I’ve said this before in different ways, but I will say it once more, “Governments are smaller than markets; markets are smaller than cultures.”  The reasoning is simple:

  • Governments can only control a fraction of what an economy or culture does.  Governments that are overbearing on an economy or culture may gain greater proportional control, but the size of the pie will shrink.  More of the economy or culture goes into hiding, away from the prying eyes of the government.
  • Markets only express a fraction of what mankind does.  They cover the tradeable aspects of what we do, but typically do not give us our deeper goals or desires for ourselves, and the culture as a whole.

When I look at the biggest economic problems facing the world today, many of them stem from deeper cultural problems.  Let’s start with the current poster child, or, canary in the coal mine, Greece.

Greece got into the Eurozone via subterfuge; they lied about the true status of their indebtedness, and Wall Street (with its counterparts in European investment banking) helped them do it.  So did a number of the other nations in the Eurozone that are presently under stress.

Now, the core members of the Eurozone wanted the Euro to grow as a currency — they were committed to an ever-wider and -deeper union.  The dream of a united Europe made them willfully blind to the low probability that the nations which were fiscal basket cases had genuinely changed.  The core should have been skeptical, and now they are paying the price, though not paying any money, yet.

The core nations that could pay or guarantee to help Greece are playing a tight game.  They act as an internal European IMF, insisting on reductions in the Greek budget deficit.  Greece does its part by saying it hasn’t asked for aid, which is unlikely.  At the same time, reductions in the Greek budget deficit bring the competing political factions inside Greece out in force.  Protests!  Strikes!  There are few arguing for what is best for Greece overall, and many arguing for a larger piece of what is a shrinking pie.  In a situation like this, it might be better for outsiders to let Greece fail,but they won’t do that.  Why?

The banks in the core nations can’t afford a default by Greece if by contagion it leads to defaults in Portugal, Spain, Italy, and Ireland.  A failure of the banking system does not conduce well to maintaining power for elites.

I have already talked about the perverse incentives for the core European nations to do anything to support Greece.  If Europe was rational, they would abandon the experiment now, or press for a Federal Europe akin to the US.  I don’t see either happening — I just see slow suffering for now, and futile playing for time.

Dubai is a place where anything can get done.  Anything indeed, but who pays the bills?  Dubai is a place of big ideas and little responsibility.    It is a moral flaw to bite off more than you can chew, particularly if you do so on behalf of others.

Many US States and Municipalities are in a world of hurt, because they compromised their long-term financial position to solve short-run budget crises.  That is the nature of the crises that we face today.

The same is true of the current US government — they fight for short term political advantage, rather than the long term good of the nation.  Who will favor the long-term and sacrifice for the greater good?

A simple summary statement here is “Greed is not good.”  Societies that are willing to sacrifice self interests have a much better probability of succeeding than societies that pursue self interest.

That’s all for now, I will pick this up in part II.

Debt levels in an economy matter.  They matter a lot.  An economy that is financed primarily by debt can be like a chain of dominoes.  If one fixed claim fails, and it is large enough, many other fixed claims that rely on the first claim could fail as well, triggering a chain of failures.  This is a reason why a fiat-money credit-based economy must limit leverage particularly in financial institutions.

Why financial institutions?  They borrow and lend.  They also lend to other financial institutions.  A  big move in the value of some assets can make many banks insolvent, and perhaps banks that lent to other banks.  The banks should have equity bases more than sufficient to absorb losses at a 99% probability level.  That means that leverage should be a lot lower than it is now.

Economies are more stable when they limit fixed claims and encourage financing via equity rather than debt.  Imagine what the economy would be like if interest was not deductible from taxable income, but dividends were deductible.

  • People would save money to buy homes, and would put more money down when they borrowed.
  • Corporations would lower their debt-to-equity ratios, and would pay more dividends.
  • Fewer people and corporations would go broke.

Pretty good, but in the short run, the economy would probably grow slower.  The debt bonanza from 1984-2006 pushed our economy to grow faster than it should have, where people and firms took more chances by borrowing more, and making the overall economy less resilient.  Debt-based economies lose resilience.

What was worse, the Federal Reserve in the Greenspan and Bernanke years facilitated the debt increases because the Fed never took away the stimulus fast enough, and offered stimulus too rapidly.  This led to a culture of unbridled debt and risk-taking.  If only:

  • Greenspan had been silent when the crash hit in October 1987.
  • Greenspan had not given into political pressure in late 1990, where he set up a process of cutting interest rates too much.
  • Greenspan had not cut rates in 1995.
  • Greenspan had not cut rates during the LTCM crisis.
  • Greenspan would have cut far less 2000-2002.
  • Instead of tightening 1/4% at a time 2004-6 , they would have raised the rate far more rapidly, completing the rise in one year.
  • Bernanke would not have let the fed funds rate go to zero, but would have limited fed funds to never go lower than 1% below the ten-year Treasury yield.  We never need more than that to stimulate, but some patience is necessary.

What’s that you say?  The economy would have grown more slowly?  Right, and the economy should have grown more slowly, rather than gunning the engine through the overaccumulation of debt.  As it is, the economy will grow more slowly for some time a la Japan, until we delever the economy enough that it can once again grow without stimulus.

The economy is at a fork in the road.  Do we:

  • Leave rates low and leave quantitative easing in until price inflation unfolds?
  • Let rates rise gradually and drain quantitative easing slowly?
  • Raise rates significantly and drain quantitative easing rapidly?

The third view is off the table.  No one wants to see any failure.  Bad decisions of the past must be grown out of, even if it takes a long time of subpar growth to do that.

When Eastern Europe left the Soviet orbit, the countries that did the best were the ones that freed their economies most rapidly.  Well, not in the short-run.  Letting companies fail is always a drag in the short run, but in the longer-run it leads to faster growth, because bad investments fail, and are replaced by better investments.

The same is true with monetary policy.  The US grew faster during periods where failures were reconciled and liquidated, rather than attempting to smooth the economic cycle — leading to fewer failures in the short run, much but bigger failures when the amount of debt became too large.

Before the crisis, when I was writing at RealMoney.com, I usually encouraged taking the less risky macroeconomic route, suggesting policies that would not increase debt levels.  The trouble was, that all of those ideas were losers in the short-run, and so they were not followed.  In the long run we are all dead, leaving the failures of short-run policies to our kids.

Personally, I would raise the Fed funds rate to 2% immediately, and let it shadow the 10-year rate less 1% thereafter.  But no one likes jolts, except when the Fed is loosening.  After that, I would rather the Fed allow inflation to raise collateral values and end the home and commercial mortgage crises.  But no, what we are likely to get is a Japan-style muddle-in-the-middle where they struggle with a slow raising of rates, and a slow end to quantitative easing, with a premature giving in when the economy has a negative burp before the removal of policy accommodation is complete.  I expect us to move in the direction of Japan.

What may change the story are sovereign defaults as government debt levels get too high.  In the short run, that may favor the dollar — it won’t fail rapidly.  But perhaps the euro might fail.  Even the yen might.  The era we are in is like the mid-1800s, when nations were constrained by their debt levels.

From the recent book “This Time is Different,” we know that countries with high debt levels grow more slowly, and defaul more frequently.  Ignore anyone who tells you that debt levels don’t matter.

I know I have written about ideas like this before, but I cannot remember where.  Let me start with a story.  I was at a Society of Actuaries conference in 2001 when I bumped into an actuary who was well-known to most before a meeting.  She recognized me, and I asked her what she was seeing that was new.  She told me, “Liquidity Derivatives.”

I shook my head for a moment and said, “Wait a minute, you mean getting a counterparty to pay cash at a time when liquidity is scarce?”  She giggled and said “Yes.”  I continued, “But wait, who would offer to pay at a time when liquidity is scarce?  She said, “That’s the problem.”  The speaker started to talk, so our conversation ended.

That is why I am skeptical about crisis derivatives.  Felix has commented on this, and he is worth a read here.  Unlike many, I do not think that all events in life can be hedged or insured.  In major disaster situations, no one can marshal the resources to make up for the disaster.  No one can insure against property damage in a war.

Citi has its own index of financial stress.  Here it is over the last 13 years:

Surprisingly, Aleph Blog has its own proprietary index for the same thing.

The graphs go the opposite way, but the correlations are over 80% in absolute value terms, and I can tell you that my measure more directly covers what Citi is going for, because it is the difference between the yield on the two-year Treasury and an index of A2/P2 commercial paper.

So, do you want to be able to fund yourself in a crisis?  Do the following: buy two-year Treasuries, and sell short A2/P2 commercial paper.  Most of the time this is a costly trade, if you can get it done at all.  But access to financing during a crisis is valuable, and should require compensation in advance to obtain it.

As for the Citi product, they should ask the question, “who would be willing to part with liquidity during a liquidity crisis?” and ask the question “Are they unquestionably solvent?”  Insurance is no good if the insurer is insolvent.  If Citi is the counterparty, I for one would not be comfortable.

Let me summarize.  Liquidity derivatives are not a reasonable product.  You never want to be asking for something when it is in scarce supply, because the odds are it will be very difficult to deliver.

Sorry I haven’t written much recently.  The recent snowstorms have tossed me around, as I care for my family, and those around me.  It is amusing in a backwards way, to see Washington, DC frozen at a time when there is so much volatility in global finance.  Yo, Treasury, make sure the skeleton crew on international finance gets in, regardless.

The incentives are perverse in every way in Europe.  If Germany, France, and the Netherlands don’t bail out Greece, then what will become of Portugal and Spain?  And later, Italy and Ireland?  In aggregate, this is big.

But, if Germany, France, and the Netherlands do bail out Greece, then will Portugal and Spain be next in line?  And later, Italy and Ireland?  In aggregate, this is big.

Perverse, indeed, and I criticize my own thoughts on the Euro that I thought would die from inflation.  No such thing.  The Euro is strong —  So strong that marginal nations were able to borrow at rates lower than they ever dreamed imaginable.  The debts built up like mad, ignoring the day when the inevitable weakening in aggregate demand would come, and debts of marginal, overindebted nations would prove weak.  The EU is validating the idea that currency union requires political union.  We learned that in the US 200 years ago, but the youngsters in the EU have to learn that lesson the hard way.

This is an ugly situation, as ugly as China forcing exports into the rest of the world, or the US Government continuing to borrow with abandon.  What seems to have no limit may find the limit more rapidly than one anticipates.

Just be aware that sovereign volatility has negative impacts on asset prices.

The place that got the most snow during the recent storm was Howard County, Maryland.  Elkridge had 38″, Columbia 34″, and at Aleph Blog Global HQ we got a measly 30″.  Here are some photos:

looking out the front of the house

back deck from the inside…

and the back deck from the outside…

looking up the street…

icicles hanging from our house — eight feet long

some of my kids starting to shovel before the storm is over… and…

360 degrees after two feet

That should be an AVI file.  There were six inches to go after that.

Well, we have been busy bees, and we may be getting busier.  There is another storm coming.  Another 10-20 inches.  Wow.

Economic commentary on this?  It’s good to have boys — we have been helping out people where we can.  Neighborhood relationships have tightened as people have made efforts to help the elderly and infirm.

Maryland can’t afford storms like these — major roads are only half to 2/3rds plowed.  This may generate a political crisis here, but I am only surmising.  Even well-off Howard County can’t keep up.

All for now, gotta buy some more snow shovels and salt, if I can find them.

When I look at the present economic environment, I am not encouraged.  But if you really want me to be discouraged, talk to me about politics.

For the last 40-80 years we have been borrowing, whether implicitly (pensions, retiree healthcare) or explicitly, deferring problems into the future, where they will be compounded with interest and survivorship (lifespans have lengthened, Kaiser, and sadly for those who pay, they want a high quality of life in their dotage).

So, at present, legislators are more partisan, whether in the states or at the federal level.  Why?  There is less slack.  Let’s start at the state level, because most of them have to balance their budgets, and can’t print money to help out.

Many states are screaming in pain.  As such, they tell their legislators in the Federal Congress to send back money.  But that toughens the debate on the Federal level.

With almost all state budgets fighting against a deficit, and some in deep trouble, it makes for interesting and ugly politics.  Much of this was created by optimistic assumptions of what could be earned from equities over the long run, much of which is now being slowly repudiated, as markets fail to live up to expectations.

The Federal budget is hopelessly out-of-whack, with 4-5% of GDP deficits out as far as the eye can see.  So, what do we do about it?

1) Raise Taxes.  I don’t like this idea, because the US Government has entered many areas where it should not be.  I would rather see the discretionary government shrink considerably.  Also, remember, Social Security and Medicare are not guaranteed.  Congress could wipe out all benefits tomorrow, and face a political firestorm.  But remember, in the Great Depression, that is just what they did.  This is why I don’t insist that rates must head higher.  It depends on society as a whole.

Raising taxes has the perverse result of slowing economic growth, which affects future taxes.

2) Inflate the currency.  Ugh.  Oppress the elderly, who cannot work to make up the difference?  Create a new inflation mindset that has all of us focusing on the short-term.  Inflationary economies by their nature become more and more short term.

3) Default on obligations.  There are several forms of this:

a) Total default: anyone with a Treasury Note is a sucker.  Global depression ensues.

b) External default: we do not honor external obligations, but honor internal ones.  Global depression ensues, but the US does relatively well.

c) Internal default: what, are you joking?  Why do we pay off the losers who lent to us?

As we look at Greece, Spain, and Portugal, we chuckle over the foolishness of the EU thinking that they could have monetary union without full political union.  It didn’t work under the Confederation, why should it work elsewhere?

But we should not chuckle.  After all, we have California, Illinois, and New York, and more waiting in the wings.  There is no bankruptcy code for the states.  I am not sure what happens if one state does not pay, aside from being shut out of the municipal bond market.

So, my point remains — what are we going to do?  Raise taxes, inflate the currency, or default?  Perhaps in a real crisis, we would slim down the government.  We might also decrease Social Security and Medicare benefits.  We might also amend ERISA, to allow for reductions in pension payments.  In a real crisis, nothing is fixed.

Or, we might tax a lot more — the depression was an example of that.  That is a reason that I am not a total bear on Treasuries.

The government has choices to make.  What should they do?  Offer your answers as best you can.

When I was a corporate bond manager, I often dealt in less liquid bonds.  Why?  They had more yield, I only bought those that my credit analysts liked, and I had a balance sheet that could hold them.  I had the option of holding those bonds, but not the obligation of holding those bonds.  As credit conditions improved in early 2003, to leave my successor with a simpler portfolio, I decided to lighten my holdings of bonds issued by a private bank.  I held 35% of the issue, and bought most of it near the height of the panic.

I told my secretary, “The phone will start ringing off the hook in 30 seconds.”  She gave me that usual sweet smile and said, “Okay, David.”  I offered a chunk of the bonds 0.2% below the last trade in spread terms, without guaranteeing the level.  To my surprise, I got a lot of bids rapidly, to the point where I said “whoa! there are too many that want these bonds.”  I recalibrated my levels and offered a “supply curve” of bonds, where I offered more the higher the price went.  I ended up selling 2/3rds of my holdings, and made significant gains for my client.  The final trade was 1/2% tighter than my initial proposed trade.

Having traded small and microcap stocks, and traded illiquid bonds, I am less afraid of illiquidity than many are.  Illiquidity is something that one can absorb, if he has a strong balance sheet and a patient disposition.

The great Peter Lynch would buy small cap stocks for Magellan, with strict orders on price.  Then he would let them sit, while they gained in value on average.  Marty Whitman buys in “safe and cheap” small cap stocks that are illiquid and holds them until their value is recognized.

If you have a strong balance sheet or patient investors, take advantage of it, and buy investments that are less liquid, where value may take a while to obtain.

But liquidity is not natural to all assets.  Most things in an average person’s life will not be liquid.  Your house and car are not liquid.  It will take a lot of effort to sell them and buy a different house and car.  So why should futures on property values be liquid, or residential mortgage-backed securities?

Well, debts that are very certain will always be liquid.  Debts that are less certain will be liquid during boom-phases, and illiquid during bust-phases.  In general, that is why AAA-rated asset-backed securities, which are usually “last loss” securities are fairly liquid, while lesser-rated securities trade rarely.

My point is that you can’t take illiquid assets and make them liquid.  Assets are liquid because they are short term, where one knows the cash flow to be received soon.

Are public stocks, like Exxon Mobil, liquid?  In one sense, yes.  During the day, when trading is in session, and there is
no news hitting the wire, then yes, quite liquid — one can get in and out of a position easily with little difference between the bid and ask.  But, when news hits, or from the closing price to the next day’s open, the price can move considerably.

Over a long period of time, the shares of two companies in identical businesses, one publicly traded, and one privately held, could deliver the same value over a long period of time.  The public company would have the ability to adjust its capital structure to buy in shares when they are cheap, and sell when they are dear, unlikely as that behavior is.  The public company would adjust its debt levels more frequently, while the private company would likely keep debt high and equity low, to keep taxes low.  The private company could act quietly and think longer term, subject to the constraints of their loan agreements.  The public company would have more bumps to its seeming value from news events, including earnings releases.

For the holder of shares in the public company, though liquidity is available, the value of the shares will vary.  For the public and private companies alike, liquidity for any large amount of the shares would be an event.  And, aside from successful maturity dates, the same would be true of large amounts of debt — there might be a public market available for small amounts of it, but just try to buy or sell a big amount, and pricing conditions are rarely favorable.  My example at the start of the post, where I sold 20% of the total issued amount for a favorable price, only happened because the willingness of investors to take risk increased dramatically since the last trade.  Yield greed had set in.

But that brings up the other definition of liquidity — what does it cost to enter/exit fixed commitments?  Tight credit spreads mean that corporations can (borrow) enter fixed commitments cheaply, and lenders, dearly.  The same applies to Fed policy — a wide Treasury curve means that it is expensive to borrow long, and cheap to borrow short — but borrowers want more security than to have a short maturity leash.

But when lenders are scared, they gravitate to short loans and high quality — cash equivalents lent to the Treasury.  If enough do that, short term yields get really low.  They can even go negative.

I remember arguing with a visiting professor at Wharton back in 1990 that negative interest rates were possible.  He told me I was nuts, people would sit on cash.  I replied, “what if you can’t keep the cash safe?”  Maybe I should have said, “What if it is inconvenient to transfer and guard several billion dollars in cash?  There are costs to that as well.”

In a liquidity trap like we are in, short-term money managers that must have US Treasury collateral must bid for it, no matter what.  They can’t move to cash.  Cash to them is very short-term debts of the most creditworthy entity that they know — their Government, the one that controls the Fed, sorta.

But the volume of lending, particularly to smaller business borrowers is light.  Is there really a lot of liquidity out there?  Or, is it being used primarily by the US Government and its affiliates while the economy is weak?  I think that is the case.

Liquidity is not magic; it can’t be created or destroyed — it just travels where it is needed.  During booms, liquidity appears abundant because of loose monetary policy and high willingness to take credit risk.  It seemingly disappears in the bust, as the marginal fixed income investor attempts to eliminate credit risk — liquidity then flows to the highest quality assets.

Liquidity is always around; it is only a question of where the marginal credit buyer has migrated.  In the current environment, it is short high-quality obligations that are still king, and lower-quality longer obligations that trail, though not as badly as last winter.

I am sure that I will write more on this topic, should I live so long.  My contentions are:

  • Securitization does not create liquidity, it only redirects it.
  • The Fed does not create liquidity, it only redirects it.
  • The Treasury does not create liquidity, it only redirects it.

Liquidity is a function of human action.  We all have to work and trade to survive.  Liquidity is where people are transacting at any given moment toward that end.  Structural changes in the economy, whether by the government or through private channels will shift where liquidity goes, but it will not change the amount of liquidity, unless the changes are so severe that the economy itself becomes much less productive.

I have been thinking about the the forces distorting the global economy.  In the long run, the distortions don’t matter, because economies are bigger than governments, and eventually economies prevail over governments.  Here are my dozen problems in the global economy.

1) China’s mercantilism — loans and currency.  The biggest distortionary force in the world now is China.  They encourage banks to loan to enterprises in order to force growth.  They keep their currency undervalued to favor exports over imports.  What was phrased to me as a grad student in development economics as a good thing is now malevolent.  The only bright side is that when it blows, it might take the Chinese Communist Party with it.

2) US Deficits, European Deficits — In one sense, this reminds me of the era of the Rothschilds; governments relied on borrowing because other methods of taxation raised little.  Well, this era is different.  Taxes are high, but not high enough for governments that are trying to create the unachievable “permanent prosperity.” In the process they substitute public for private leverage, and in the process add to the leverage of their societies as a whole.

3) The Eurozone is a mess — Greece, Portugal, Spain, etc.  I admit that I got it partially wrong, because I have always thought that political union is necessary in order to have a fiat currency.  I expected inflation to be the problem, and the real problem is deflation.  Will there be bailouts?  Will the troubled nations leave?  Will the untroubled nations leave that are the likely targets for bailout money?

4) Many entities that are affiliated with lending in the US Government, e.g., FDIC, GSEs, FHA are broke.  The government just doesn’t say that, because they can still make payments.

5) The US Government feels it has to “do something” — so it creates more lending programs that further socialize lending, leading to more dumb loans.

6) Residential real estate is still in the tank.  Residential delinquencies are at all-time highs.  Strategic default is rising.  The shadow inventory of homes that will come onto the market is large.  I’m not saying that prices will fall for housing; I am saying that it will be tough to get them to rise.

7) Commercial real estate — there is too much debt supporting commercial real estate, and too little equity.  There will be losses here; the only question is how deep the losses will go.

8 ) I have often thought that analyzing the strength of the states is a better measure for US economic strength, than relying on the statistics of the Federal Government.  The state economies are weak at present.  Part of that comes from the general macroeconomy, and part from the need to fund underfunded benefit plans.  Life is tough when you can’t print your own money.

9) The US, UK, and Japan are force feeding liquidity into their economies.  Thus the low short-term interest rates.  Also note the Federal Reserve owning MBS in bulk, bloating their balance sheet.

10) Yield greed.  The low short term interest rates touched off a competition to bid for risky debt.  The only question is when it will reverse.  Current yield levels do not fairly price likely default losses.

11) Most Western democracies are going into extreme deficits, because they can’t choose between economic stimulus and deficit reduction.  Political deadlock is common, because no one is willing to deliver any real pain to the populace, lest they not be re-elected.

12) Demographics is one of the biggest  pressures, but it is hidden.  Many of the European nations and Japan face shrinking populations.  China will be there also, in a decade.  Nations that shrink are less capable of carrying their debt loads.  In that sense, the US is in good shape, because we don’t discourage immigration.

I think earnings quality is one of the great neglected concepts of investing.  Why do many growth investors blow up on seemingly promising companies?  The answer is often that the investors did not review earnings quality.  Why do value investors fall into value traps?  The answer is often that the investors did not review earnings quality.

I have reviewed a number of books, and written many articles about earnings quality  Because so much of the investment world is blind here, the idea still has punch.

Thornton O’Glove hits at the subject in a traditional way — accrual accounting entries are always more suspect than cash entries.  He focuses on:

  • Being skeptical — don’t trust management, analysts, auditors.
  • Look for inconsistencies in disclosure.  Who tells a happy story broadly, bet is serious in regulatory filings?
  • Who plays games with one-time events?  What companies push the limits in determining what is a one-time event?
  • How do companies play with their accruals in order to report income?
  • Is taxable income significantly out of whack with GAAP income?

The book was written in the Mid-1980s, before it was easy to review SEC filings.  That has changed, but few really review filings today, even though it is easy to do so.

This is a good book, and you can learn a lot from it, but many of the references are dated, as in the classic version of “The Intelligent Investor.”  I mean, I recognize most of the examples, but many readers will say, “Huh, I’ve never heard of that company!”

Do you want to improve your investing?  Look to earnings quality.

Who could benefit from the book?  Any investor could benefit from the book, particularly those that analyze fundamentals.

If you want to buy the book, you can buy it here: Quality of Earnings

Full disclosure:  I bought this book.  I review books old and new.  This old book still has value, and I recommend it.  It will require more effort than most investors are willing to put forth, but I believe it will yield value to those who work with it.  This is simple stuff, but it is work, and there is always a barrier to entry around work.

Also, anyone entering Amazon through my site and buying anything — I get a small commission, but you don’t pay anything more.  I love it when both my readers and I win.