The Aleph Blog » 2010 » February

Archive for February, 2010

You Can’t Cheat an Honest Man

Saturday, February 27th, 2010

An honest man knows that you can’t get something for nothing.  Discounts?  Sure, when warranted, but nothing is ever truly free.  Someone has to pay.

That is one reason why I have been skeptical about Greece and Goldman Sachs.  It would be really hard to trick an honest government into using derivatives in order to get into the EU.  Honesty requires full disclosure when the parties on the other side have asked for it, even if they are not checking too closely for their own reasons.

Which brings up another angle of the story.  If EU governments cared that much about the sanctity of the Euro, why did they not inquire more closely about derivatives?  Why is it a surprise now?  At the time when Greece entered the EU, the use of derivatives was well-known, why did the governments of the EU not challenge Greece, given its checkered history with respect to default.

Even if Goldman was marketing swaps to marginal European governments wanting to get into the EU, with many other investments banks imitating them, the governments weren’t dumb.  “What, we get to get into the EU, and all we have to do is pay a lot more 15-20 years from now?  That’s a deal.  (We will grow out of these promises.)”

Alas, but the growth does not come, but the debts come due.  As I often say, “you can’t cheat the cash flows.”  Income statements and balance sheets may lie, but it is hard to lie about cash flows.  Those are indisputable accounting entries.

Even if they did the swaps, I do not lay the major portion of the blame on Goldman Sachs, but on Greece.  Greece was the one in need, and they could have cut their budget, but would not do so for political reasons.  Now that trouble is back, bigger and badder than ever.

The same applies to Jefferson County, Alabama.  They played a variety of games to lower current costs, and assumed that it would be so for the future.  Fools.  You can’t get something for nothing.  You will either pay something in the future, or bear a risk that you do not understand.  Anyone who is mature enough to be a board member in the county had better be worldly wise enough to know that you can’t get something for nothing, and that advisors may have ulterior motives.

Did investment banks like Goldman Sachs take advantage of a bunch of rubes?  No.  They took advantage of politicians who were looking for a cheap deal, and were willing to cut corners in their due diligence.

You can’t cheat an honest man.  Honest men don’t cut corners, and they pay in full, on ordinary terms.  But those wishing for a low-cost way out of the political troubles on the cheap are great targets for those that want to cheat others.

More on Sovereign Risk and Semi-Sovereign Risk

Friday, February 26th, 2010

When does a sovereign or semi-sovereign government default?  I have seen three answers:

1) When debt is greater than future seniorage revenue (central bank profits) plus future debt repayments.  (Kind of a tautology, but what is implied is that if future debt repayments are onerous, a government would default.)

2) When the interest rate a government pays is greater than the likely growth rate of revenues. (I.e., if you are paying more than your revenue growth rate, the indebtedness will continue to grow without bounds…)

3) When the structural deficit is high, and total interest paid exceeds the size of the structural deficit.  (In that case, default would bring the budget into balance, at the cost of being shut out of the bond market.  But, given the situation, in the short run, being shut out of the bond market isn’t a problem.  There would be problems if the day comes when they need to borrow again; negotiations would begin over paying old debts.)

I will propose a fourth idea: governments can lay claim to a percentage of the GDP of their country/state/municipality.  How large that can be will vary by culture.  Beyond a certain point, attempts to take more than the natural limit for that culture will not result in higher revenues, because people will hide income, and/or leave the country/area.  When debts and unfunded obligations exceed the present value of maximum GDP extraction by the government, default is likely, the only question is when it will happen – when does cash flow prove insufficient?  Perhaps the earlier three rules can help with that.

Tough Time to be a Municipality

Revenue is declining for almost all states and municipalities.  Given the need to run balanced budgets (on a cash basis), and not having a central bank to fall back on, the problems are much deeper for States and Municipalities than for the Federal Government.  This report from the Rockefeller Institute shows how widespread the loss of revenues is.

But what should larger governments do for smaller governments in this crisis?  Oddly, the best answer is nothing, and even some of the Europeans recognize this.  Smaller governments need to grasp that they have to solve their own problems, and not rely on the Federal government to help – it has enough problems of its own.

So, if I had any great advice for strapped municipalities in California, or any other place in the US, one of the first things I would recommend is that you assume you aren’t going to get any help.  Those that could help you are in worse shape.  Such does the Pew Institute indicate.  Few states have their pension and retiree healthcare benefits funded.  They won’t have excess funds to aid municipalities, and my even compound the problem by reducing revenues shared with municipalities in order to stem their own budget shortfalls.

The Federal Government Won’t Be Much Help Either

The politics of the US are dysfunctional enough with opaque congressional earmarking benefiting local and special interests.  It will be yet more dysfunctional if states and municipalities ask the US Government for aid.  Besides, the US Government has issues of its own.  Tonight, it will release the 2009 Financial Report of the United States Government, somewhat behind schedule.  With all of the chaos, who could blame them for being late?  My suspicion is that when one adds up the explicit debts of the US Government and its unfunded obligations, it will add up to a figure near four times GDP.  If the US dollar were not the global reserve currency, we would have long ago slipped into chaos.

What would it take to make the US’s debt to GDP ratio stop rising permanently?  We would need to run surpluses of around 8% of GDP, if I understand the charts on page 5 right.  Absent some major shift in governing philosophy, that’s not even close to being on the table.

As I wrote in my seven part article, My Visit to the US Treasury, Part 5: After the meeting, I said to one Treasury staffer, “One of the quiet casualties of this crisis is that you lost your last bit of slack from the entitlement systems.”

“What do you mean?”

“Just this, prior to the crisis, Social Security and Medicare would produce cash flow surpluses for the Government until 2018.  Now the estimates are 2016, and my guess is more like 2014.  The existing higher deficit takes us out to the point where the entitlement systems go into permanent negative cash flow.  This means that the US budget is in a structural deficit for as far as the eye can see, fifty years or more, absent changes to entitlements.”

He looked at me and commented that it would be the job of a later administration.  No way to handle that now.  To me, the answer reminded me of what I say to myself when I go on a scary ride at Six Flags with my kids.  There is nothing we can do to change matters.  The only thing to adjust is attitude.  So, ignore the fact that you are afraid of heights, and enjoy the torture, okay?

Now, with interest rates so low on the short end, there is one further risk: that the Fed would keep rates low simply to keep  the US Government’s financing costs down.  As the Kansas City Fed’s President Hoenig said recently,

“Depending on your assumptions about the economy, that federal debt will grow at an unsustainable level starting immediately, or in a very few years,” Hoenig said. “We do have significant private debt, so that’s in place, so what worries me about that [is] that puts pressure on the Fed to keep interest rates artificially low as you try to deal with that debt.”

The US Government is in a tough spot financially, and if inflation rises (which is not impossible, consider stagflation in the 70s), its ability to continue to finance itself cheaply will erode.  On the bright side, the US is still viewed as a safe haven, so if there are troubles in Europe or Japan, the US will benefit from additional liquidity in the short run.

Back to the States

For another summary of how tough things are at the states, consider this piece from the Center on Budget and Policy Priorities.  Because many state budgets assume a better economy than they actually got, and some were quite optimistic, the average state has a 6.6% gap to fill as a percentage of its 2010 budget.  The gap projected for 2011 is 17% of the 2010 budget.  Not pretty, and if you want to look at it from a bottom-up perspective, this article offers a lot of links to the various emerging troubles.

One further wrinkle in the matter is Vallejo, California, which is in Chapter 9 now.  In the past, muni bond investors and insurers felt assured that in defaults by cities and counties that they would eventually be paid back in full.  With Vallejo, that may not happen; bondholders may have to take a haircut.  If that happens, and it establishes a precedent for Chapter 9 cases, yields will rise for cities and counties that can file for Chapter 9, in order to reflect the increased risk of loss.  Higher future borrowing costs will further burden city and county budgets.  There is no free lunch in the muni bond market.  (For more good articles by Joe Mysak of Bloomberg, look here.)

Conclusion – Why do I Write This?

This is a pretty gloomy assessment, but it is consistent with the deleveraging process that is rippling through the US economy.  All sorts of hidden leverage have been revealed including:

  • Reliance on optimistic economic assumptions in budgets.
  • Reliance on a robust housing sector.
  • Reliance on financial guarantee insurers.
  • Reliance on increasing leverage at banks, and sloppy underwriting of loans.
  • Reliance on Fannie and Freddie to absorb poorly underwritten mortgages.
  • Reliance on large pension and retiree healthcare promises to keep wages low, and not funding those promises to keep taxes low.
  • Reliance on high stock returns to pay for pensions.
  • Reliance on increasing debt levels in households.
  • Low bond yields make it difficult to invest for pensions.

And there may be other things we have relied on that may fail.  Banking crises often lead to financial crises, as is pointed out in the excellent book, This Time is Different.

  • The US government can always borrow more.
  • The Treasury and Federal Reserve can stimulate the economy out of any crisis.

My main message is that this is a serious situation almost everywhere in the US.  We have borrowed ourselves into a corner.  I write this so that all parties can understand the dynamics going on, so that when muni defaults happen, and the normal dynamics in the bond market shift, you won’t be surprised at the results.  Also, now you have links to a wide number of reports indicating how serious the problems are with Federal and State debts and unfunded liabilities, so that you can do your own digging on the topic.

Of Credit Ratings, Sovereign Risk and Semi-Sovereign Risk

Thursday, February 25th, 2010

This post was prompted by Barry’s article Credit Rating Firms: Worthless in a Bull market, Damaging in a Bear Markets.

When I was a bond manager, we had a rule for our analysts — ignore the rating, but read the write-up.  The analysts at the rating agencies would give their true opinion in the write-up.  The buy side analysts usually found themselves in agreement with what was written, and would tell us what they thought the rating really should be.

After that, the portfolio managers were encouraged to ignore the rating, except to calculate the yield haircut for the incremental capital employed.  Those doing structured products developed their own models for benchmarking the risks of deals, ignoring the ratings, but reading the reports, because there was often really good information on the weak points of deals, including things not mentioned in the prospectus.

As managers, we knew we could always find seemingly cheap bonds for a given rating, but they were “cheap for a reason.”  We would avoid them.  Who would buy them?  Collateralized Debt Obligations [CDOs].  In CDOs were run by mechanical rules that relied on the ratings of the debts, among other things.

As such, they tended to fail.  After seeing the debacle 1999-2002 in CDOs, most insurers swore off CDOs — aside from AIG.  They were structurally weak securities with lousy collateral.

-==-=–=-==-=–=-=

The rating agencies have a hard task.  In the old days, they said that ratings were good for a full credit cycle.  Bond managers wanted stable ratings, and didn’t want to be bothered with ratings that were higher in the boom, and lower in the bust.

In 2001, after Enron, the rating agencies took several actions to be more proactive about ratings.  Result: a lot of ratings moved down rapidly, led to a collective screech from bond managers.  Result 2: the rating agencies stopped being proactive.

Barry is mostly right that in a bull market, ratings are worthless, and in a bear market, you don’t need them.  But they do have uses:

1)  Many bonds have no one analyzing them — particularly small deals.  A rating helps create a buyer base.

2)  The bread-and-butter corporate ratings are usually pretty accurate.

3) They summarize a lot of useful data in a small space.

4) What the analysts write is usually pretty good.  They are reasonably good at ranking credits within a given class against one another.

The corruption occurred higher up in the firms, because they mis-set the ratings for categories as a whole.  CDOs too high, subprime CDOs way too high, Munis too low, CPDOs ridiculous etc.  Part of the problem is inadequate thinking and risk aversion about new asset classes, because they don’t have loss data for assets that have been bought to securitize.

I’ve written too much, but I will give you one more key lesson of the period 1990-2008 regarding ratings, and this applies to sovereign issues today: Ratings that must be maintained in order to avoid a given result are dangerous, and good bond managers avoid investing in such bonds.

Examples:

1)  Insurers that made their Guaranteed Investment Contracts [GICs] putable on ratings downgrades.  (Fixed rate failure early 90s [Mutual Benefit], floating rate late 90s.  [General American / ARM Financial])

2) Enron-like structures that would force issuance of preferred stock on a downgrade (and some other triggers)

3) Reinsurance treaties callable on a downgrade.

4) Swap counterparty agreements requiring more capital on a downgrade.

5) Step-up bonds, where more interest is paid after a downgrade — not worth it…

It is perverse to want more out of a company when they are downgraded — often it leads to a collapse.  As a bondholder, it does not pay to stand near cliffs where a downgrade can change the creditworthiness of a company.

Sovereign governments are the same way.  You can’t make them pay; the only big penalty is getting shut out of the bond market — which means that in the future, their budget would have to be balanced on a cash basis.  So, I offer one simple insight on sovereign risk — I suspect that sovereigns default when the interest payments are more than structural budget deficit.  At that point, it would pay for a government to default.  Of course, this would have to be a situation where the structural budget deficit is high, and there is little hope of bringing it down politically.

Now one could just print their way out of the situation, and hand fresh currency to creditors — but at a cost of high interest rates and inflation, which could crush economic activity in real terms.  Partially inflating to do it, and borrowing to make interest payments would face a similar hurdle, because the borrowing would likely be at higher rates due to inflation.

But States of the US, municipalities whose States don’t allow them to file for Chapter 9, members of the EU, and other Semi-Sovereign credits that don’t have access to a printing press have it tougher, but I think the same test applies.  If the structural budget deficit is high, but less than interest payments, the odds of a default rise considerably, because if they cease paying the interest, the budget is balanced.  Being shut out of the bond market does not matter at that point.

Now, there are still costs to defaulting.  Rare would it be for a government to stop being profligate after a default.  They would need the bond market back at some point, and then the negotiation over past debts would begin.  There would also be seizures of assets abroad.  There might even be economic sanctions.  If the defaulting nation is big enough, it could cause some bank failures, leading to a broader set of crises.  At some level of crisis, war is not impossible, improbable as that may be.

-=-==–==–=-=-=-=-=-=-=-=-=-=-=-=-=-=-=

Coming back full circle, I am reminded that corporate credits don’t typically default because they can’t refinance, they typically default because they can’t make the interest payment.  My opinion is that it is the same for sovereign debts, except that is more sturm und drang around it because of currency, political, and solvency of financial institutions issues.

So, what would be a good next step?  Create a table of Sovereign and Semi-sovereign debtors, estimate their structural budget deficits and their interest payments.  My question: has anyone done this already?  Is there a good place to look where the data is summarized?  Let me know any ideas in the comments, and thanks.

Three Years at The Aleph Blog!

Wednesday, February 24th, 2010

Three years at The Aleph Blog?  Has it been that long?  Yes, the Shanghai crisis is that far in the past, which foreshadowed our current troubles, though I denied it at the time at my new blog.

Why do I write here?  Is it for fame?  There isn’t much of that.  Money?  Sorry no, I make less than $3000/year off the blog; that does not justify my time.  My employer is pushing me?  Oh please, they would be happier if I did not blog, I think… eh, they like the notoriety, but would not want to pay for it.  Power?  What power?

Look, I write what I write because I believe it.  No other reason.  I write because I have had a strong impulse since the ’90s to find a way to give back to those who have/know less.  Everyone should do pro bono work in society.  It holds society together.

In general, I try to take a positive view of other bloggers, but I have no permanent favorites, though I have friends.  Politicians and regulators, not so.  They are almost all replaceable.  Our society needs change, and change will not happen without replacing the elites that govern us.  Vote out incumbents, and support third parties.  We need real change in America, not just the difference between the evil party (Democrats) and the stupid party (Republicans).

I write this partly from private criticism from other bloggers, who accuse me of writing for less than honorable motives.  Ugh, to quote that great moral philosopher Popeye, “I yam what I yam.”  There is nothing behind me.  I am not involved in politics in any deep way.  My blog does not make much money.  I write what I write for the sake of expressing my opinion.  That’s what I do.  I would rather that I lived in a less contentious era where I could spend more time on portfolio management issues.

So, what do I say after three years?  Thanks to my commenters, and thanks to my readers.  You are who I write for, and I thank you.  You have many things that you can do in life, but you deign to read me, and write about me.  Thanks ever so much; I do not deserve you.

To all of my readers: may the fourth year be the best of all!

David

PS — my apologies on e-mail; I get so much of it that I can’t get to it.  I want to reply, but am swamped.  Apologies.

Thoughts on my Last Two Posts

Wednesday, February 24th, 2010

Some follow-up on my last two posts.  I will be talking to those that suggested parties that would be willing to create a definitive bond blog.  But, others brought up a good point, which I am well aware of, but forgot for a moment.  The bond markets are mainly institutional.  Institutional bond investors have no lack of research sources to guide them.  Retail investors get ripped of, or are relegated to government bonds, ETFs, or mutual funds.  So, maybe creating a definitive bond blog would not be a good use of time?  Maybe, maybe not.

What is clear is that such a blog would have to be retail-focused.  It could not dwell on minutiae that would be valuable to institutional investors, but would have to deal with the hard problems that retail investors face with fixed income.

The alternative would be to try to do a blog for institutional investors and bright amateurs, and invite institutional investors to write pseudonymously — think of it as a Zero Hedge for fixed income, without so much attitude.  But would institutional investors read it?  They are inundated already.

Now, John Jansen himself has encouraged the idea, which I appreciate.  He did great work while he was at it.  Could we do as well or better?

Thoughts?  I am still game for this idea, write to me here.

=–=-==–==-=–==-=–=-=-=-=-==–==-=-=-=-=-=-=–=

How long to the point of no return?  I don’t know.  In all of the time that I wrote at RealMoney, I tried to point at directions, but not give timetables.  Giving timing is a mug’s game.

But let me consider some of the commentary that I have received.  My last two posts generated so much traffic that people were not able to access my site for a time.

Promises, promises.  What is a promise to pay worth?  All I know is that the more promises there are outstanding, the less a promise is worth.  The same applies to the Federal Reserve, who issues small-denomination short-duration 0% CP, otherwise known as currency.

Some say that so long as a primary dealer can “repo previously issued govt bonds at the central bank to gain reserves to purchase the new issue bonds at a Treasury auction, that nation can never default, no matter what the level of debt to GDP ratio is….” The effect of that is to raise interest rates.  Higher rates will harm the economy.  As more long-term promises are issued, the safety/value of a promise diminishes.  The same is true of short-term promises, but the effect is more immediate.

Which reminds me that nations with a lot of debt to roll over are most at risk.  There are others in worse shape than the US.  The US Dollar may be the best among bad major currencies, as I have argued on many occasions.  Also, banking crises tend to lead to sovereign debt crises.  The nation absorbs the losses of the banks, and then some fail as a result.

In a true free market, no one would care about currency levels.  They would take spot and future currency rates and factor them in as a cost of doing business.

The Keynesian solutions assume that growth will occur as a result of government spending.  I disagree.  In Japan, there has been no end of such spending, and from what I have read, that spending has not resulted in additional productivity.  Additional productivity only comes from projects that yield more benefits than their costs, and Japan has had more than its share of white elephants.

Throwing a brick through the window and having the glass repairman do his work may raise GDP, but the net worth of society is diminished.  True growth comes from entrepreneurs competing for advantage, and finding places where there are needs to be met.

That is one reason why I say that the deficit spending of the US is destructive.  It does not reflect the needs of people, but the needs of politicians currying favor with interest groups.  We need to shrink the US Government, so that it cannot meddle with the details of our lives.  Let it focus on defense, justice, internal security, and public health, goals worthy of a government.  Let local governments deal with other issues.

The budget troubles will percolate down to all municipalities.  It cannot be otherwise.  Local governments will toss out less needed actors, such as social workers, and retain those more needed, like policemen.  On the whole, society will be better off, as we reduce unproductive actors.

Growth matters a lot.  We need to focus on eliminating things that constrain the growth of the economy, without sending the government budget into greater deficit.  Let the US government reduce corporate welfare.  Let them eliminate the deduction for employee health care expense — that will shrink the health care sector significantly.  My view is that we need to eliminate all tax preferences in the economy, and tax people/institutions in their increase in value every year.  Get the government out of the social engineering business.  Let’s have true tax reform.  Let government do what it does well, and leave the rest to the people.

I recognize that I have a point of view here.  My contention is (aside from ethical issues) that when there is a high level of debt in an economy, that efforts to stimulate fail.  Better not to stimulate at all, ever.  Rather, focus on constraining credit, so that speculation does not overcome the economy, whether personal or corporate.

As for now, let us encourage short sales, foreclosures and bankruptcies, which eliminate debt.  Prices will reset lower, but predominantly equity-financed businesses will not fail easily.  Once the Debt/GDP ratio gets below 1.5x, the economy will grow on a healthy basis again.

Could We Create a Really, Really Good Bond Blog?

Saturday, February 20th, 2010

Across the Curve is gone.

Accrued Interest is gone.

I’m still here, but bonds aren’t my sole focus.  Long time readers know that I have a wide variety of interests in investing.  I sometimes think my following is smaller, because not everything I write appeals to my audience.  It is hard to predict what I will write about.

Are there other good bond blogs?  I haven’t seen any, but maybe my perspective is limited.

This post is a call to all who think they have something to say about the fixed income markets — do you want to try to create the definitive fixed income blog?  I would be willing to host and moderate it, but I would need bright, aggressive minds to write and explain to readers what is going on in fixed income.

Why?

The bond market is bigger than the stock market, and those that invest there are brighter in one sense — they have to make decisions over small differences yields, versus the safety of those yields.  They are dumber in another sense, because the rewards of managing equities are larger than that of bonds except at the largest managers.

So, I put out the call to those that want to write about the bond market.  Do you want to create one great blog?  Let me know, and maybe we can make a difference for those that need to learn about fixed income.  Remember, this is about giving something back.  We are paid well enough, but can we create something  useful for the broader investing public?

I have no idea as to whether this could work or not, but I welcome your thoughts.

How Long, To The Point Of No Return?

Saturday, February 20th, 2010

Alea posted a paper, and The Big Picture a slideshow on sovereign debts, by the same author.  We have had a blessed period post-WWII, where there have been no defaults of major nations.  But that is not normal.  Nations default on their debts if they get too large, or they repudiate through inflation, or they raise taxes on a docile public.

The main point of the paper is that we are past the point of no return in most major nations, without significant changes that would diminish living standards for some time.  Add the implicit obligations to the explicit debt, and there is quite a mountain to climb.  Defaults are coming, the only question is what nations will default.

I often think that economists need to get out of the math ghetto, and study history.  Math is not capable of capturing nuances.  I write this as one who uses advanced statistical analyses regularly.  History is more robust than mathematical analyses.  Math occludes understanding in economics because it forces a numerical simplification of matters that have more dimensions than are admitted in the analysis.

Are there doubts about this?  Here are some simple tests: How well do macroeconomic models forecast, particularly at turning points?  On microeconomics, what kind of R-squared are they getting when they test the general equilibrium neoclassical model?  Are many of the testable hypotheses are not rejected?  When last I looked, R-squareds were in the percentage single digits, and most testable hypotheses were rejected.

So why do we think that developed nations could not default on their debts?  The book This Time is Different, should disabuse such notions.   Major nations have often defaulted on their debts.  It is regrettable, sinful, but normal.

Personally, I think that all of the developed nations as a group have gotten lazy, and also do not realize the degree to which they are interconnected, particularly through their banks.  This is not a call for governments to reach out and help one another, but a yellow flag to say, “Don’t bail out other nations.  Focus on the effects on your own country; if you must do bailouts at all, focus on your local financial institutions, and then create risk-based capital rules that penalize foreign lending, and encourage diversification in what foreign lending is done.  This is logical in a credit-based system, because you only regulate one side of the transaction.

I am not arguing for isolationism in investing, but there is a tendency in the bull phase of the credit cycle to assume that nations don’t default, and so lending to sovereign credits that are weak becomes the trade of the moment.  Good regulation of financials limits the ability of those regulated to be yield hogs, particularly in the bull phase of the credit cycle.

-==-=-=–=-=-=-==-=–=

Nations are mortal.  They don’t last forever, historically, if they last 200 years, that is significant.  Even with nations that last so long, they can repudiate debts multiple times in their lives, though there is a cost — being shut out of the bond market for a time, until lenders forget.

So, what is the calculus on national default?  It is an option, but what influences the choice?

  • Willingness of public to accept more taxes.
  • Willingness of the public to accept reductions in services.
  • Strength of the economy.
  • Willingness of foreign creditors to buy more debt.
  • Willingness of locals to save through buying national debt.

Default happens when a nation gives up; they conclude that there is no way that they can pay off the debts incurred.

Nations have not given up so far, but unless economic growth increases significantly, there will be defaults in many places eventually.

My TIPS, Treasuries, and Inflation Model — III

Friday, February 19th, 2010

TIPS Treasuries and Inflation Model 3

Personally, I don’t think it is a big deal that the Fed raised the discount rate.  The discount rate plays a small role in monetary policy.  I do think that the record steep yield curve is the bigger story.

The forward Treasury yield curves at present are telling a story.  Here are the main ideas of the story:

  • Short interest rates will rise dramatically for the next 15 years then decline dramatically.
  • Same for inflation rates, but make that 17 years.
  • Real short-term rates peak 12 years out, but the same story.

For proof, look at these graphs that summarize the results of my model:

If you think short term inflation rates will be lower in the short run, then short short TIPS and go long nominal short bonds.

If you think that long inflation rates will be higher than the models indicates, then short long nominal bonds, and go long TIPS of similar maturity.

But after all of this I would simply say that the upcoming offer of the 30-year TIPS looks fairly priced in the “when issued” market.  I look forward to the issue of the 30-year TIPS, and I know it will improve my model.

Book Review: Diary of a Hedge Fund Manager

Friday, February 19th, 2010

This is a book that gives a feeling for being in hedge fund management, rather than a dry description of what needs to be done if you are in the rare position of being asked to manage a hedge fund.

The author was an ambitious guy.  Growing up in Canada, he wanted to play professional hockey.  He played ably in youth leagues, the minors, and college.  Making the pros was not to be.

So, what does a competitive guy do when he can’t pursue his dream?  He pursues another dream, managing money. He works hard, and gets one break after another, and eventually manages his own firm, which he sells out to a larger one.  He gets a plum job at a firm that proves less than patient with his current performance, and he gets let go.  Even that is a triumph for the author.  He starts his own firm, which is what he is still doing today.

Think of an analogy to sports — every player makes mistakes, but the best players recover from mistakes well and learn from them.  The author definitely got his share of breaks, both good and bad, but he responded to the bad breaks well, and came out the better for it.

Though this book is about hedge funds and other areas of investing, really, this book is about the author.  It tells his story, and as the story gets told, you pick up incidental points along the way:

  • What is it like to be an intern at a trading firm?
  • How do you learn as you go?
  • What was it like inside CSFB during the dot-com bubble?
  • How to interview management teams to get an edge.
  • How to sense if someone is lying.
  • In general, the Fund of hedge funds operators are not desirable clients.
  • Get a sense of the strength of consumers
  • Get a sense of the three time horizons — days/weeks, months, and years.  (He uses other terms than this, but I appreciated his logic here, because it seemed a lot like what I did as a corporate bond manager.  Have a sense of short-term momentum, medium-term trend and long-term mean-reversion.)
  • Very good to good means sell
  • Very bad to bad means buy
  • The value of keeping a trading journal, and reviewing performance.
  • Be careful who you do business with, because eventually they may show you the door for less than good reasons.
  • Surviving the credit bubble’s bust.  Buying back in when people are panicking.

The book runs 204 pages, but roughly 30 don’t have much on them.   The book is breezy, and though I mentioned a lot of things that I got out of the book, readers less familiar with the subject matter might miss some of the points.  He does not spend a lot of time on the details. On the other hand, a reader less familiar will get a feel for what it is like to be a part of a fast-paced area in investments.

Who would benefit from the book:  Those that would like to read the tale of an interesting guy who had a tiger-by-the-tail initial career in investments.

If you want to but the book, you can get it here: Diary of a Hedge Fund Manager: From the Top, to the Bottom, and Back Again.

Full disclosure: The publisher sent me this book. They send me a lot of books, and I review as many as I can. I don’t like every book that I receive, but typically I review the ones that seem the best, and let the rest pile up. Anyone entering Amazon through my site, and buying anything, I get a small commission, but your price does not go up. Such a deal.

PS — the blog for the author’s firm is here.

A Question of Cultural Failure (II)

Wednesday, February 17th, 2010

Good cultures balance short and long-term goals.  Focusing too much on the long-term can lead to overinvestment, and problems like Japan still faces.  Focusing on the short-run can lead governments and companies to focus on manipulating budget and earnings numbers to fulfill their own selfish ends.

At present, we have no surplus of long-termism, but a surfeit of short-termism.    Many economic players have decided that it is in their interest to play for time  — make things look good in the short run, and maybe a magical fix will appear for long run problems.

It seems that the EU thinks that if they can make Greece behave, that all will be right.  Well, tell that to those that protest in Greece.  Let each EU nation rather take a step back and ask, “What is cheaper in the long-run, bailing out Greece, or bailing out my banks with Greece exposure?”  The latter is probably cheaper, but not certainly so.  Given the lack of unanimity, the situation would lean toward bailing out domestic banks, because bailing out Greece requires the cooperation of separate nations, many of which have electorates that strongly oppose a bailout of Greece.

But, that could mean a virtual dissolution of the Eurozone.  Not necessarily.  You could end up with a lot of nations in default, and shut out of the bond markets (the PIIGS), while the rest do seemingly fine, as they quietly bail out their banks.

In that situation, the Euro would still exist, and might continue to be the currency of nations that are in default.  They just could not borrow any more at any rate in Euros, and perhaps not in any currency.

But the Eurozone itself would be in tatters, at least from a marketing standpoint.  What is good about being in the Eurozone?  Free trade?  Well Britain has that, even though they are a basket case, at least they control their own destiny, sort of.  The veneer that being in the Eurozone means that you are a high quality borrower is shattered.  Credit spreads over the German Euro benchmark will be high indeed for nations that have been undisciplined in their finances.

-==-=-=–=-=-==-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

People and governments like stasis.  No change.  Why?  It makes policy simple.  If something is in trouble, give it aid.  But — what if the trouble is an indication that people don’t want what is being produced by the one that is in trouble?  Capitalism is wonderful because it is dynamic. It can quickly adjust to changing conditions, unlike socialist bureaucrats.  Rather than volatility being a negative, with capitalism it is a positive.  It shows that the economy needs to change, that losses on prior bad investments should be recognized.  Failure to see things like this lessens the flexibility of the economy, and makes the eventual adjustments much larger than they would have to be if we did not interfere in the economy.

Now, this applies all over the world.  China is creating some of the biggest white elephants in history, so it seems.  Like Japan in the late 80s, they are building up useless industrial capacity.  Naive Keynesianism says that it does not matter what one spends money on, what matters is that the money gets spent, and quickly.

We may as well throw bricks at every window we see with that logic, knowing that GDP will record that glassman’s wages, but will not record the loss from a broken window.

Alas, we have too much automotive capacity, so we support automotive firms in the US.  We have too many bankers and too much capacity to build homes, so we support that as well.  Far better that we let firms fail, and let the assets be released to better uses.  Why waste your life or capital in an industry where there is not enough demand?

-==–==-=-=–==-=-=-=-=-=-=-=-=-=-=-=-=-

In one sense, my claim of cultural failure boils down to not being willing to recognize losses.  In another sense, it is using the political process to invalidate economics.  Why should the government bail out company A and not company B?

The present political climate in the US could be summarized as a question of fairness.  Why should some benefit from bailouts, and not others?  There should be some answer here that doesn’t sound lame.  Lame answer: we were protecting the whole economy by protecting banks.  Better answer: we goofed in protecting the banks.  We should have let them fail, and bailed out depositors.  Don’t bail out anyone; let housing prices drop until ordinary people can afford them.  But if you must bail out, go down to the lowest level, and bail out those with mortgages, which will benefit not only them, but everyone above them.

This leaves aside moral hazard — all bailouts are a mistake.  Far better to let all fail, and let the system reset.  Run a hard culture where failure is punished.  That will cause people to avoid failure with greater assiduousness.

I will have more on this in the likely final segment for this topic.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

 Subscribe in a reader

 Subscribe in a reader (comments)

Subscribe to RSS Feed

Enter your Email


Preview | Powered by FeedBlitz

Seeking Alpha Certified

Top markets blogs award

The Aleph Blog

Top markets blogs

InstantBull.com: Bull, Boards & Blogs

Blog Directory - Blogged

IStockAnalyst

Benzinga.com supporter

All Economists Contributor

Business Finance Blogs
OnToplist is optimized by SEO
Add blog to our blog directory.

Page optimized by WP Minify WordPress Plugin