I’ve thought about the issue for a while, and I want to summarize what the key areas for bank reform are, so that you all can know why legislation like the Dodd Bill won’t achieve much.  There are five key areas that have to be addressed to avoid “Too Big to Fail”:

  1. Limit short-dated funding, and encourage liquid assets.  Place strict limits on banks regarding funding that is likely to run in a crisis.  Encourage asset-liability match across the whole yield curve.  For the cognoscenti, match partial durations.  For bank CEOs, hire some life actuaries to help you.  (We’re cheap — for what you get!  Plus, we have an ethics code superior to others in the financial sector.  Wait.  You don’t want that?!)
  2. Limit the ability of operating banks/thrifts to lend to, invest in or enter into derivative transactions with other financial companies.  This is the critical provision to avoid contagion-type effects.  Most proposals ignore this.
  3. Fix the accounting.  Go to a principles-based approach, and reveal the complexity embedded in securitization and derivatives.  Limit the amount of derivatives that can be written for purposes that do not reduce risk.
  4. Raise the capital required as a percentage of assets, and make the capital required disproportionately rise with the assets.
  5. Fix the risk-based capital [RBC] formula. The banks should copy the appointed actuary function of Life Insurance Companies. Then do industrywide experience studies on asset performance, so regulators will know how risky the assets really are, and then the regulators can feed the results into the risk-based capital formulas, and benchmark what banks lend well and badly by category, which would lead to much better overall risk control, and very frustrated bank managements, because capital would go up, and ROEs down.

Note that I have not mentioned Glass-Steagall.  My view is let banks do what they want with assets, but let the RBC formula limit risky asset categories.  Equitylike risks should be funded with equity.  What could be simpler?  Such a policy would have commercial banks out of equitylike businesses in a flash.

That is the heart of the matter.  But I want to expand on point 3.  Imagine a bank that has bought a Single-A slice of a trust-preferred collateralized debt obligation, 5% of the tranche.  Rather than placing the asset on the balance sheet at the amount paid, the following should happen:

  • The asset side of the balance sheet should have an asset equal to 5% of the assets of the CDO.
  • The liability side of the balance sheet should have two entries — one for 5% of the AAA and AA part of the deal, which are loans levering up the single-A interest, and one for 5% of the BBB and below part of the deal, which provide protection to the single-A tranche.

That is the real economics of the deal, though it is far messier than reporting one single-A bond.  As it happened with the not-so-hypothetical CDO that I describe, the liability for BBB and below is zero now, and the AAA and AA part of the deal have value equal to the loans.

As for swaps, they are an exchange of this for that.  Place this and that on the balance sheet.  Let RBC limit the exposures.

We can get really complex about preventing bank defaults, but the main trick is making sure short-term funding does not run.  A close second, is preventing investment in other financials, which destroys the possibility of contagion.

If we can do those two things, preventing too big to fail will be a breeze.  But who has the guts to do that?

Tonight’s rule:  Massive debt issuance on a sector-wide basis will usually have a slump following it, due to a capacity glut.

If you are a bond manager, it pays to do what is difficult.  Buy proportionately less or none of the sector that is the heavy issuer.  Even  more, sell into it, and try to create a balanced portfolio without the hot sector.

When a sector as a whole borrows far more than in the past, it is often a mania, and the management teams are expanding capacity all at once, because conditions are so favorable.  I experienced this twice as a bond manager.  When I came on the scene in 2001, I tossed out all of my investment grade telecom bonds (aside from some of the Baby Bells), and auto bonds.  I could not see how they would make money over the long haul.

Those were two sectors heading for capacity gluts.  Yet there was a bigger capacity glut growing — that of the banks.  As 2005-2007 progressed, it was difficult to keep a balanced corporate bond portfolio, because almost half of all issuance was from financials.

Debt issuance is the option of optimists, and in an era where your competitors are issuing debt, it is hard to not imitate them.  But when everyone is optimistic in a sector, and levering up, that is often a time where subpar performance resides.

There is more than a hint of seeming success as a sector adds progressively more debt.  Pass on too many deals, and you begin to feel like a stick-in-the-mud.  There is a lot of pressure to change your strategy when things are running so hot.  Rather than change strategies in mid-stream, a good manager will sit down with colleagues and discuss:

  • What companies are misunderstood, and are safe to invest in.
  • What companies are misunderstood, and are definitely not safe to invest in.
  • Are there safe industries in the sector that aren’t adding so much debt?
  • On the scale from historic widest spreads over Treasuries, to historic lowest, where are we?  What inning of the tightening game are we in?
  • Stop looking at companies, and let’s create a model of the sector on the whole.  Is there enough business to justify all of the expansion that is going on?  What is happening to product pricing?
  • Who is the marginal buyer of the hot sector, and of yieldy paper generally?  Do they have strong or weak balance sheets?  How fast will they sell if things go wrong?
  • How fast are new deals completing?  Are the syndicates testing the waters to price deals too tight, in order to restore normalcy to bidding?
  • Are fools making money?  Have they been making money for a little while or a long time?  Are ordinarily risk-averse investors beginning to imitate them?
  • Where is the Fed?  Perhaps today it would be “What is the Fed?”  Are they getting ready to jerk the rug out from under the markets?  How complacent are expectations?
  • How long can we suffer underperformance before money begins to get pulled from us?  Are our clients educable or not?  Do they appreciate the risks in the market?  Why do we always get the dumb clients?  (Wait, don’t answer that, you get the clients that you deserve…)
  • And more, but you get the picture…

By the time you are done, you have a roadmap toward how you will add and subtract exposure in areas of the hot sector that you like and don’t like.  You will know your limits, and will maximize performance given those limits.  Finally, you will have an estimate of how long the hot sector will do well, and a trading strategy for the short run.

Capacity gluts are tough.  They have such an air of inevitable success as companies compete to dominate a promising area.  But ideas that are great if one company pursues the opportunity are only good when two do so, and average when three or four join the party.  But when a half dozen to a dozen join in, results will be poor.

This goes double for equity investors.  Avoid sectors that have high debt issuance.  At minimum, if you are a momentum investor, follow the mo, and decide in advance what sort of decline will cause you to make an exit.

Impractical Application for Today

This is all very nice, you might ask, but where are the debts building up today?  Need you ask?  We have just seen some of the biggest transfers of debt from the banking system and consumers to the government.  Government debt is the hot sector.

Wait, you might say.  How can this principle apply to governments?  They don’t go broke, at least, that what Walter Wriston told us.  Sorry, but Reinhart and Rogoff’s book says differently.  Government defaults are not unusual.  Also, banking crises are often followed by sovereign crises.

Wait, you might say again.  I have to limit my risks.  Governments will always be the safest credit in a currency because that can tax the other credits.  Maybe, but there are limits.  As tax rates get very high, they don’t produce incremental revenue.  Yes, I know this sounds like supply side economics, but there is a difference here — I believe higher tax rates would produce greater revenues at present.  But there is a tax level that governments cannot exceed before tax revenue goes down.  A sound business in a country with an unsound taxation policy might survive even if the government refused to pay on their debts.

I know, that government would likely try to inflate their way out, but indexing of benefits and political outcry might hinder them.  I don’t believe that it would be easy to inflate out of a debt crisis.  Too many economists derive simplified models of reality, and don’t consider how ugly the politics will be in the situation.  Sorry, men aren’t rational, particularly not as groups, and there would be a lot of sturm und drang, and delay.  Who could tell what foreign nations might do in response?

Still, I would underweight Treasuries relative to high quality bonds in other sectors.  Issuance is high as far as the eye can see — and beyond 2050, given all of the difficulties with entitlement programs.  Many high quality corporates won’t have much issuance over that same period; they will be scarce versus the massive amount of government debt to pay.  Beyond that, when the Fed tightens, debt costs for the government will rise dramatically.  Perverse, huh?  When you have so much to refinance, everything fights against you.

So, avoid the hot sector.  Suffer underperformance for a while, but decide in advance what mitigating actios you will take, lest you be a buyer out of insecurity near the peak, when losers capitulate prior to the bear market.

I did not ask for this book, but I am glad the publisher sent it to me for free.  There is a lot of concern over inflation in the present era, but not a lot of structured thought about what drives inflation.

This book takes the long term perspective, and looks at the wide array of monetary arrangements, and analyzes which arrangements produced more or less price inflation.  The author shows that there is generally an inflationary bias in all currencies.  Currencies that are backed by precious metals tend to experience less inflation, but many governments using such currencies debase the metals or clip the coins.  That said, it does restrain inflation, because inflating a  metallic-based currency takes a lot of work.

To have significant inflation, one must have unbacked paper money.  The same is true of defaults in bonds.  In order to have a crisis, much debt must be issued relative to the assets and earning power of the companies.  The debt is not backed by sufficient repayment capacity, and thus there are some defaults.

A fiat currency in and of itself, is not sufficient to create hyperinflation.  Hyperinflation only happens when the government finances itself by printing money with abandon.

The book further distinguishes itself by explaining situations where foreign currencies come in to act as shadow currencies inside nations.  Further, the book describes how inflationary situations end.  One constant is that people quickly analyze where purchasing is declining, and seek stability through metals or relatively stable fiat currencies.

One strength of the book is that at the end of each chapter, the author summarizes all of the main points.  I recommend this book.


The book is not dry, but it has a distinctly academic feel.  Not everyone will take to the book easily.

Who would benefit from this book?

Economists would benefit from the book, and also those that like reading about the history of inflation.  Few things truly change in History; the names may change, but we make the same mistakes.

For those who want to buy the book, you can buy it here: Monetary Regimes And Inflation: History, Economic And Political Relationships.

Full disclosure: Though I get books for free from publishers, I burn time to read books in full, and write reviews that are balanced.  Those entering Amazon through my site and buying anything will end up sending me a small commission, but they will not pay more in order to do that.

Many of you have heard of the blog Naked Capitalism, and its pseudonymous writer, Yves Smith.  Well, she has written what I regard as an ambitious book, ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism.  It is ambitious for several reasons:

  • It tries to be comprehensive about all aspects of the crisis.
  • It digs deeper than most, analyzing flaws in economic and financial theories that underpinned the errors of the crisis.
  • It looks at the political angle of how laws and regulations were subverted, while alleging conspiracy probably too much, when ordinary greed in the open and stupidity could cover the causes of the crisis.

There is a tension between capitalism and democracy.  We don’t like to talk about it, but it is there.  Property rights are human rights, and should be protected.  Governments often determine that certain contracts are not valid on public policy grounds.  (I.e., gambling, prostitution, arson, assassins, etc.)

Democracies also do not like rivals for power.  If business gets too big, to the point where it is influencing the decisions of the government, democracy fights back.  I write this as one who would err on the side of property rights rather than democracy.  Property rights are a direct descendant of the eighth commandment, “You shall not steal,” whereas the form of government of any nation is a thing of relative indifference.  Many nations have different ways of ruling themselves.  It is not yet proven that democracy is the best form of government.  Personally, I think it is more prone to corruption than most governmental forms.  But it has the advantage of motivating the people.

I draw the line when businesses use political power to exclude rivals.  It is one thing to be really clever, and dominate your market, like Google.  It is another to have a natural monopoly like the old AT&T, before technology obsoleted them.  But it stinks to have a system where major financials, who have nothing of patentable value, hold the nation hostage, saying “Bail us out or the financial system fails.”

I argued against the bailouts, as did Yves, but the government caved under the asymmetry of “Heads we win, Tails you lose.”  It came up tails for all of us.

Yves digs deeper than many critics.  She questions the assumptions of the economics profession,with its gloss of pseudo-science.  She pokes at the questionable assumptions underlying much of finance theory.   She looks at those who got it right regarding the crisis, and were marginalized as a result.  Where I differ is that there isn’t necessarily a conspiracy behind unwillingness to listen to discordant theories.  Academic guilds ignore researchers who question their closely held beliefs, regardless of the truth of the matter.  They know that it couldn’t be true, and the outsider doesn’t really understand their discipline.  I do not charge them with ill intentions, but stupidity.

What I really appreciated about the book was its willingness to challenge academic economics and finance.  She did it well, but left little in her wake as to what to look to as a substitute.  The willingness of economics to engage in pretend games with high level math is ridiculous.  If we restarted economics from scratch today, whether mathematical or not, it would not look like much of the sterile games that are played in leading economic journals.  Ask the question: how many benefit outside the economics profession from what is written in economic journals.  Answer: precious few.

I have many more things to say about this book, but this review is long enough as it is.  Let me say that there are few books that I have marked up as much as this one.


I do not go in for conspiracy theories.  Usually, most evil can be performed outside of darkness; people still don’t notice for the most part.

Yves should have spent more time on the enablers of the crisis — yield hogs.  You can’t buy protection on a company that you think will die, unless there is a yield hog out there that wants extra income that they think they are getting for free.  AIG was the largest of them, but by no means the only one.

She complains a bit much about “free markets.”  Aside from trading with the enemy, why should trade be constrained?  Why should I try to take away the property rights of my neighbor?  Beyond that, suppose you are right.  Where would you draw the lines?  It is one thing to criticize, and quite another to propose new policy.  Personally, I make an effort that when I suggest that something be demolished, that I recommend something else to take its place.  It is easy to be a critic, but hard to be a builder.

Who would benefit from this book:

Most people would benefit from the book, if they read it realizing that the things that happened do not require that parties conspired to make this happen.  Those who would especially benefit include economics and finance professors; they need the criticism.

If you want to buy the book, you can buy it here: ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism.

Full disclosure: The publisher sent me the book for free.  I spent several hours reading it in full.  If you enter Amazon through my site and buy anything, I get a small commission (6-7% typically).  But, your costs don’t rise versus going to Amazon directly.  I have avoided doing a “tip jar” because I would rather people benefit from the books I review, while allowing Amazon to pay me indirectly.

As I looked over the carnage that was the bond market yesterday, I was reminded of my piece 17 months ago called Broken….  But as I read that, I said to myself, “Who are you kidding?  Yes, things were bad today, but nothing like when the bond market was falling apart out of fear of corporate credit risk.”

True enough, but I found yesterday disturbing.  Why?

1) Increasing chatter of troubles in the Eurozone, given Fitch’s downgrade of Portugal, and an increased insistence that Greece will not be bailed out, leading to a drop in the Euro.  Many say that it is impossible that the EU would not prop up Greece, but consider the German mindset here.  They traded their hard Deutschemarks for Euros.  They expect a hard Euro.  Their view is that if you want the benefit of being in the Euro, you must behave like Germans.  Anything else would be profoundly unfair — benefits come to those who have discipline.  There are two alternative views of what it means to be in the Eurozone, and they can’t be reconciled.  At most, one of those views will survive.  I think the German version is more likely.

My view is by no means the consensus, but without Germany on board, there is no Greek bailout.  The IMF is too small to truly help Greece.  If Greece were to default, it would harm banks in Europe, but it is a lot cheaper to help local banks than to help Greece.  That makes me a little bullish on the Euro, because if Greece defaults and leave the Eurozone, it sends a warning to other profligate nations, and leaves the core of the Eurozone stronger.  Beyond that, vacations in Greece would become the rage, as they would be very cheap, even including the frictions of exchanging Euros into “New Drachmas.”

Here’s a 12-month graph of the Euro:


My view is that the Euro will weaken further if they bail out Greece, and rally if they don’t.  Guess which the Germans will choose?  They will favor a strong Euro, even if it means shrinking the Eurozone.

2) I want to find the guy(s) who taught me when I was a young and impressionable mortgage bond manager (age 38, I came to the game late) that swap spreads could not go negative; sorry, it ain’t true.  John Jansen used to complain about the 30-year swap spread, but now we are negative at 10 and 7 years as well, and 5 years is not far away at +7 basis points.


But why?  If swap yields represent the levels that AA banks fund at, then how can they yield less than a AAA government?

Here’s my answer, though there are other good ideas to consider.  As a corporate bond manager, I underweighted two names that I really did not like, GE and AIG.  Though AAA, they traded as if they were single-A, and they had a lot of debt outstanding.  I always felt they were too levered, and that the rating agencies were giving them too much credit for being big.  Having run the GIC desk of a small well-capitalized insurer, with lower ratings, less leverage, and a higher ROE than other larger competitors, I was/am biased against firms with bad credit profiles that get good ratings only because they are big.  That they could fail is not conceivable.  Please ignore that AIG did fail, and that GE Capital would have failed in late 2008 or early 2009 without the TLGP.  The US Government played favorites, ignoring CIT, Advanta and others.

But, it is inconceivable the the US Government would fail.  That said it is issuing a lot of debt, and it is hard to absorb it all, so yields have to widen.  Very highly rated corporates offer some diversification, so they trade at lower yields than the behemoth that needs more and more liquidity.  Look at the lousy 5-year auction yesterday.  The Street is choking on Treasury paper.

The move in Treasury yields was large, but not overwhelming, maybe 98th percentile in severity:


3) Then there was the move in mortgage bond yields.


Up 15 basis points, near the Treasury move, but much more than the move in swaps, which are closer to how mortgages fund.


Looks like about a 10 basis point move, which means mortgages cheapened by 5 basis points or so.  That’s big!

Further, there was the change in the MOVE [Merrill Option VolatilityEstimate] index.  Think of it as the VIX for Treasury securities.  Up considerably:


All of this is somewhat panicky in terms of feel.  Is this a turning point? If it is, how much steeper can the curve get, or will the Fed genuinely tighten?

4) On a day like this, where things are falling apart, it does not help to hear Bill Gross say that he likes stocks over bonds.  I know, this is not nearly as serious as the above three, but I agree with him, weakly.  Bonds don’t have much upside here.  Large cap high quality stocks, which are a decent proportion of the S&P 500, still seem cheap.  Maybe that is true only in a relative sense, but I will stick with Jeremy Grantham here.

Here are two more wrap-ups of the day:


Be careful.  We live in a world where few governments are following orthodox rules of finance.  Indebted governments may turn to inflation, or higher taxation, or default.  At present, there is no decided answer to what will likely happen.  Governments are still trying to figure it out, hoping that some marginal nation like Greece will choose a course of action that tells them what or what not to do.  In a sense, we are waiting for some entity to make a bold move that changes the game, and then others will decide whether to do that, or, the opposite action.  Until then, keep your powder dry, and be nimble.

I like to review books, and I will do it whether I get compensation or not.   Unlike most reviewers, I read the books that I review, unless I indicate otherwise.  I have read this book.

This is a book designed to show readers where they can find useful resources on the Web for investing.  The author has a long affiliation with Seeking Alpha, an organization that I have supported, and benefited from during my time of blogging.

The book gives readers a panoply of sources to gain investment ideas from: blogs, aggregators, the sites of mainstream publications, data vendors, etc.  He focuses on the social web for investing, showing places where investors can help one another in the search for profits.

Areas that are focused on include:

  • Following blogs
  • Following professionals through their 13F filings
  • Message boards, and their successors
  • How to do investment screening
  • Following insiders
  • Rumors
  • Doing fundamental industry research

There is a lot here, and the author handles it well.  I was never bored with this book.  He has a very good selection of sites on the internet for delivering investment information.


Look, any book on the internet and investing is likely to be of limited value 2-3 years out.  Things change that fast.  If you buy that book, pay attention to it and use it rapidly.  The advantages that the book describes will largely be gone by 3 years.

Who would benefit from this book?

Investors that use the internet would benefit from this book.  It will help them find better sources for data, and aid them in navigating the noise of the internet.

If you want to buy this book: TradeStream Your Way to Profits

Full disclosure:

I received this book from the author for free.  If anyone enters Amazon through my website and buys anything, I get a small commission.  I don’t want to do a “tip jar.”  If you get value from what I do, and you need something where Amazon offers you the best price, buy it there, after entering through my site.  Amazon pays me, and you pay nothing extra.  What  a great deal.

Again, Greenspan’s comments are in italics.  Part 1 can be found here.  Greenspan’s full paper can be found here.

Part of the dynamic here is while leverage is increasing, and sham prosperity is growing, there are few that will argue against it, and those who do are regarded as shrill misfits.  In the short run, the powerful in society benefit from the growth of a credit bubble.

The evaporation of the global supply of short term credits within hours or days of the Lehman failure is, I believe, without historical precedent. A run on money market mutual funds, heretofore perceived to be close to riskless, was underway within hours of the Lehman announcement of default. The Federal Reserve had to move quickly to support the failing commercial paper market. Unsupported, trade credit withdrawal set off a spiral of global economic collapse within days. Even the almost sacrosanct fully collateralized repurchase agreement market encountered severe unprecedented difficulties.

We need to dig very deep into peacetime financial history to uncover similar episodes. The call money market, that era’s key short term financing vehicle, shut down at the peak of the 1907 panic, “when no call money was offered at all for one day and the [bid] rate rose from 1 to 125%.”36 Even at the height of the 1929 stock market crisis, the call money market functioned, though rates did soar to 20%. In lesser financial crises, availability of funds in the long-term market disappeared, but overnight and other short-term markets continued to function.

It is easy to make too many assumptions… that markets that have never failed can’t fail.  To assume depressions can’t happen again.  Any market can become overlevered — ANY MARKET.  Further, collateralized lending has a great tendency to attract bad loans, because lenders overestimate the value of collateral.  Also, all short-term borrowing at banks carries considerable risk, particularly non-consumer funding, because there are no guarantees.

Given this virtually unprecedented period of turmoil, by what standard should reform of official supervision and regulation be judged? I know of no form of economic organization based on a division of labor, from unfettered laissez-faire to oppressive central planning, that has succeeded in achieving both maximum sustainable economic
growth and permanent stability. Central planning certainly failed and I strongly doubt that stability is achievable in capitalist economies, given the always turbulent competitive markets continuously being drawn towards, but never quite achieving, equilibrium (that is the process leading to economic growth).

It is not equilibrium that drives growth, but disequilibrium.  Excess demand drives supply.  Excess supply drives demand.  The concept of equilibrium in economics is almost useless, because the system is too noisy, and the tendency toward equilibrium far weaker than the creativity of mankind creating new products, new markets, new technologies, new needs, etc.

The aftermath of the Lehman crisis traced out a startlingly larger negative tail than most anybody had earlier imagined. I assume, with hope more than knowledge, that that was indeed the extreme of possible financial crisis that could be experienced in a market economy.

Again, the Great Depression was worse, but it would not be impossible to have a crisis worse than that.  People don’t like to think about these things, but jst because they are painful to think about does not mean they can’t happen.

Greenspan goes on to add that bank capital levels need to be raised, but does not note that on his watch, bank capital levels were reduced.  He also comments on how the government standing behind the banks rescued them, but does not comment on the moral hazard engendered by the government intervening.

The rates of return on assets, and equity (despite the decline in leverage, moved modestly higher during the years 1966-1982 owing to a rapid expansion in non-interest income, such as fiduciary activities, service charges and fees, net securitization income, (and later investment banking, and brokerage). Noninterest income rose significantly between 1982 and 2006 (increasing net income to equity to a near 15%) as a consequence of a marked increase in the scope of bank powers.

That in part reflected the emergence in April, 1987 of court sanctioned, and Federal Reserve regulated, “Section 20” investment banking affiliates of bank holding companies. The transfer of such business is clearly visible in the acceleration of bank gross income originating relative to that of investment banks starting in 2000 (exhibit 15).

Bank profitability exploded after 1986 for several reasons:

  • The Greenspan Put — recessions were never allowed to eliminate bad lending.
  • Securitization — originating loans to sell to others can be far more profitable than holding them on balance sheet.
  • Offering complex loans/services to corporations is more profitable.
  • Offering complex loans/services to individuals is more profitable.

After wallowing in the backwaters of economics for years, “too big to fail” has arisen as a major visible threat to economic growth. It finally became an urgent problem when Fannie Mae and Freddie Mac were placed into conservatorship on September 7, 2008. Prior to that date, U.S. policymakers (with fingers crossed) could point to the fact that Fannie and Freddie, by statute, were not backed by the “full faith and credit of the U.S. government.” Market participants however, did not believe the denial, and consistently afforded Fannie and Freddie a special credit subsidy. On September 7, 2008, market participants were finally vindicated.

Greenspan and I can agree here.  There was always a “wink, wink” regarding the guarantees behind the GSEs.  The US Government would never let them fail in entire.

For years the Federal Reserve had been concerned about the ever larger size of our financial institutions. Federal Reserve research had been unable to find economies of scale in banking beyond a modest-sized institution. A decade ago, citing such evidence, I noted that “megabanks being formed by growth and consolidation are increasingly complex entities that create the potential for unusually large systemic risks in the national and international economy should they fail.” Regrettably, we did little to address the problem.

Give Greenspan a little credit here — he did urge the slimming down of Fannie and Freddie.  But he did little to slim down the growing large banks.  Indeed, he approved the waivers that allowed for the growth in large banks prior to the repeal of Glass-Steagall, approved of the repeal of Glass-Steagall, and waived deposit-share limits on big bank mergers.

The solution, in my judgment, that has at least a reasonable chance of reversing the extraordinarily large “moral hazard” that has arisen over the past year is to require banks and possibly all financial intermediaries to hold contingent capital bonds, that is, debt which is automatically converted to equity when equity capital falls below a certain threshold. Such debt will, of course, be more costly on issuance than simple debentures, but its existence could materially reduce moral hazard.

I doubt that will work, much as I like free market solutions.  To be effective, that would have to be a large fraction of the liability base.  I doubt we have that many buyers willing to take on “worst of equity and debt risks” at any reasonable yield premium.

However, should contingent capital bonds prove insufficient, we should allow large institutions to fail, and if assessed by regulators as too interconnected to liquidate quickly, be taken into a special bankruptcy facility. That would grant the regulator access to taxpayer funds for “debtor-in-possession financing.” A new statute would create a panel of judges, who are expert in finance. The statute would require creditors (when equity is wholly wiped out) to be subject to statutorily defined principles of discounts from par (“haircuts”) before the financial intermediary was restructured. The firm would then be required to split up into separate units, none of which should be of a size that is too big to fail.

We can agree here as well.  Using the government as a DIP lender with big complex firms costs the taxpayers little, and makes the consequences fall on those who made the bad investments.

The Federal Reserve and other regulators were, and are, therefore required to guess which of the assertions of pending problems or allegations of misconduct should be subject to full scrutiny by, of necessity, a work force with limited examination capacity.  But this dilemma means that in the aftermath of an actual crisis, we will find highly competent examiners failing to have spotted a Madoff. Federal Reserve supervision and evaluation is as good as it gets even considering the failures of past years. Yet the banks still have little choice but to rely upon counterparty surveillance as their first line of crisis defense.

I’m sorry, but Madoff should have been detectable.  Buyer beware is still the first line of defense, but it should not be the only line of defense.

The global house price bubble was a consequence of lower interest rates, but it was long term interest rates that galvanized home asset prices, not the overnight rates of central banks, as has become the seeming conventional wisdom. In the United States, the house price bubble was driven by the low level of the 30 year fixed rate mortgage that declined from its mid-2000 peak, six months prior to the FOMC easing of the federal funds rate in January, 2001.

Greenspan then goes into a series of statistical arguments that attempt to show that long Treasury interest rates correlated more with mortgage rates than the Fed Funds rate was.  Thus, the Fed was not to blame for the housing bubble.  This misses several points.

  • The Fed exerted a a degree of suasion over the long end of the curve.
  • The FOMC kept short rates low for a long time, and though long rates moved less, still, they moved in the direction of short rates.
  • Mortgage hedgers forced long rates lower given the negative convexity (short optionality) of the market.
  • The Fed had oversight over the banking system.
  • Mortgages became shorter in their effective length as the bubble grew.

The presence of abundant Fed liquidity swamped the markets, and led to low spreads on risky instruments (the Great Moderation).  Greenspan must take responsibility for this, after all he accepted the good side of it while times were good.

To my knowledge, that lowering of the federal funds rate nearly a decade ago was not considered a key factor in the housing bubble. Indeed, as late as January 2006, Milton Friedman, historically the Federal Reserve’s severest critic, in evaluating the period of 1987 to 2005, wrote, “There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind.”

Friedman was not the Fed’s severest critic.  He accepted its existence.  Many would rather have the Fed done away with, because of the inherent dishonesty of fiat money.  Why does the Fed get to create something that must be accepted as valuable to everyone else?  It is a form of coin-clipping at best.

Greenspan also misses John Taylor’s point with respect to policy being too low for too long.  It is not as if the Taylor Rule uses any asset variables for policy purposes (though a better model might do so).  But the interest rates that the model generates would have an impact on asset prices, and the willingness to build homes, many of which would be excess.

Yes, there were global problems here, with the Chinese over-providing liquidity to the US.  But as I argued at RealMoney at the time, the Fed could have fought that and run an inverted yield curve for some time.  They did not do it, but removed liquidity very slowly.

But the notion of an effective “systemic regulator” as part of a regulatory reform package is ill-advised. The current sad state of economic forecasting should give governments pause on the issue. Standard models, other than those that are heavily add-factored, could not anticipate the current crisis, let alone its depth. Indeed, models rarely anticipate recessions, unless again, the recession is add-factored into the model structure.

I agree that there is no good way to create a systemic risk regulator, because the Fed creates most of the systemic risk.  Who will regulated the Fed?  Should that not be Congress?

But, I am sorry, the crisis was anticipated by many of us.  Here is the secret, Alan: the area receiving the greatest increase in debt is the area where systemic risk is growing.  Finance is a mature industry.  Large increases in debt are likely bubbles.  After all, given that the accounting rules allow risky loans to recognize credit margins as paid, in the short run it always pays to write risky loans, until illiquidity kills the lender.


This is the end of this short series.  Greenspan is a bright guy trying to preserve his legacy, tattered as it is.  The Fed Funds rate had huge impact over the whole economy during his tenure, as he was aggressive in providing liquidity, and led us into the eventual liquidity trap that Bernanke now has to deal with.

33 Greenspan, Alan. Technology and Financial Services. Before the Journal of Financial Services Research
and the American Enterprise Institute Conference, April 14, 2000.
34 Yields on riskless longer maturities can fall below short-term riskless rates if tight money persuades
investors that future inflation will be less.
35 Hugo Bänziger, chief risk officer at Deutsche Bank. Financial Times, November 5, 2009.
collateralized repurchase agreement market encountered severe unprecedented
We need to dig very deep into peacetime financial history to uncover similar
episodes. The call money market, that era’s key short term financing vehicle, shut down
at the peak of the 1907 panic, “when no call money was offered at all for one day and the
[bid] rate rose from 1 to 125%.”36 Even at the height of the 1929 stock market crisis, the
call money market functioned, though rates did soar to 20%. In lesser financial crises,
availability of funds in the long-term market disappeared, but overnight and other shortterm
markets continued to function.

This article is derived from Greenspan’s latest paper.  Greenspan’s comments are in italics. Mine are in normal type.

Greenspan begins his argument: The bankruptcy of Lehman Brothers in September 2008 precipitated what, in retrospect, is likely to be judged the most virulent global financial crisis ever.

Quite a statement, and one that I think is false, at least so far.  The Great Depression was far worse.

Yet the ex post global saving – investment rate in 2007, overall, was only modestly higher than in 1999, suggesting that the uptrend in the saving intentions of developing economies tempered declining investment intentions in the developed world.  That weakened global investment was the major determinant in the decline of global real long-term interest rates was also the conclusion of the March 2007 Bank of Canada study.5 Of course, whether it was a glut of excess intended saving or a shortfall of investment intentions, the conclusion is the same: lower real long-term interest rates.

The truth was that because central bank policy had not cleared away malinvestment, but had coddled it, when the emerging markets attempted to save more (whether privately or by government fiat), interest rates fell, because there were fewer productive places to invest.

Similarly in 2002, I expressed my concerns before the Federal Open Market Committee that “. . . our extraordinary housing boom . . . financed by very large increases in mortgage debt – cannot continue indefinitely.” It lasted until 2006.  (Greenspan footnoted: Failing to anticipate the length and depth of emerging bubbles should not have come as a surprise. Though we like to pretend otherwise, policymakers, and indeed forecasters in general, are doing exceptionally well if we can get projections essentially right 70% of the time. But that means we get it wrong 30% of the time. In 18½ years at the Fed, I certainly had my share of the latter.)

Much as I appreciate Greenspan’s possible intellectual foresight in 2002, and his willingness to admit that he was sometimes wrong, I find fault in that he did not act on it.  He kept rates low through 2004, and defended the provision of liquidity by saying it would continue for a considerable period of time.

Clearly with such experiences in mind, financial firms were fearful that should they retrench too soon, they would almost surely lose market share, perhaps irretrievably.  Their fears were formalized by Citigroup’s Charles Prince’s now famous remark in 2007, just prior to the onset of the crisis, that “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Such was life under the Greenspan Put.  Make money while liquidity is cheap.  The Fed has our back, so lend to all but the worst prospects, and sell the loans as quickly as possible.

The financial firms risked being able to anticipate the onset of crisis in time to retrench. They were mistaken. They believed the then seemingly insatiable demand for their array of exotic financial products would enable them to sell large parts of their portfolios without loss. They failed to recognize that the conversion of balance sheet liquidity to effective demand is largely a function of the degree of risk aversion. That process manifests itself in periods of euphoria (risk aversion falling below its long term, trendless, average) and fear (risk aversion rising above its average). A lessening in the intensity of risk aversion creates increasingly narrow bid-asked spreads, in volume, the conventional definition of market, as distinct from balance sheet, liquidity.

In this context I define a bubble as a protracted period of falling risk aversion that translates into falling capitalization rates that decline measurably below their long term trendless averages. Falling capitalization rates propel one or more asset prices to unsustainable levels. All bubbles burst when risk aversion reaches its irreducible minimum, i.e. credit spreads approaching zero, though analysts’ ability to time the onset of deflation has proved illusive (sp).

I think Greenspan would benefit from reading my “What is Liquidity?” series.  Risk aversion is a function of asset-liability matching (as he notes), but also of the degree of certainty of being able to make or meet fixed obligations.

I very much doubt that in September 2008, had financial assets been funded predominately by equity instead of debt, that the deflation of asset prices would have fostered a default contagion much beyond that of the dotcom boom. It is instructive in this regard that no hedge fund has defaulted on debt throughout the current crisis, despite very large losses that often forced fund liquidation.

Good, but your prior policies fostered debt-based finance, because recessions were never allowed to get too deep, and businessmen rationally chose to finance with cheaper tax-deductible debt, rather than expensive equity, because they concluded that the Fed would not allow big crises to happen.

Mathematical models that define risk, however, are surely superior guides to risk management than the “rule of thumb” judgments of a half century ago. To this day it is hard to find fault with the conceptual framework of our models as far as they go. Fisher Black and Myron Scholes’ elegant option pricing proof is no less valid today than a decade ago. The risk management paradigm nonetheless, harbored a fatal flaw.

I disagree.  Good risk management is dumb risk management.  Simple rules outperform complex ones over a full market cycle.  Even Black-Scholes is open to question, given better models that reflect fatter tails.  Aside from that, B-S did not materially improve on Bachelier (or actuaries that had discovered the same formula on terminable reinsurance treaties several years earlier).  Black, Scholes, and Merton get too much credit for what was discovered previously.

Only modestly less of a problem was the vast, and in some cases, the virtual indecipherable complexity of a broad spectrum of financial products and markets that developed with the advent of sophisticated mathematical techniques to evaluate risk. In despair, an inordinately large part of investment management subcontracted to the “safe harbor” risk designations of the credit rating agencies. No further judgment was required of investment officers who believed they were effectively held harmless by the judgments of government sanctioned rating organizations.

Rating agencies offer opinions, not guarantees.  They are a beginning for research, not an end.  No one should rely on any third party when anything significant is at stake; they should analyze the situation themselves.

A decade ago, addressing that issue, I noted, “There is [a] . . . difficult problem of risk management that central bankers confront every day, whether we explicitly acknowledge it or not: How much of the underlying risk in a financial system should be shouldered [solely] by banks and other financial institutions? “[Central banks] have chosen implicitly, if not in a more overt fashion, to set capital and other reserve standards for banks to guard against outcomes that exclude those once or twice in a century crises that threaten the stability of our domestic and international financial systems.

“I do not believe any central bank explicitly makes this calculation. But we have chosen capital standards that by any stretch of the imagination cannot protect against all potential adverse loss outcomes. There is implicit in this exercise the admission that, in certain episodes, problems at commercial banks and other financial institutions, when their risk-management systems prove inadequate, will be handled by central banks. At the same time, society on the whole should require that we set this bar very high. Hundred year floods come only once every hundred years. Financial institutions should expect to look to the central bank only in extremely rare situations.”

At issue is whether the current crisis is that “hundred year flood.” At best, once in a century observations can yield results that are scarcely robust. But recent evidence suggests that what happened in the wake of the Lehman collapse is likely the most severe global financial crisis ever. In the Great Depression, of course, the collapse in economic output and rise in unemployment and destitution far exceeded the current, and to most, the prospective future state of the global economy. And of course the widespread bank failures markedly reduced short term credit availability. But short-term financial markets continued to function.

This was not a once-in-a-century event.  It was produced by weak monetary policy, and weak credit policy, leading to too much private debt being created.  Had the Fed done its duty, and kept monetary policy tighter for longer, we might not have come to this ugly juncture.  This situation is not an accident.   It could have been prevented by the Fed had it kept interest rates higher for longer.

More as this series continues…

Jake at Econompic Data had a good post on credit and equity.  (He runs a good site generally.)  They are correlated, but not all of the time.  As I commented:

When yields are low, equities thrive because financing costs are low.

When the defaults come, future equity returns are low, because financing rates rise, killing some and wounding others.

When yield spreads are very high, future equity returns are high, because returns come as spreads tighten.

You can see more on pages 14-22 of this presentation that I gave:


Though I promised some posts after my presentation to the Southeastern Actuaries Conference, I never followed up.  Here is part of my belated follow-up.

As I noted in my presentation:

  • Credit and equity returns are closely correlated in bear markets.
  • Illiquidity events become more common when equity prices are falling, and credit spreads rising.
  • Complexity and structure raise illiquidity during crises.
  • Bonds with negative credit optionality underperform in a crisis.

I would add that credit and equity returns are closely correlated coming out of a crisis as well.  But here are some examples, starting with 2007-2009


and then 1999-2004:


and then 1989-1993:


and then 1980-1983:


and then 1969-1975:


Finally, 1927-1944:


What I concluded:

  • Credit booms are different – equities rise, while credit spreads stay low and stable.
  • There are sometimes exceptions when selloffs are sharp, like 1987 or 1998.
  • Ignore what the government says. It is impossible to eliminate the boom-bust cycle. The best a good businessman can do is try to understand where he is in the cycle, and be prepared.
  • Building liquidity looks dumb after credit spreads have been tight for a few years, but can save a lot of performance. The same is true of an “up in credit trade.”
  • During the bust phase, illiquid companies and investments get whacked. It is often good to “leg into” such investments during the panic. This is when credit analysis really pays off, because during the panic, everything gets hit.
  • Equity risk shows up in insurance lines of business like Surety, D&O, E&O, Mortgage, Financial, etc.
  • If you have equity risk in your liabilities, reduce credit risk in your assets. Same is true if you need to regularly buy equity options. When implied option volatility rises, credit spreads tend to rise as well.


There are few corporate yield series that date prior to 1990.  Until computers became powerful enough, bonds traded on a dollar price basis, and yields, much less spreads, were not comprehensively recorded.  One of the few corporate yield series with a long history is Moody’s Corporate Bond Indexes, which goes back to 1919.  There are some oddities to that index, but there aren’t many choices if you go back a long way.  It composed of bonds in a given ratings category, 20-30 years long, unweighted average on yields.  The averages tend to yield more than most bond managers that I have talked with think they can get.

My credit spread variable was the yield on the Baa series less that on the Aaa series.  I think it is a really good proxy for credit conditions and overall market volatility.

Anyway, this was part of a talk that I gave to the Southeastern Actuaries Conference.  I’ll do a few more posts from that, but if you want to look at the report, you can find it here.

Unlike most people who analyze investments, I think there are periods of time where domestic long-only investors may be consigned to low or even negative returns.  As investors, we are generally optimists; we don’t like can’t win situations like the Kobayashi Maru.

When money market funds offer near-zero yields, asset allocation becomes complicated.  Near the beginning of such a period, it might pay to take a lot of risk when credit spreads are wide.  But when they are more narrow, but wide by historic standards, the question is tough.

I start analyses like this the way I do the the piece Risks, not Risk.  I look at the individual risks and ask whether they are overpriced or underpriced.  Here is my current assessment:

  • Equities — slightly undervalued at present, particularly high quality stocks.  (US and foreign)
  • Credit — Investment grade credit and high yield are fairly valued at present.
  • Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties.  There will be more defaults, both in commercial and residential.
  • Yield Curve — Steep.  It is reasonable to lend long, so long as inflation does not take off.
  • Inflation — Low, but future inflation is probably underestimated.
  • Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
  • Commodities — the global economy is not running that hot now.  There will be pressures on resources in the future, but that seems to be a way off.
  • Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

All that said, for retail investors, I am not crazy about the options at present.  I would leave more in money market funds than most would as a part of capital preservation.  I would also invest in high quality dividend-paying stocks, because they are undervalued relative to BBB corporates.

Beyond that, I would consider fixed income investments in the Canadian and Australian Dollars.  I am skittish about the US Dollar, Euro, Pound, Yen and Swiss Franc.  (The least of those worries is the US Dollar itself.)

We live in a world where risk is often not fairly rewarded at present, due to the liquidity trap that the major central banks have enter into.  My view here is to play it safe when conditions are not crazy bad, and take a lot of risk whe credit markets are in the tank.

As for now, I would hold high quality US stocks that pay dividends, US money market funds, and Canadian and Australian short term bond funds.  Commodities and companies that produce them should play a small role as well.

  • Equities — somewhat overvalued at present.  (US and foreign)
  • Credit — Investment grade credit is slightly overvalued, and high yield is overvalued.
  • Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties.  There will be more defaults, both in commercial and residential.
  • Yield Curve — Steep.  It is reasonable to lend long, so long as inflation does not take off.
  • Inflation — Low, but future inflation is probably underestimated.
  • Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
  • Commodities — the global economy is not running that hot now.  There will be pressures on resources in the future, but that seems to be a way off.
  • Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.