Growth in total factor outputs must equal the growth in payment to inputs.  The equity market cannot forever outgrow the real economy.

This is the “real economy rule,” and was listed first in my document, but i have not gotten to it until now.  It is very important to remember, because men are tempted to forget that financial markets depend on the real economy.  If the global economy grows at a 3% rate, well guess what?  In the long run, payments to the factors — wages, interest, rents, and profits will also grow at a 3% rate.  Maybe some of the factor payments will grow faster, slower, or even shrink, but you can’t get more out of the system than the system produces year by year.

  • The value of equity is the capitalized value of the profit stream.
  • The value of debt is the capitalized value of the interest stream.
  • The value of property, plant and equipment is the capitalized value of the rent stream.
  • The value of a slave/employee is the capitalized value of the wage stream.

Hmm, that last one doesn’t sound right.  We no longer capitalize people, as if one could legally own a person today.  Contracts for labor are short-term, and employees typically can leave at will.

But, there can be bubbles in property, debt and equity markets.  We just happen to be the beneficiaries of a situation where we have simultaneously had bubbles in all three.  Think of late 2006 — high values for residential and commercial real estate, low credit spreads, and high P/Es (relative to future profits).  Market participants expected far more growth than the overindebted economy could deliver.

Important here are the discount rates.  By asset class, relatively low discount rates relative to swap or Treasury yields indicate complacency.  It is one thing if stocks move up because profits are rising rapidly, and another if the discount rate is declining.  Similarly, it is one thing if stocks are rising because GDP is growing rapidly, and thus revenues are rising, and another thing if it is due to profit margins rising, and profit margins are near record levels, as they are today.

Extreme profit margins invite competition.  Extreme profit margins tend not to last.

In many asset classes, investors were fooled.  Home buyers bought thinking the prices could only go up.  They ignored the high ratio of property value relative to what they would currently pay.  Commercial real estate investors bought at lower and lower debt service coverage ratios.  Collateralized debt investors accepted lower and lower interest spreads at higher and higher degrees of leverage.  With equity, investor assumed that growth in asset values in excess of growth in GDP would continue.  The stock market does grow faster than GDP, but the advantage is less than double GDP growth.

Thus after the long rally, with no appreciable growth in the economy, I would be careful about equities, and corporate debt as well.  Some yields are high relative to long run averages, but the risk is higher as well.

The main point is to remember that the real businesses behind the financial markets drive performance in the long haul, even if adjustments to the discount rate do it in the short run.  To be an excellent manager, focus on both factors — likely payments, and rate at which to discount.  But who can be so wise?

Sorry that I did not do this in real time.  When the FOMC released its report, I was with my sons touring college campuses.  Anyway, here is the comparison:

David J. Merkel, CFA, FSA

28 April 2010

April 2010 Redacted FOMC Statement

March 2010April 2010Comments
Information received since the Federal Open Market Committee met in January suggests that economic activity has continued to strengthen and that the labor market is stabilizing.Information received since the Federal Open Market Committee met in March suggests that economic activity has continued to strengthen and that the labor market is beginning to improve.They shade their views up a bit on the labor market.  I think that is premature.  They are missing the weakness in employment.
Household spending is expanding at a moderate rate but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.Growth in household spending has picked up recently but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.No real change, though they shade their views up a bit on the labor market.  There is little growth in household spending.
Business spending on equipment and software has risen significantly. However, investment in nonresidential structures is declining, housing starts have been flat at a depressed level, and employers remain reluctant to add to payrolls.Business spending on equipment and software has risen significantly; however, investment in nonresidential structures is declining and employers remain reluctant to add to payrolls. Housing starts have edged up but remain at a depressed level.Shades up housing.
While bank lending continues to contract, financial market conditions remain supportive of economic growth.While bank lending continues to contract, financial market conditions remain supportive of economic growth.No change.
Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.No change.
With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.No real change.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.No change.  This gives you the trigger for when they will raise the Fed Funds rate.  As I said last month, watch capacity utilization, unemployment, inflation trends, and inflation expectations.
To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve has been purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt;Paragraph dropped.  MBS purchases are done.
those purchases are nearing completion, and the remaining transactions will be executed by the end of this month.Paragraph dropped.  MBS purchases are done.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.No change.
In light of improved functioning of financial markets, the Federal Reserve has been closing the special liquidity facilities that it created to support markets during the crisis. The only remaining such program, the Term Asset-Backed Securities Loan Facility, is scheduled to close on June 30 for loans backed by new-issue commercial mortgage-backed securities and on March 31 for loans backed by all other types of collateral.In light of improved functioning of financial markets, the Federal Reserve has closed all but one of the special liquidity facilities that it created to support markets during the crisis. The only remaining such program, the Term Asset-Backed Securities Loan Facility, is scheduled to close on June 30 for loans backed by new-issue commercial mortgage-backed securities; it closed on March 31 for loans backed by all other types of collateral.No real change.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh. Voting against the policy action was Thomas M. Hoenig, who believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to the buildup of financial imbalances and increase risks to longer-run macroeconomic and financial stability.Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh. Voting against the policy action was Thomas M. Hoenig, who believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to a build-up of future imbalances and increase risks to longer run macroeconomic and financial stability, while limiting the Committee’s flexibility to begin raising rates modestly.Hoenig dissents, as last month.  Thinks that we might be starting a new financial bubble, and that it might affect future FOMC policy, making a shift more severe.


  • The FOMC is overly optimistic on employment and housing issues.
  • Hoenig still dissents; hasn’t gotten bored with it yet.
  • Watch capacity utilization, unemployment, inflation trends, and inflation expectations.
  • As a result, the FOMC ain’t moving, absent increases in employment, or a US Dollar crisis.  Labor employment is the key metric.

Economic systems are the result of cultures.  Where there is little cultural agreement, the economic system will be unstable, as will be governmental action.

No, this is not another “Rules” post.  But this is a post about the Eurozone and Japan today.  Japan faces trouble, but there is cultural agreement on what should be done, so there is no great crisis today, though the demographics may force issues eventually.

The Eurozone does not publicly recognize that there are large disagreements over what economic policy should be.  In the countries that are in economic trouble, there are many that push their governments to spend more on them, forcing the governments to borrow more.  This is particularly true of the unions.

My view of unions is that they slowly kill whomever they serve.  Industries with high unionization die eventually.  Countries that support unions die slowly as well.

Unions introduce inflexibility into the economic process which has a huge cost, eventually.  Greece is controlled by its unions.  They are willing to seek their own prosperity even if it leads to the destruction of the nation.  They don’t think the nation will be destroyed, but think that there are parties in power that hold back value from them, and they must be opposed, deluded fools that the unions are.

But there is a bigger problem for the Eurozone.  What do they do about Portugal, Ireland, Spain, and maybe Italy?  Yeah, the Eurozone could rescue Greece, but could it rescue Spain?  The answer is simple, NO.  But rescuing Greece discourages Spain from taking hard actions.

There is a lot of moral hazard involved in rescuing countries in the Eurozone.  Far better for nations to rescue banks that have lent to Greece, Portugal, Ireland, Spain, Italy, etc.  From what I have read, Europeans don’t exist.  Nations exist around a common culture and language.  Nations in Europe exist, and many act against the concept of a Eurozone.

Both positively and negatively, one can say that the Eurozone can’t make everyone into Germans.  The Germans exercised discipline that other nations would not.  Because of the size of Germany, and those allied with them in the Eurozone, the Euro is a hard currency, harder than many cultures/nations with lower labor productivity would like.

Why is the Euro weak?  Because the present crisis has relegated it to the status of an experiment.  Wondering over how Eurozone obligations will be repaid is an issue outside the Eurozone.  There are solutions, but they are painful — 1) let Greece become a state of Germany.  Not happening. 2) Let the Eurozone pour money into Greece; I’m sure they will reward you by adopting austerity measures, not. 3) Let Greece default, and then, let the Eurozone attempt to ameliorate it.  It will be difficult, and I doubt that debts to Greece will be settled at over 40% per Euro.

The major trouble is that banks in countries with relatively orthodox finances have lent to countries with liberal finances.  Well, who else could have done it, but the banks making the loans are in a fix because their health is subject to the creditworthiness of those that they lent to, which should be no surprise, but we forget.

Thus the big crisis in Europe is really over the soundness of the banking sector.  Rather than bailing out nations in trouble, far better to bailout your own banks that made bad loans, and let the profligate nations fail.  Remember, the Eurozone was not a promise to support profligate nations, but an effort for responsible nations to share a common currency.  If nations are not responsible, it is not the responsibility of the other Eurozone nations to subsidize them.

Do you want to save the Eurozone?  Save it by protecting your own banks, and letting profligate nations fail.  You will end up with a “hard” Eurozone of nations that are not profligate, and can live up to the demands of a strong currency.  The Eurozone exists without the UK.  It can exist without Greece, Portugal, Spain, Italy, and Ireland.

Subsidies don’t work, and that is what the loans to Greece are.  The Greeks will just suck them in, and continue their unruly fracas over who gets what.  Far better to let Greece fail, and scare marginal nations to clean up their acts.


I don’t write this because I want the US Dollar to prosper because of a failure of the Euro.  Hey, I want credible alternatives to the Dollar, because it is at best the best of a bunch of sorry currencies, and I am not ready to sign on to the cult of Gold.  I like gold as a currency, but am not crazy about it as an investment.

My view is that the Euro can exist even after the failure of nations that leave the Euro, and that Euro obligations could still be enforced on defaulting nations because of the large amount of commerce inside Europe.

My advice to European statesmen, including those that share my surname, is to focus on your national interests.  The Eurozone is too vague to matter to those who elect you.  Focus on protecting your banks, rather than those the banks have lent to, which would waste money.




With regard to equity market performance, I am torn.  My head says, “Go with the momentum. Broad rally here.”  My heart says, “Profit margins will be at records with the 2011 earnings estimates; aim for industries that are out of favor.”

If I try to unify the two, I remain convinced that high quality companies are the better place to be — better valuations and far less risk.

In any case, I am looking at modifying my portfolio, and the industries that interest me fall into energy, utilities, healthcare, and stable sectors.

Note for my first model, the green zone is the anti-momentum or value zone.  The red zone is the momentum zone.

Use the model consistent with your personality.  If you like buying mean-reversion buy in the green zone.  Momentum, buy the red zone.

My selections in “Dig Through” reflect higher quality areas of the market that I think will be rewarded over time.  Remember that I am for outperformance over a three-year period, though I have often done that over shorter periods.

The second industry table comes from the S&P 1500 supercomposite, while the first comes from Value Line.  The results are broadly similar.  Still, at this point in the markets, I am more inclined to caution than risk-taking.  I feel that it is 10% upside and 30% downside here.

These are only educated guesses, but as I readjust my portfolio, I sense that I will toss out cyclicality, and buy utilities and other stable  companies.

I write this because I was invited to be on CNBC on the topic, but I suggested that my opinion would not make for good television.  That said, I have taken my four prior posts on the topic, and assembled them into one comprehensive post.  I do not intend on posting on this again.  With that, here is my post:

The ratings agencies have come under a lot of flak recently for rating instruments that are new, where their models might not be do good, and for the conflicts of interest that they face.  Both criticisms sound good initially, and I have written about the second of them at RealMoney, but in truth both don’t hold much water, because there is no other way to do it.  Let those who criticize put forth real alternatives that show systematic thinking.  So far, I haven’t seen one.

Most of the current problems exist in exotic parts of the bond market; average retail investors don’t have much exposure to the problems there, but only less-experienced institutional investors.

Here are my five realities:

  • Somewhere in the financial system there has to be room for parties that offer opinions who don’t have to worry about being sued if their opinions are wrong.
  • Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves, or something similar.  The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.  The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
  • New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
  • There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
  • Ratings can be short-term, or long-term, but not both.  The worst of all worlds is when the ratings agencies shift time horizons.

Ratings are Opinions

The fixed-income community has learned that the ratings agencies offer an opinion, and they might pay for some additional analysis through subscriptions, but if they were forced to pay the fees that issuers pay, they would balk; they have in-house analysts already.  The ratings agencies aren’t perfect, and good buy-side shops use them, but don’t rely on them.  Only rubes rely on ratings, and sophisticated investors did not trust the rating agencies on subprime.  My proof?  Look how little exposure the Life and P&C insurance industries had to subprime mortgages outside of AIG.  Teensy at best.

Please understand that institutions own most of the bonds out there.  We had a saying in a firm that I managed bonds in, “Read the write-up, but ignore the rating.”  The credit analysts at the rating agencies often knew their stuff, giving considerable insight into the bonds, but may have been hemmed in by rules inside the rating agency regarding the rating. It’s like analysts at Value Line.  They can have a strong opinion on a company, but their view can only budge the largely quantitative analysis a little.

Let’s get one thing straight here.  The rating agencies will make mistakes.  They will likely make mistakes on a correlated basis, because they compete against one another, and buyers won’t pay enough to support the ratings.

So there are systematic differences and weaknesses in bond ratings, but the investors who own most of the bonds understand those foibles.  They know that ratings are just opinions, except to the extent that they affect investment policies (”We can’t invest in junk bonds.”) or capital levels for regulated clients.

On investment policies, whether prescribed by regulators or consultants, ratings were a shorthand that allow for simplicity in monitoring (see Surowiecki’s argument).  Now, sophisticated investors knew that AAA did not always mean AAA.  How did they know this?  Because the various AAA bonds traded at decidedly different interest rates.  The more dodgy the collateral, the higher the yield, even if it had a AAA rating.  My mistake: I, for one, bought some AAA securitized franchise loan paper that went into default long before the current crisis hit.  Many who bought post-2000 AAA securitized manufactured housing loan paper are experiencing the same.  Early in the 2000s, sophisticated investors got burned, and learned.  That is why few insurers have gotten burned badly in the current crisis.  Few insurers bought any subprime residential securitizations after 2004.  But, unsophisticated investors and regulators trust the ratings and buy.

Financial institutions and regulators have to be “big boys.” If you were stupid enough to rely on the rating without further analysis, well, that was your fault.  If the ratings agencies can be sued for their opinions (out of a misguided notion of fiduciary interest), then they need to be paid a lot more so that they can fund the jury awards.  Their opinions are just that, opinions.  As I said before, smart institutional investors ignore the rating, and read the commentary.  The nuances of opinion come out there, and often tell smart investors to stay away, in spite of the rating.

How Can Regulators Model Credit Risk?

It started with this piece from FT Alphaville, which made the point that I have made, markets may not need the ratings, but regulators do.  (That said, small investors are often, but not always, better off with the summary advice that bond ratings give.)  The piece suggests that CDS spreads are better and more rapid indicators of change in credit quality than bond ratings.  Another opinion piece at the FT suggests that regulators should not use ratings from rating agencies, but does not suggest a replacement idea, aside from some weak market-based concepts.

Market based measures of creditworthiness are more rapid, no doubt.  Markets are faster than any qualitative analysis process.  But regulators need methods to control the amount of risk that regulated financial entities take.  They can do it in four ways:

  1. Let the companies tell you how much risk they think they are taking.
  2. Let market movements tell you how much risk they are taking.
  3. Let the rating agencies tell you how much risk they are taking.
  4. Create your own internal rating agency to determine how much risk they are taking.

The first option is ridiculous.  There is too much self-interest on the part of financial companies to under-report the amount of risk they are taking.  The fourth option underestimates what it costs to rate credit risk.  The NAIC SVO tried to be a rating agency, and failed because the job was too big for how it was funded.

Option two sounds plausible, but it is unstable, and subject to gaming.  Any risk-based capital system that uses short-term price, yield, or yield spread movements, will make the management of portfolios less stable.  As prices rise, capital requirements will fall, and perhaps companies will then buy more, exacerbating the rise.  As prices fall, capital requirements will rise, and perhaps companies will then sell more, exacerbating the fall.

Market-based systems are not fit for use by regulators, because ratings are supposed to be like fundamental investors, and think through the intermediate-term.  Ratings should not be like stock prices — up-down-down-up.  A market based approach to ratings is akin to having momentum investors dictating regulatory policy.

Also, their models that I am most familiar with only apply to publicly-traded corporate credit.  Could they have prevented the difficulties in structured credit that are the main problem now?

What to do with New Classes of Securities?

Financial institutions will want to buy new securities, and someone has to rate them so that proper capital levels can be held (hopefully).  But what are rating agencies to do when presented with novel financial instruments that have no significant historical loss statistics?  Many of the likely buyers are regulated, and others have investment restrictions that depend on ratings, so aside from their own profits, there is a lot of pressure to rate the novel financial instrument.  A smart rating agency would punt, saying there is no way to estimate the risk, and that their reputation is more important than profits.  Instead, they do some qualitative comparisons to similar but established financial instruments, and give a rating.

Due to competitive pressures, that rating is likely to be liberal, but during the bull phase of the credit markets, that will be hidden.  Because the error does not show up (often) so long as leverage is expanding, rating agencies are emboldened to continue the technique.  As it is, when liquidity declines and leverage follows, all manner of errors gets revealed.  Gaussian copula?  Using default rates for loans on balance sheet for those that are sold to third parties?  Ugh.

Some will say that rating agencies must say “no” to Wall Street when asked to rate exotic types of debt instruments that lack historically relevant performance data.  That’s a noble thought, but were GICs [Guaranteed Investment Contracts] exotic back in 1989-1992?  No.  Did the rating agencies get it wrong?  Yes.  History would have said that GICs almost never default.  As I have stated before, a market must fail before it matures.  After failure, a market takes account of differences previously unnoticed, and begins to prospectively price for risk.

But think of something even more pervasive.  For almost 20 years there were almost no losses on non-GSE mortgage debt.  How would you rate the situation?  Before the losses became obvious the ratings were high.  Historical statistics vetted that out.  No wonder the levels of subordination were so small, and why AAA tranches from late vintages took losses.

When prosperity has been so great for so long, it should be no surprise that if there is a shift, many parties will be embarrassed.  In this case both raters and investors have had their heads handed to them.

Now there are alternatives.  The regulators can ban asset classes until they are seasoned.  That would be smart, but there will be complaints.  I experienced in one state the unwillingness of the regulators to update their permitted asset list, which had not been touched since 1955.  In 2000, I wrote the bill that modernized the investment code for life companies; perhaps my grandson (not born yet), will write the next one.

Regulators are slow, and they genuinely don’t understand investments.  The ratings agencies aren’t regulators, and they should not be put into that role, because they are profit-seeking companies. Don’t blame the rating agencies for the failure of the regulators, because they ceded their statutory role to the rating agencies.  But if the regulators ban asset classes, expect those regulated to complain, because they can’t earn the money that they want to, while other institutions take advantage of the market inefficiencies.

Compensation and Conflicts

Some say that rating agencies must be encouraged to make their money from investor subscriptions rather than fees from issuers, to ensure more impartial ratings.  If this were realistic, it would have happened already.  The rating agencies would like nothing more than to receive fees from only buyers, but that would not provide enough to take care of the rating agencies, and provide for a profit.  They don’t want the conflicts of interest either, but if it is conflicts of interest versus death, you know what they will choose.

Short vs. Long-Term Opinions

Ratings agency opinions are long-term by nature, rating over a full credit cycle.  During panics people complain that they should be more short-term.   Hindsight is 20/20.  Given the multiple uses of credit ratings, having one time horizon is best, whether short- or long-term.  Given the whipsaw that I experienced in 2002 when the ratings agencies went from long- to short-term, I can tell you it did not add value, and that most bond manager that I knew wanted stability.


Some say rating agencies no longer should have exclusive access to nonpublic information, to even out the playing field.  That sounds good, but the regulators want the rating agencies to have the nonpublic information.  They don’t want a level playing field.  As regulators, if they are ceding their territory to the rating agencies, then they want the rating agencies to be able to demand what they could demand.  Regulators by nature have access to nonpublic information.

Some ask for greater disclosure of default rates, but that is a non-issue.  They also look to punish rating agencies that make mistakes, by pulling their registration.  Disclosing default rates is already done, and sophisticated investors know this.  Yanking the registration is killing a fly with a sledgehammer.  It would hurt the regulators more than anyone else. The rating agencies are like the market.  The market as a whole gets it wrong every now and then.  Think of tech stocks in early 2000, or housing stocks in early 2006.  To insist on perfection of rating agencies is to say that there will be no rating agencies.  It takes two to make a market, and agencies will often be wrong.


As for solutions, I would say the following are useful:

  • Competition.  I’m in favor of a free-ish market here, allowing the regulators to choose those raters that are adequate for setting capital levels, and those that are not.  For other purposes, though, the more raters, the better.  I don’t think rating fees would drop, though.  Remember, ratings are needed for regulatory purposes.  Will Basel II, NAIC, and other regulators sign off on new credit raters?  I think that process will be slow.  Diversity of opinion is tough, unless a ratings agency is willing to be paid only by buyers, and that model is untested at best.
  • Compensate with residuals and bonuses (give the raters some skin in the game)
  • Deregulation (we can live without rating agencies, but regulators will have to do a lot more work)
  • Greater disclosure (sure, let them disclose their data and formulas (perhaps with a delay).
  • Have regulators bar unseasoned asset classes.


Let those who criticize the ratings agencies bring forth a new paradigm that the market can embrace, and live with in the long term.  Until then, the current system will persist, because there is no other realistic way to get business done.  There are conflicts of interest, but those are unavoidable in multiparty arrangements.  The intelligent investor has to be aware of them, and compensate for the inherent bias.

Unless buyers would be willing to pay for a new system, it is all wishful thinking.  Watch the behavior of the users of credit ratings.  If they are unwilling to pay up, the current system will persist, regardless of what naysayers might argue.

Tonight’s post could be one in the “rules” series, but since I did not get this idea prior to 2003, when I started investment writing at, it does not qualify for me.  But here it is:

At the end of the day, the world as a whole is owned 100%.  There are people with short positions, calls, puts, etc., and even things more exotic.  Those are noise around the real economy that produces the goods and services of our world.

Beyond that there are debt transactions in order to own assets, or purchase products and services.  But every debt is an asset to another party, and cancels out across the globe.  There are no debts on net in the world.

Does that mean that debts are irrelevant?  No.  Debts are relevant for two reasons: 1) Highly indebted economic systems are inflexible, because there are too many fixed claims.  They are far more prone to crises.  2) The debt of financial companies is very important because they often borrow short-term to finance longer-term assets.  In the current crisis, repo funding is the great example of this.

A financial firm thinking long run would not do repo financing because it can be easily pulled.  It would float long debt equal to the term of the assets that they want to finance.  But that might make their margins inadequate.  Don’t you know that short rates are volatile, and that they tend to be lower then long term rates most of the time?

Well, maybe.  But when debts increase, parties step forward to finance long credit via short borrowing.  That is an essential element of the credit system when it is in bubble mode.  (Side note: the exception to this is lending against sticky checking and savings account liabilities.  Those liabilities are sticky only because of deposit insurance.  The policy question there is whether the insurance premium is set too low. In hindsight, the answer is yes, though at my prior employer, we talked about the inadequacy of the FDIC, and bank reserving regularly.)

Though all debts net out to zero across the global economy as a whole, a lot depends on who owns the debts.  If the debts are owned by those who are borrowing money, risks of a debt crisis rise.  The layering of debt upon debt, and borrowing short to lend long decrease financial system resilience.

Finally, the willingness to make loans to marginal borrowers is really a statement that lenders are willing to make an equity investment in someone they are lending to, or some property that they are lending against.  Formally, it is all a loan, but economically the lender is betting on prosperity, much as a stock investor might.

When I wrote my piece on the residential housing bubble at RealMoney back in May of 2005, I did not focus on the high prices much; instead, I focused on the financing issues:

  • Amount of debt vs assets
  • Borrowing short term to buy a long-lived asset, a house.
  • Quality of the debt underwriting

And, much the same when I wrote my piece on subprime mortgages in November 2006, too much leverage, the teaser rates are short term borrowing, and the loan underwriting was horrible.  As with residential mortgages generally, subprime mortgages were even more set up for failure.

If you want to find a bubble, focus on the financing.  The rise in asset prices is not sufficient, assets must be misfinanced for there to be a bubble.

When I was writing at RealMoney, I did a series of four articles to illustrate market dynamics:

Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders’ Hands, Part 1
Get to Know the Holders’ Hands, Part 2

I wanted them to have similar titles, but it was not to be.  Even for managing equities, understanding the balance sheets of companies, and those that own companies can make a difference.  When stocks are owned by those that can truly buy and hold, downside is limited.  When stocks are owned by those who are under pressure to earn money in the short run, upside is limited.

But what of liabilities for which there are no assets?  What of underfunded municipal and corporate pension plans?  With the corporate plans there is bankruptcy and the PBGC.  With municipalities, and the Federal Government it is more questionable.  There are few assets to lay claim to, even if there were a right to do so.  They rely on increased taxation, and the willingness of the courts to enforce pension promises.  This will prove politically difficult, and perhaps prove to be a greater challenge to the constitution than anything previous, because the economic demands are far greater than what the US taxpayer has been willing to bear.

Still, the greater challenge for countries is the ability to continue to manage debt issuance.  As we see with Greece today, that is not a simple thing.  Countries can be misfinanced, as much or more so than corporations.

Risk management is primarily management of liquidity, and planning to avoid  liquidity risks over the long haul.  Easy to state, hard to do.  The siren song of the short-run is so compelling, but the long–run eventually arrives, and when it does, it comes to stay.  Plan your life, or your corporation’s life such that you control your destiny, and are never in a spot where you are forced to do anything.  That takes discipline, but the man who controls his own soul is ready to rule things far greater.

Could an investment bank go to junk status?

Some of my “rules” were phrased as questions.  I wrote that one prior to 2002, possibly musing about downgrades in the credit ratings of investment banks.  But today we know the answer: NO.

There are functions in the credit markets that only belong to strongly capitalized entities.  Anything involving a large degree of credit risk requires an exceptionally strong balance sheet.  Though my original question was about investment banks, think of mortgage and financial insurers.  Where are they today?

Looking at my list of financial/mortgage insurers from three years ago, this is what I find:

  • Ambac Financial Group [ABK] — Aaa/AAA to C/CC (default in all but name)
  • ACA Holdings — A to default
  • Assured Guaranty — Aa3/A+ to A3/A+
  • MBIA Inc — Aa2/AA to Ba3/BB-
  • MGIC — A1/A to Caa1/CCC
  • PMI — A1/A to Caa2/CCC+
  • Primus Guaranty — Baa1/BBB+ to B2/CCC
  • RAM Re — Aaa/AAA — Ba3/NR
  • Radian — A2/A to Caa1/CCC
  • Syncora — Aaa/AAA to default
  • Triad Guaranty — A- to default.

Let me make a modest suggestion: financial and mortgage insurance does not work in times of extreme financial stress.  Aside from Assured Guaranty every insurer offering coverage from financial/mortgage risks got smashed.  Aside from AGO, all are at junk credit levels.

What this says to me is that the method of regulating financial and mortgage insurers is wrong.  Financial risks are more severe than other risks, and a greater amount of capital must be held for solvency. When financial risks go bad, many risks go bad.

But wait, you say, at the greater level of capital, no one will buy the insurance.  That might be true in the short run, but in the long run pricing levels will adjust.  Insurance for mortgages will be bought, if the credit is secure.

Back to investment banks.  They must be fundamentally sound institutions, given the high degree of leverage employed.  Once they have a junk rating, fewer will do business with them, much like the financial insurers.

As a result my answer is no, no credit-sensitive institution can be junk-rated.  Even a low-investment-grade rating is a stretch. During the boom phase, any investment grade rating can work; in the bust phase only the best market practices maintain a credit rating. and few credit sensitive entities maintain an investment grade rating.

The more entities manage for total return, the more unstable the financial system becomes.

The shorter the performance horizon, the more volatile the market becomes, and the more index-like managers become.  This is not a contradiction, because volatile markets initially force out those would bring stability, until things are dramatically out of whack.

I was at a conference on Stable Value Funds, I think around 1995.  The meeting hadn’t started  but a few attendees  had arrived.  We were talking about the need to find yield in the market when one said (with an arrogant attitude), “Yield?  Why not total return?”

A tough question, and one none of us were ready for at the time.  My thoughts a few days later were on the order of, “If only it were that simple.  Right, you can generate positive returns over every time horizon worth measuring.  Okay, Houdini, do it.”

Total return investors don’t have long time horizons.  Investors with short time horizons either aim for momentum plays, or aim for yield.  Momentum persists in the short run, so play it if you must, remembering that the market gets more volatile when many play momentum.

Yield is less volatile than momentum, at least most of the time.  But yield is a promise, and frequently disappoints during times of stress.  Look at all of the dividend cuts over the past two years.

But consider this from a different angle.  Imagine your boss comes to you and says, “I want you to deliver the best returns to me every day versus the S&P 500.”  Okay, beat the S&P 500 every day.  That means the portfolio has to be a lot like the S&P 500, with some tweak that will beat it.  Anything too different from the S&P 500 will miss too frequently.

Now, I would say loosen up, why constrain daily performance?  Aim for great returns over the long haul, and don’t sweat years, much less days.  Great asset management requires a willingness to be wrong over significant periods, with a strong sense of what will work in the long run.

Those with short horizons will tend to index relative to their funding need, whether it is cash, short bonds, or indexed equities.  Note that most managers should have long horizons, but clients evaluate the returns of the past quarter or month, and the manager feels as if he is on a short leash, which makes him look to the next month or quarter, and makes him invest more like an index.


If you have a good manager, set him free — lengthen the performance horizon; give him room to do things that are unorthodox.  Ignore the consultants with their foolhardy models that constrain manager behavior.  Let me tell you that you are brighter than the consultants, and can better manage managers than they do.  Their models encourage managers who hug the indexes to avoid doing too much worse than them, and so you get index-like performance.


At turning points, a different breed of investor shows up.  At busts, investors show up who will buy and hold, bringing stability to the market.  They look at fundamental metrics and conclude that their odds of losing money are small.  At the booms, a different investor leaves.  They will sell and sit on cash.  Similarly, they think the odds of losing money, or, not making as much, is large.


Good money managers think long term, but all of the short-term measurements fight against that.  They force managers to think short term, or else their assets will leave them.  That is a horrible place to be.  Better that clients should ignore the consultants, and aim for the long-term themselves.  You will do much better choosing managers for yourselves and ditching the consultants who (it should be known) merely chase performance.  With help like that, you may as well invest in the hottest stocks with a portion of your portfolio — you might do better than you are doing now.

Most academic economists are irrelevant, so we can ignore them.  The few that are relevant are worth noting.  They can write such that ordinary people can understand — think of Milton Friedman with his “Free to Choose.”  Such economists are viewed skeptically by the “profession” because they interact with the unwashed.

So it is with Ayres and Nalebuff.  I have rarely been impressed with what they write.  Like Freakonomics, they write about stuff that is sensational, and challenge the conventional wisdom.  Yo, the conventional wisdom is right most but not all of the time.  Anyone that focuses on where the conventional wisdom is wrong will commit a lot of errors in an effort to be novel.

Now, Abnormal Returns and Sentiment’s Edge have made their polite comments, but now it is time for my less polite comments. I have five main critiques of their paper, which stems from the lack of practical experience in the markets for these two professors.

1) History is an accident.  It is fortunate that they are analyzing the US, rather than nations whose markets got wiped out during a war.  It is not impossible that the US could face a similar crisis in its future.  Try the same analyses with Argentina or Peru.  Will it work?

2) Even in the US stocks don’t outperform bonds by that much.  My estimate of the equity premium is around 1%.  Yes, the economics profession says the equity premium is higher, but they use a wrong metric; they should use dollar-weighted returns, not time-weighted returns.  The estimate of 4% equity returns over margin rates, which are higher than bond yields, is hooey.

3) Average people aren’t capable of managing portfolios that are 100% equities, much less levered equities.  It is well known that people invested in equity funds tend to buy and sell at the wrong times.  It would be far worse with leveraged portfolios.

4) Leveraged ETFs tend to underperform over time, have you noticed?  This is a mathematical necessity.  Through options and swaps, which have larger bid-ask spreads, maintaining the leverage is at low cost is tough.  If the advantage over margin rates were true, there would be real advantages to leverage.

5) What if everyone did it?  The paper is a typical, “If you had done this in the past, you would have done a lot better.”  Duh, and I can do better versions of that than the authors.  Going back to point one, history is an accident, and cannot be relied on.  Point two, their math is wrong.  Point three, average people can’t implement it.  Point four, those who try to do this don’t do as well as you might expect.

The last point is that everyone can’t do this.  Can you imagine what would happen if everyone aged 25-41 suddenly invested into equity exposure equal to twice their assets?  Stock prices would shoot up, and would offer little future returns to holders.  Stocks aren’t magic, and over the very long haul, they tend to return what the GDP does plus a few percent.

Think of Alan Greenspan encouraging people to finance using ARMs at the worst time possible.  The authors here encourage young people to speculate on equities with leverage at a time when the market is somewhat overvalued.  If this were a good idea, you would have seen many people doing it already, and it is not a common practice.  Don’t listen to academics that have little practical experience for investment advice.

One final note: when I wrote at RealMoney, I took a contrarian view that for average investors, no one should be fully invested.  Even the great Ben Graham never exceeded 75% invested.  My view is that average people must limit their risks or they will not be able to sustain their investment plans.  A 50/50 or 60/40 balanced fund approach is best for the average person — they will never get scared enough to abandon it.

Leverage is for experts only, and I have never used leverage.  Only use leverage if you are more of an expert than me.  (I write this not out of pride, but out of my experience where so many have gotten burned by taking too much risk.)

I like CXO Advisory, and always read them as they publish.  That said, I think they sometimes have a weakness in their methods by not using multivariate techniques when it would make sense.  So, when their article, “Interest Rates and Utilities,” I asked myself, “What would this look like if I used multiple regression?”

Rather than looking at correlations one at a time, multiple regression looks at them all at once, and tries to analyze which are the biggest factors.  Now unlike CXO, I used interest rate variables that have credit risk.  Why?  Corporations face credit risk, and they fund themselves with risky paper, unlike the US Treasury.  So, my two interest rate variables are the Moody’s Corporate Baa Average, which contains only long bonds, and the 30-day A2/P2 commercial paper yield as calculated by the Fed [H15s030Y].  These better measure funding costs for corporations.


All of these variables are highly significant.  Two go the way one would suspect, and one doesn’t.  Like REITs, performance is positively related to the market as a whole, and negatively related to Baa yields.

But, A2/P2 yields are positively related to returns.  Fascinating, and a reason why we should always use the long and short end of the yield curve for analyses.  They don’t measure the same thing.  Short-term liquidity is different from long-term borrowing rates.

Why are short-term rates positively related to returns?

  1. They are a measure of confidence in the economic system.
  2. Inflation drives both short-term rates and utility profit margins.

At least, I think that is the case.  As I often say, be skeptical about statistical arguments about the market, particularly when there is little economic reasoning behind the discussion.

With that, I simply say that yes, higher long-term interest rates do affect utility stock prices.  And higher short term rates will indicate inflation, and drive utility prices higher.  Beyond that utilities go higher as the market does, but the beta is low.

Are Utilities Like Bonds or Like Stocks?  They are like both of them.  Learn to enjoy that, unless the regulatory regime changes.