggregate, or all of the consumers in aggregate, the average cost of capital is a lot higher than what the US Government could borrow at in perpetuity.  Rather than evaluate the Trills at the rate of the US Government at 4.4%, I think the proper rate is more like 7%, give or take a percent.  You might think 7% is too high, but there are significant risks to growth in any economy from government intervention, plague, war, famine, etc.  At 7%, the value of a trill drops from \$1400 to \$400.  The difference is the guarantee of payment by the US government, rather than the economy as a whole, so long as the US Government is solvent.

And, that is another significant difference.  If the US government is ever credit impaired, Trills will cease to be a share of one one-trillionth of the US economy.

I have suggested before that Dr. Shiller is more creative than the markets will allow.  Derivative instruments are facile creatures — we can dream up anything, but what derivatives the cash markets will support is another matter.  Shiller’s housing ETFs have gone away.

Trills are government bonds, should they ever be created.  They are not shares in the US economy.  That distinction is significant to the value of the securities, and the effect on the republic of the United States.

1) There is a new blog that I recommend: Macroeconomic Resilience.  I have commented there recently, and I think that he understands the complexity of markets in ways that most Ph. D. economists don’t.  Here is a recent post, and my comment.

http://www.macroresilience.com/2010/01/01/moral-hazard-a-wide-definition/comment-page-1/#comment-6

One job ago, at a hedge fund that was bearish on financials, we would talk about this all the time.  Regulators could have stopped the crisis in the early 2000s had they simply enforced lending standards.  The banks would have screamed and ROEs would have gone into the single digits, but the crisis could have been prevented.

But, regulators are to a degree subject to politicians.  Politicians, in the absence of any moral compass aside from re-election, are mainly beholden to those that fund their campaigns, when the electorate is without education, or a moral compass as well.  Thus, regulations were neutered.

After that, how many businessmen would watch out for the companies they served, instead of what would maximize their pay?  There were some bankers that did so and got shown the door.  There were other banks owned privately, were conservative, and missed the crisis.  It could be done, but the management team or owners had to deliberately sacrifice the short run in favor of missing an uncertain crisis.

Chuck Prince said something to the effect of “When the music is playing, you gotta get up and dance.” to justify doing business in the face of bad credit metrics.  Well, yes, in a place where no one cares for the long-run health of the firms, or of society as a whole.

Someone has to care for the long run.  Better it be free individuals rather than the government.  But if free individuals will not do it, eventually the government will.

2) I have been a fan of Michael Pettis for many years, from his publication of his book, The Volatility Machine.  Here is a comment that I posted at his blog, which I highly recommend:

Michael, I ordinarily agree with you on almost everything economic, but I can’t agree on the trills. I believe in asset-liability matching, even at the government level. Try to match term risk and liquidity risk to what is being funded.

I have argued that the debt structure of the US government has been getting too short, and recommended that the US Treasury lengthen its funding policies — I even said that to the Treasury officials that I met with in November.

http://alephblog.com/2008/11/25/issuing-debt-for-as-long-as-our-republic-will-last/
http://alephblog.com/2009/11/04/my-visit-to-the-us-treasury-part-2/ (2 of 7)

But trills have exceedingly long duration — the remind me of some structured settlements that I have had to model, but these are perpetuities — even longer for the coupon to grow. Duration looks like it would be north of 40 — it depends on the assumptions used.

A perpetuity growing at GDP rates saddles our posterity with debts that they cannot bear. Cheap debt up front — really costly on the back end.

http://alephblog.com/2009/12/27/not-so-cheap-trills/

But, thanks ever so much for your blogging. I learn so much from you. Keep it up.

3)  Insurance for those dropping out of school?  Sounds really dumb:

http://blogs.wsj.com/economics/2009/12/31/would-insurance-for-college-failure-keep-more-students-enrolled/

This sounds like a product that only dumb insurers would write. Never write insurance where the insured has better knowledge and more control than the insurance company.

4) Many are crying over auction rate preferred securities.  But most of the assets that were harmed were owned by corporations, who had investment professionals that chose auction rate preferred securities because they yielded significantly more than money market funds, but with seemingly little risk, and the system worked for around 20 years.

They took above average risks, and now they expect to be bailed out?  I have read through many ARPS prospectuses.  For those that read them, the risks were clearly disclosed.  I do not have a lot of sympathy for those that did not do their job.

5) From the “bitter taste” zone, we learn that foreign investors in US debt lost the most versus investing in the debt of other developed nations in 2009.  Should that surprise us when demands for loans accelerated dramatically in 2009?  I don’t think so, and most reasonable analysts would agree.

## Yield = Poison (2)

My first real post at the blog was Yield = Poison.  In late February 2007, prior to the blowup in the Shanghai market, I felt frustrated and wanted to simply say that every fixed income class seemed overvalued.  Short and safe seemed best.

It reminded me of a discussion that I had with a colleague two jobs ago, where in mid-2002, the theme was “yield is poison.”  I did the largest credit upgrade trade that I could in the second quarter of 2002, prior to the blowup of Worldcom.  Moved the whole portfolio up three notches in four months.  Give away yield; preserve capital for another day.

I feel much the same, but not as intensely in the present environment.  Spreads could come in further if the government keeps providing low cost liquidity to those who make money on the spread they earn on financial assets.  But most fixed income assets do not reflect likely default costs.  Perhaps the long end of the Treasury curve is worth a little allocation of assets here, if only as a deflation hedge, but if the Fed is going to start lightening up on their QE, and the Treasury will be having high issuance, I might want to stand back for a while  while supply will be high, and try to buy near the end of the quarterly refunding.

There is another sense in which I say “yield = poison,” though.  When rates for safe assets are low, retail and professional investors are both tempted to stretch for yield.   Wall Street is more than happy to deliver on your desire for yield.  It is their top illusion, in my opinion.

Two examples from my bond trading days: the first was some local brokers asking to buy a small amount relatively highly-rated junk bonds from us.  They were offering a full dollar over the usual market price.  They called me, since I ran the office, but I handed them over to the high yield manager, who said, “Jamming retail, are we?”  [DM: placing overpriced bonds in customer accounts.]  After a lame reply which amounted to,”Look, don’t ask us about what we are doing, we’re offering you a good deal, do you want to sell your bonds or not?”  the high yield manager sold them a small amount of the bonds, and we didn’t hear from them again.

The second example was when a bulge bracket firm called me and asked me if I owned a certain very long duration bond.  I said yes, and he made me an offer several dollars above what I thought they were worth.  With a bid that desperate, I said I could offer a few there, and more a little back, but for the block he would have to pay more still.  He offered something close to the “more still” price, and I sold the block to him there.

As we were settling the trade, I asked him, “Why the great bid?”  He said, “We need the bonds for retail trusts.  They get an above average yield, but if rates fall, after five years, we buy them out at par, and keep the bonds.  If rates rise, they take the loss.”

Even on Wall Street, if you have a good relationship, you get an honest answer.  That said, it made me sorry that I sold the bonds, even though it was the best thing for my client.

There are many ways to frame the yield question at present, here are two:

• You are on a fixed income, and you are having a hard time making ends meet.  Should you lend longer to earn more, go for lower rated credits, or do nothing?
• You are earning almost nothing on your money market fund.  You need liquidity, but where else could you invest it?

I would be inclined to buy a mix of foreign-denominated bonds, but most people can’t deal with that.  So, I would advise them to build a “bond ladder” where they have high quality issues maturing every year for the next 10 years.  As each bond matures, I would use the proceeds to buy bonds ten years out, re-establishing the 10-year ladder.

But don’t reach for yield.  Odds are, you will get capital losses great than the excess yield you hoped to receive.  And remember this, don’t buy products someone else wants to sell you.  Specifically, don’t buy high yielding investment products that Wall Street sells to enhance your income.  They prey upon those who want more money, and are weak in their knowledge of how the markets work.

To professionals: don’t reach for yield now; long-run, you are not getting paid for the risks.  You have seen how illiquid structured products can be in the face of credit uncertainty, and impaired balance sheets of holders and likely purchasers.  You have seen how spreads can blow out (bond prices fall), and roar back in (prices rise again) in the absence of safe places to invest money.

I’ll give the Treasury and the Fed this: they have created an environment where savers are punished, and have to take significant risks to get yield.  They have created a situation where the markets are dependent on subsidized credit, and speculation dominates over lending to the real economy.  They are pushing us deeper into a liquidity trap, as low-to-negative return investments in autos, homes, and banks get supported by cheap public credit, rather than getting reconciled in bankruptcy, so that capital can be redeployed to higher returning projects.

Anyway, enough for now — more later.

## Happy New Year

Happy New Year.  I would like to begin by thanking my readers for supporting me in 2009.  Let us hope and pray that 2010 will be even better.

That said, the investment grade corporate bond market, the junk bond market, and the bank loan markets can’t have a better year in 2010.  Rates would have to go below Treasuries, perhaps even to zero.  Also, it will be tough, but not impossible for stocks to manage a gain better than 26.5% gain in 2010.  But it would require stellar corporate earnings amid continued low financing rates, with no significant continuation of corporate defaults at a high level.

I don’t hold this view with a ton of confidence, but today’s selloff was supposedly due to the Fed deciding to consider selling some of the bonds that they have bought over the last six months or so.  I’ve said before a number of times that it is a lot easier to begin an easing program than end one.

The quantitative easing was a way of buying bonds expensively, which would hold down rates in the process.  The bond market ran in front of the Fed, pushing up bond prices, figuring (correctly) that the Fed was a forced buyer.  As the end of the process drew near, bond investors sold as the Fed began buying their remaining bonds.  Now the Fed thinks of selling.  Well, even with the yield curve near record levels of steepness, it could get steeper (though probably not by much, I get the weird feeling that something will break, but I don’t know what).  Once it becomes evident that the Fed has shifted from buy to sell mode, some bond investors will start shorting the market.  Given the record financing schedule that the Treasury will be doing, there will be a lot of supply hitting the market.  The yield curve steepness anticipates much of this, but there will be a very negative tone if the Fed and Treasury are selling bonds at the same time.

This makes the recent actions with Fannie & Freddie more understandable.  Fannie and Freddie can take losses on mortgages, and the losses get passed on to the US Government, eventually.  Losses on bad housing debt gets turned into additional government debt.  (Wonderful, not.) The US Government can use Fannie and Freddie to try to reflate the housing market, at least the lower end of it.

The trouble with all of this is that we are bailing out less productive assets, and taxing more productive assets to do so.  We don’t need more housing, banks, or autos.  We have too much capacity in those areas.  Bailing them out is a recipe for stagnation, a la Japan.  Handing over investment decisions to the government is an utter and total waste of resources.  The role of government in the economy should be to punish theft and fraud, and prevent them where they can.  Assuring prosperity is not possible, so don’t try to promise it, much less attempt it.

I think the Treasury and Fed are trapped.  They will have a really hard time removing the stimulus, because they don’t want to raise interest rates.  Banks have become more reliant on low rates since quantitative easing started.

Then there is China.  Because they own so much of our debt, they are the prisoner of the US.  If the US were to default, their financial system would likely fail.  China is running a bubble policy of its own, and real estate prices are rising, though the ability to service debt is rising more slowly.  As with the Fed, forcing rates down can work for a while.  But only for a while.  Some of that bubble extends to the US, sucking in our debt to keep their currency cheap.  Dumb as a rock, but hey, we get cheap goods, and they get expensive debt.

There is an endgame here, but I do not know the what or the when.  The US Government could default only on external debt.  Hey, if Argentina can do it, so can we, and don’t think that the US Treasury isn’t drawing up contingency plans for that even now.  What could be more a more fitting end to being the world’s reserve currency than to default in the end, but protect their own citizens, and send a large portion of the global banking system into insolvency, aside from that in the US?  Truly perverse, after the way the US has gamed the system so far.  Who knows, after such a crisis, the new US Dollar might seem to be the best possible global reserve currency, but I doubt that would happen when wounds are fresh.

Anyway, here is to a great 2010.  May all of your debtors pay you full value.