Before I start this evening, a small apology to my readers.  Things have been busy around here; blogging has been well below what I would like to do.  Worse, for some unexplainable reason, the hosting of my blog fell apart two days ago, and not for any change that I made.  As it was, WordPress deemed my theme to be broken.  So, I went in search of a new theme that would be compatible with what I used to have with Salattinet, and chose Green Apple.  I am a little more than half through in modifying it.

That said, I needed to make changes and had been delaying doing so.  I have modified my blogroll to reflect who I regularly read.  For the most part, I feature those that say more, but say it less frequently.

I will modify my leftbar to make it shorter, so that the site loads faster.  I will categorize my book reviews, and place the least recent of them on a separate page.

Though I like long post blogging, I will do more short posts.  My site will load a lot faster, so for those that visit the site directly, it should not be as much of a pain.

I expect to have this complete over the next month.  Much as this episode was a pain for me, I kept a good attitude about it, and am looking forward to the better blog that may result from the changes.


In order to write tonight’s essay, I scanned Kartik Athreya’s letter, and used OCR to turn it into a tractable file.  I had to correct OCR errors, but I left his spelling and grammar errors alone.  The formatting is slightly different, and fits on three pages, not the original four.

In many ways, economics and finance are about competition.  Writing about economics and finance is tough.  There are many facets to write about; there are feedback loops galore.  So, why do some writers in the blogosphere gain followers, and others don’t?

Tough question.  Being an engaging writer helps in the intermediate-run, and being a scandalmonger helps in the short-run.  In the long-run, all that matters is that the writer is right frequently, makes sense to readers, and has the humility to admit errors.  The economics and finance blogosphere is highly competitive, and talent tends to prevail over long periods of time.  Blogging is more of a meritocracy than peer-reviewed journals.  It more closely resembles “perfect competition.”

There is another aspect to blogging that is different from writing for economic journals: we have more of a slant toward positive economics than normative economics.  Ethics plays a larger role in what bloggers write about than what timid Ph.D. economists will write about.

Just as Law is too important to be left to lawyers, with all of their self-protecting biases, even so Economics is too important to be left to economists with Ph.Ds.  The economics guild protects its own in much the same way as described in Thomas Kuhn’s The Structure of Scientific Revolutions. Bad paradigms survive until a significant number of young scientists displace the paradigm, and replace it with a new one that explains things better.

Economics needs a better paradigm, and I do not mean better mathematical formulas.  For decades economists have been playing sterile math games assuming what they define as rational behavior which is not rational.

Simple example: when I was much younger, I was traveling with the two senior members of my Ph. D. dissertation committee, and I asked them, “But what if consumers don’t maximize?  What if they conserve on maximization, because maximization takes a lot of effort, and take the first ‘good enough’ solution?”  Their answer was the intellectual equivalent of a shrug.  Without maximization, mathematical economics falls apart.  Besides, Milton Friedman taught us that the realism of assumptions doesn’t matter.

I disagree.  It matters a great deal.  If we can’t get optimization to work, all of the implications of a model will fail; there is no way to get correct significant estimates of an optimization model, if people merely satisfice.  And most of us know that we are under time and knowledge constraints, and do not optimize.

The same issues apply to the Microeconomic theory of the firm.  But now let us consider Macroeconomics, which is even squishier.  Academic macroeconomists did not distinguish themselves regarding the recent economic crisis.  Few predicted it, versus a greater number of economist in the business world that did predict it.  Think about it: what should we say about macroeconomic models that claim that the financing structure of the economy is neutral?  That it does not matter how much is financed by debt versus equity?

As I said to Dr. Carmen Reinhart when I met her, “We need more economists that are students of history, and fewer that can do the pretty math for the ideal world that does not exist.”  She seemed to agree.

Get in contact with real data.  Abandon theories that don’t make sense when applied to the real world.  Work in the markets; see if you can make money.  Be practical and adjust.  If businesses can’t lever up infinitely, why should we assume that governments can do so?  Because they can tax or inflate it away?  Ah, but each comes with a cost.


With respect to Athreya’s letter, I would tell him to grow up, and genuinely compete with those who blog on economics and finance.  Though I am not a Ph.D., I did pass my comprehensive exams and oral exams from UC-Davis, an institution far more prominent than the University of Iowa, at least as far as applied economics goes.  That my dissertation committee left me, and that I could not set up a new committee killed my Ph. D.  It did force me to become an actuary, (my wife-to-be and I wanted to marry and start our family) and learn a lot of practical things about markets and funding structures that most economists will never bother with, to their practical detriment.

In my days at Johns Hopkins and UC-Davis, the longer that I studied, the more I learned that economics waves its hands at the problems that come whenever detailed studies attempt to test the main theories.  The results aren’t pretty; far better to have ad hoc theories that work over a limited range, than theories that proceed from basic principles, but do not work.

Yes, economics is hard.  Much harder than most economists think.  They need to abandon Keynesian, Chicago, and Neoclassical thinking, and aim for something that fits the data more closely.  That may not be the Austrian School, but it will be closer to that than the Neoclassical School.

We need an economic paradigm that is willing to tell the politicians that their actions will do no good, and will likely do harm; that central banks can’t create prosperity.  Governments exist to enforce justice, not goose the economy.

When we are in the bust phase of the economy, there are no good solutions, except to take the pain, realize the losses, and come to a quick end through a painful “big bang.”  This is the solution our central bank and politicians are fighting.  The “Japan solution” that is being followed refinances assets that are in oversupply at progressively lower rates, allowing bad assets to survive, and encouraging unproductive investment.  Real progress comes from accepting that there is no easy solution, and allowing the economy to liquidate bad investments without hindrance from the government or central bank.

The solution comes in preventing booms from getting out of hand, and always letting recessions be hard enough to liquidate bad investments.    We can’t do that now in the midst of the bust, but after the bad debts of our economy are liquidated, much as the Depression ended in 1941 when Debt/GDP reached 1.4x due to compromises and payoffs, and not due to the government or Fed, there can be real growth again, because less-indebted consumers and businesses are ready to act.

To Mr. Athreya, I would say that he has insufficiently embraced the complexity of the economy.  It is so complex that reducing it to mathematics does not work well.  But in a spirit of friendship, I invite him to visit me in Maryland and have lunch or dinner with me, at my expense.  Maybe I will tell him the story of when I got to question the head of the Richmond Fed.

That’s all for now.  There is more to say, but I am tired, and might not continue the essay so well.


I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My main industry model is illustrated in the graphic.  Green industries are cold.  Red industries are hot.  If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”  Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.  Yes, things are bad, but are they all that bad?  Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

If you use any of this, choose what you use off of your own trading style.  If you trade frequently, stay in the red zone.  Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?  Why change if things are working well?  I’m not saying to change if things are working well.  I’m saying don’t change if things are working badly.  Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.  Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.  This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.  It forces me to be bloodless and sell stocks with less potential for those wth more potential over the next 1-5 years.

I still like energy names here, utilities, and reinsurers, particularly those that are strongly capitalized.  I’m not concerned about hurricanes for the strongly capitalized; they will be around to benefit from the increase in pricing power after any set of hurricanes.

I’m looking for undervalued and stable industries.  Human resources — sure, more part time workers.  Healthcare information?  A growing field, even with the new “health bill.”  Same for Biotech.

Even in a double dip, toiletries will still be purchased.  Phone calls will still be made, and the internet will still be accessed.  Perhaps life insurers are worth a look here; after all, the Bush tax cuts are expiring, and there will be more demand for tax avoidance.

I’m not saying that there is always a bull market out there, and I will find it for you.  But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.  I don’t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.  The red zone is more highly cyclical than I have seen in quite a while.  I will be very happy hanging out in dull stocks for a while.

Changes in italics.

April 2010June 2010Comments
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. Information received since the Federal Open Market Committee met in April suggests that the economic recovery is proceeding and that the labor market is improving gradually.Shades down their views on the economy as a whole, and employment as well.
Growth in household spending has picked up recently but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.Household spending is increasing but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.Shades down their view of household spending.
Business spending on equipment and software has risen significantly; however, investment in nonresidential structures is declining and employers remain reluctant to add to payrolls.Business spending on equipment and software has risen significantly; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls.Shades down their view of business spending.
Housing starts have edged up but remain at a depressed level.Housing starts remain at a depressed level.Marks down their view of housing significantly.
While bank lending continues to contract, financial market conditions remain supportive of economic growth.Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad. Bank lending has continued to contract in recent months.Flips the two issues.  Shades their view of bank lending down.  Blames weaker financial markets on weakness in the Eurozone, which is slightly unfair.
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.Nonetheless, 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.Statement flipped around, but same language.  Do they do this for fun?
Prices of energy and other commodities have declined somewhat in recent months, and underlying inflation has trended lower.New statement, buttressing their low inflation views.
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 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.
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.  A useless statement.
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.Statement deleted because it is obsolete.  The liquidity crisis is gone for now, they hope.
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.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.No change at all.


  • Two months ago I wrote: The FOMC is overly optimistic on employment and housing issues.
  • Now the weakness is evident.  Hope has given way to modest pessimism, as they have shaded virtually all of their views of economic strength down.
  • Implicitly blaming the Eurozone is cheap, we have enough issues on our own for the weakness – residential housing, commercial real estate, and over-indebted consumers.
  • Hoenig still dissents; hasn’t gotten bored with it yet.  Have we gotten bored with him yet? J
  • The key variables are 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.

I first became interested in Social Security back in the 80s.  In order to become a Fellow in the Society of Actuaries you had to study all manner of insurance programs, both private and social, to understand the framework in which insurance and pension products existed.

The Greenspan Commission back in 1981-1983 proposed another large increase to Social Security taxes.  The system only needed a small lift to get it past some demographic difficulties, but the Commission proposed, and Congress passed a large change, which would mean that the Social Security would develop a large base of Treasury Notes, because income to the system would outstrip benefit payments for a long time, and the proceeds would be invested in Treasuries, because they are a neutral asset.  Investing in other assets would invite socialism and cronyism.

But really, what was needed was to move to a pay-as-you-go system, as Pat Moynihan suggested in the early 1990s.

But the fix could never be permanent, because even as taxes were increased, the benefits increased along with them, and there would come a day of reckoning.  But when?  There are three dates that many would point to:

  1. When the excess of taxes over benefits would peak.
  2. When benefits and taxes would be equal.
  3. When the trust fund would be broke.

I always looked at the first of these, whereas most commentators looked at the last of them.  My reasoning worked like this: the Federal Government has cynically integrated its budget with Social Security to make its deficits look smaller.  This is like a drug to the government; the real pain will come to it when the subsidy begins to fall.  By the time it goes negative, the US Government will account for it separately, so as to minimize the deficit again.

Given my view of how the US Government could no longer balance its books, the real change would come when they would have to increase their borrowing because there was not as much excess from the Social Security system.

When I first started looking at the Social Security system, the three dates in question were in the 2010s, the 2020s, and in the 2040s.  I thought that those dates were optimistic, but what I did not expect was that the current economic crisis would accelerate the first two dates dramatically.  As it is, date one has passed in 2008 (+/- a year), and I think the second date is happening in 2010.  Bruce Krasting’s post highlights the details, but I would concur, this recession will not end rapidly in the place where is counts for Social Security — employment.  We are not likely to see Social Security deliver surpluses to the US Government anymore.  Thus I expect deconsolidation of Social Security’s finances with that of the Federal Government.

What I never expected was that dates one and two would come so rapidly — almost together.  Let the morons who talk about trust fund exhaustion pontificate.  “We have all of these assets with which to pay future benefits….”  Nonsense.  As they sell bonds issued to the Social Security System, they must issue even more debt to the public.  How much can they bear, and at what yield?

Going back to my trip to the US Treasury, I want to remember one particular incident:

After the meeting, I said to one Treasury staffer, “One of the quiet casualties of this crisis is that you lost your last bit of slack from the entitlement systems.”

“What do you mean?”

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

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

The crisis has accelerated that date to 2010.  That’s a lot of change in just eight months.  The long-term problem is upon us now.  We are at the point of no return, absent large changes that those influenced by Keynesians will resist.

There are no good solutions now.  Budgetary cuts and tax increases reduce the possibility of government default.  They also will tend to slow the economy, unless the tax increases stem from cutting cheating, and the budget cuts affect only things that are a fraudulent waste.

Once you reach the point of no return, it doesn’t matter what prescriptions one follows — failure is coming.  One can shape the type of failure, but not that there will be failure.

All that said, there are still options, though none of them are good.  Will the currency be inflated?  Will the government default?  Will taxes be raised dramatically? I don’t know.  Be alert; be ready.  The endgame is here; we will see what moves the government makes.

PS — I have a signed copy of A. Haeworth Robertson’s book, Social Security: What Every Taxpayer Should Know.  He was the Chief Actuary of the Social Security System for a time, and a noted skeptic of the program.  He sent me the copy after I shared some of my misgivings with him in the 1990s.

Alas, but the average actuary has been skeptical of the Social Security system, and I have met many actuaries that work there, and they agree.  But leaders of the Society of Actuaries, when asked to give a clear warning on the troubles to come have refused.  I have my theories as to why — they curried favor with politicians for their own personal reasons.  Sad.

Full disclosure: If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

This will be a bit of an unusual post for me.  How often do I suggest option trades?  Almost never.  But because of auctioning of TARP warrants, there are a decent number of very long dated options trading on some bank stocks, and many of them are cheap.  I’m here to talk about the cheapest one this evening, Comerica.

Comerica warrants [CMA/WS] closed at $14.50 today, a price that makes the computer say, “does not compute.”

CMA neg vol

The Comerica warrants are trading so cheaply that they discount negative volatility.  At zero volatility, the warrants would trade 5% higher:

CMA zero vol

And at a fair-ish volatility level, 17% higher.

CMA 20 vol

Now there are two ways to extract value here.  Buy the warrant and sell short 2/3rds of a share of the common stock, which is empirically delta-neutral.

CMA delta neutral common

As the delta of the positions change, adjust your hedge in the common stock to reflect it.  The other way is not to short the common stock, but to short long dated options.  The most liquid long dated options are the 40s expiring in 2012.  The hedge would be to sell options on 170 shares of stock against every 100 warrants owned.

CMA delta neutral optionsOver ten months the transaction makes a profit with CMA stock between 30 and 53.  That is one wide band, and there is still room for adjusting hedges in ways that could improve matters.

Now, I am open to feedback from readers/bloggers who trade options.  What’s wrong with this idea?  Free money is rare in the markets, but this warrant really seems like a mispriced security.

Full disclosure: no positions

PS — note that you may not get favorable margining being long the warrant and short the option.

Internet issues are resolved, so here’s a post of things that built up while things were down.

1) You know that I have mixed feelings about the Fed.  They have done a poor job with bank regulation, monetary policy, and managing systemic risk.  The trouble is, if you’re going to have a fiat currency, monetary policy is credit policy, and so your central bank should broadly control credit if you are going to do that at all.  (If not, then set up a currency board, or back your currency with silver/gold.)

So when I hear that the Fed is winning in reconciliation of the finance bill, I think it is good in some ways – yes, they should oversee small banks, but bad because the Fed should not have bailout authority, or at least they should not be able to hide what they do when monetary policy is unorthodox.  It is one thing to delay oversight of ordinary dealings, but rotten to hide debasement of the currency through special dealings with favored entities.

But I see little value in the size of the Fed.  They have too many people doing too little.  Monetary policy and bank supervision?  Fine if they do it well.  But the institution as a whole could be radically slimmed.  Congress should take closer control of the Fed, slim it down, and focus it on the missions that it should attend to.

2) I am not impressed with Donald Kohn.  He has a farewell interview with the Wall Street Journal, and not once does he mention the buildup of debt in our economy, partially fostered by easy monetary policy from the Fed, as a problem.  Blind guy, and even worse, he still doesn’t get that bubbles are typically able to be seen in advance, or, that the Eurozone isn’t structurally flawed.

Thought experiment time.  What if we tossed out all the Fed governors, and replaced them with a bunch of notable value investors?  Value investors suffer from the problem that we see problems early, and adjust portfolios too soon.  That could be of benefit to monetary policy, because value investors often see when things are becoming overdone, well in advance of it becoming too big to handle.  This would be a big improvement on the current system.

3) I get email from congressional staffs asking for advice on issues, or asking me to write about them.  Recently I was asked what I would ask the nominees for the Federal Reserve Board.  This is what I said:

  • We find ourselves in this crisis because the Fed ran an asymmetric monetary policy for years: loosen aggressively when the least crisis comes up, and tighten slowly until there are small squeaks of pain.  This led short interest rates progressively lower, until we found ourselves in the liquidity trap that we are now experiencing.  How are you going to get us out of this liquidity trap?
  • How are you going to provide decent opportunities to savers so that capital formation can begin again?
  • What have you done in your life that qualifies you for this level of responsibility?
  • To the economists: neoclassical economics did us no favors with respect to this crisis.  Only a few Austrian economists predicted it, along with a few practical economists in the business world.  We need a new paradigm for monetary policy.  Are you capable of providing it?
  • To the non-economist: You will be working primarily with neoclassical economists, with their theories uncontaminated by data.  How will you avoid being sucked in by their groupthink?

4) When I went to hear Raghuram Rajan and Carmen Reinhart at the Cato Institute, I was very impressed with what both of them had to say.  Rajan was the skunk at the farewell party for Alan Greenspan back in 2005 at Jackson Hole, when he was the only one to fully suggest that imbalances were building up due to debts being incurred in the financial sector.  Few aside from The Economist noted what he said.  More noted Donald Kohn’s dismissive response, which was not erudite, in my opinion.

Both noted that the current financial reform bill would do little to fix the real underlying problems, with which I agree.  It constrains in many areas that don’t need it, and does not constrain areas that were significant to the crisis – e.g., the GSEs and the Fed.  Imagine a simple proposal that would immediately force flexibility onto the economy: dividends are deductible, but interest payments (and preferred dividends) are not.  An easy way to lower leverage, and encourage flexible finance.

Also, they noted the possibility that the US Government would engage in financial repression, which would force people to invest in government securities on unfavorable terms.  Ugly stuff.

And as an aside, we met in the F. A. Hayek Auditorium.

5) Can Hayek be cool?  Perhaps, give the recent rap video.  I am not surprised that few neoclassical economists give Hayek any credit; he cuts against most of what they stand for, so why should they commit treason?

As for Glenn Beck, I get tired very quickly of the facile answers that appeal to the anger of the masses.  There are real problems, and we need to deal with them, but oversimplifying the problems will not get us to the solutions; it will only create a new set of problems.  I have no favor toward the Tea Party; they don’t stand for anything coherent.  I am not an Austrian economist, much as I like some of their ideas.  My ideas have been derived from my observation of how financial systems work over the last 25 years.

6) Following Austrian economics would be a huge improvement over what we usually do, though there is a problem.  Once you hit the bust, nothing works.  The Austrian view will be a “big bang” and clean it up fast, but it will be a lot of sharp pain.  The virtue of Austrian Economics is that it would restrain the boom, and thus make it less likely that one faces the pains of the bust.  But there are no easy solutions in the bust.

Focus on the boom, not the bust.  Solve the boom, and the bust does not come.

7) It is common that many debt classes that have few defaults get an aura about the qualitative factors that forestall default.  Well, what of municipal finance?  Under stress, is it possible that the cultural factors that made default less likely might wither, and defaults cascade in likelihood?  Yes, I think that is possible, and I think that is why Buffett is lightening the boat on munis.

8 ) Solve the revolving door problem for the SEC?  Pay them more.  I get it, but are we really willing to pay market-based salaries for expertise?  I doubt it.  The government tends to be chintzy; penny wise and pound foolish.

But if you hired real experts, would the government be willing to set them free and let them corner real frauds?  That is the question.

9) Fannie and Freddie common stocks are on their way to zero.  Their NYSE delisting is just one more step in the road to total dissolution.  The simplest solution is to fold them into GNMA, and slim down the massive operations that don’t do much for the mortgage market.

10) The unequal signal problem exists with the banks that took TARP money.  We hear a lot about those that repay, but little about those that do not pay.  Well, here is an article about those who did not pay.

11) Evan Newmark is occasionally annoying, but often perceptive.  Should President Obama do what he does not want to do?  It couldn’t hurt; his allies on the far left are already disaffected. The question is whether he can be as dispassionate as Bill Clinton, and pursue a centrist course.  I don’t think he is capable of that, because he is too smart, and smart people, unless they moderate their idealism, don’t compromise well.

That’s all for now.

Pardon the infrequency of posting.  I have been having internet issues.

1) A response to those commenting on my piece A Stylized View of the Global Economy: when I say stylized, is does not mean that every nation fits the paradigm, only that most do.  My view is that the debt overages will have to be liquidated, and there is no possible policy that can avoid it except large scale inflation.  Those looking for clever ways out of this bind will be disappointed by what I write.  When nations are heavily indebted their options decline, particularly when they don’t control their own currency.  For the US I say that we should have liquidated insolvent firms rather than bailing them out.

Also, read Falkenstein as he takes on the idea that stimulus spending works.  I have little confidence that the linear reasoning behind stimulus spending yields long-term economic benefits.

2) One blogger that I have some respect for, but have not mentioned often is Bruce Krasting.  He writes some good things on US social insurance programs. His recent post Social Security at Mid-Year highlighted what should shock many: we have hit the tipping point on Social Security.  From here on out it will be a drag on the federal budget.  Expect Congress to remove it from the federal budget.  It no longer aids the illusion of smaller deficits.  (What a cleverly hidden illusion.)

As he commented at the end of his article:

-SS is $2.5T of the $4.5T Intergovernmental account. I believe that this entire group is going cash flow negative. The IG account cost us ~$160 billion in interest last year, but some out there are pretending the IG account does not exist. An example of this is in the following link.

Sorry, U.S. Federal Debt Is NOT Approaching 100% Of GDP Anytime Soon

This kind of thinking is not only lunacy; it is dangerous.

And I agree.  There only two ways to look at the balance sheet of the US.  Look at explicit debt vs GDP, regardless of who is owed the debt.  Or, look at total liabilities vs GDP.  But never look at explicit debt not used to fund social insurance funds.  It is meaningless.  The total liabilities number tells the whole story.

3) Spain is in trouble.  Their banks are borrowing a lot from the ECB, with no end in sight.   Perhaps that leads them to push for stress testing across all European banks.  Or, maybe things are so bad that the banks are identified with the sovereign credit, and both are tarnished.

4) Or consider the Eurozone as a whole: the system begs for debt relief, but the Euro and ECB are tough taskmasters.  The Euro has been an excellent successor to the Deutschmark in terms of preserving purchasing power, but perhaps purchasing power needs to be sacrificed in order to relieve debtors.  The ECB is steps away from monetizing the debts of its governments.  Perhaps they could preserve the Eurozone by destroying the value of the Euro.  Germany might not stand for it, but it has significant unfunded liability issues as well.

As with the US, unless there is a large inflation, debts will eventually have to be liquidated, whether through austerity or default.  There is no other way.  Austerity will have its costs, but unless debts are inflated away or defaulted, those are costs that must be paid.

5) Can pensions be cut?  The typical answer is no, but what if a state pays less than what was promised in inflation-indexed terms?  That is what is being tested.  I think that eventually states and municipalities will be forced into bankruptcy because they can’t make employee benefit payments, and still maintain minimal services to the populace.

6) Debtors prison.  I have mixed feelings here, because I think that those that can’t pay should not be put there for long, if at all.  Those that can pay but won’t, should go there.  Regardless, this is a trend, and those that think they can walk away from debts should think twice before doing so.  You may be setting yourself up for prison.

This is just another front in the war against those who can pay but won’t.  More lenders are suing those who won’t pay, and going after their assets.  My only surprise is that it has taken so long for this to happen.

7) Fannie and Freddie are a giant black hole.  It astounds me that there is any respect given to two companies that have lost massive amounts of money since their inception.  The US would have been better off without them, and will be better off with them in bankruptcy.  The US should not promote single family housing as a goal, because it cannot create the conditions where marginal people can be capable of financing housing on their own.

So, when some suggest one last bailout, I say, let them fail.  Cancel the common and preferred stocks, and fold the remainder into Ginnie Mae.

8 ) Occasionally, there are really dumb articles, like this one.  The time for debt was November 2008 through March 2009, when I recommended investing in junk bonds.  There is little reason to borrow now; valuations are relatively high, don’t take your life into your hands.

9) And, occasionally, smart articles, like this one.  If you are in a volatile profession, reduce your risks by investing in high quality bonds.  If you are in a safe profession, invest in stocks.  When I went to work for a hedge fund, the first thing I did was pay off my mortgage, so that I could take more risk, without worrying about getting kicked out of my house.

10) Felix Zulauf has generally been a bearish guy, and so has done well over the past decade.  But is he right now?  Will stocks revisit their March 2009 lows?  It is possible, but I lean against it.  We would need a situation where most of the developed nations decided to aim for recession and stay there a while.  I do not see that yet.

11) Is it is liquidity problem or an insolvency problem?  If you have to ask, it is usually insolvency.  Consider Richard Koo, and his thoughts on the matter.

12) Using the rubric of the “Tragedy of the Commons” Kid Dynamite points out how it sets up the wrong incentives if we bail out profligate states and municipalities.  As a part of my “new mormal,” it is no surprise to me that this is happening.  It should be happening, and will happen for at least the next five years.

13) Because of my employment agreement, I can’t tell you exactly what I know about the demise of Finacorp.  But I can tell you that the article cited is wrong.  Finacorp never carried an inventory of assets.  It only crossed bonds between buyers and sellers.  The failure of Finacorp occurred for far simpler reasons.

While trying to figure out what I should do, given the demise of my prior firm, I have been attending some events in Washington, DC to stay sharp, and consider what others are saying on public policy issues.  So, on Monday I went to the American Enterprise Institute to listen to their presentation on “Preventing the Next Bubble.”

Now, if you’ve read me for a while, you know that I think that the boom-bust cycle can’t be repealed, but it can be modified.  You can either get a bunch of moderate booms and busts, where the busts are allowed to burn out naturally, or you can try to suppress the busts (wrong strategy, try suppressing the booms), leading to anemic booms, declining marginal productivity of capital, and when bust suppression no longer works, you get a colossal bust, like the Great Depression or now.

There’s no free lunch in macroeconomics.  Academic economists foolishly look for ways to optimize economic performance.  They end up overinterpreting limited data, and given the biases of politicians that employ economists, suggest intervention where none is needed.

All that said, I enjoyed the presentations.  I felt the discussions were worth the two-plus hours that I spent on the matter, as well as the people that I met.

Preventing the Next Bubble

Bill Foster (U.S. House of Representatives (D-Ill.)) led off, suggesting that if you can make LTV ratios in residential lending countercyclical, you can  eliminate booms and busts.  He wants to put that into law next year.

He is an engineer by training, and like most engineers and physicists, they adopt a mechanistic model to control the economy.  My father-in-law, an eminent physicist, often suggests the same to me.  I tell him that economics is more similar to ecology than physics.  People hate having their freedom restrained, and so when arbitrary rules are imposed, even smart rules, they look for means of escape.  But his proposal misses many items:

  • Mortgage insurers will undo the tightening, and I can’t see a way to outlaw mortgage insurance.
  • Fraud issues still exist — appraisal and application fraud will undo some of the constraint, as will seller financing.
  • Monetary policy will be hindered by the countercyclical restraints on mortgage lending, and the Fed will loosen more aggressively as a result.  (Yes, I am looking 20 or so years out here, to when monetary policy normalizes.)

In my opinion, any proposal for preventing bubbles that does not limit the Fed is not a real proposal.  That said, the Fed had the ability during the housing bubble to constrain mortgage underwriting, and did not do it.  Why should a new law change matters?’

The next presentation was from Jay Brinkmann, of the Mortgage Bankers Association.  His presentation dug into reasons why demand for housing was unsustainable.  Whether it was weak underwriting, tight spreads, teaser rates, fraud, or incompetent credit models, there were a lot of reasons for failure.

But the politics of fixing things is tough.  Who wants to oppose the CRA, Realtors and Builders?  I would note that really tough credit busts occur with secured lending, because lenders ge deluded by the seeming value of the collateral.

Next was Allan Mendelowitz, of the Federal Housing Finance Board.  His presentation discussed how one could fight a mortgage bubble.  I noted four ways to fight:

  • Raise underwriting standards.
  • Decrease the abilities of the GSEs to lend.
  • Remove/decrease tax subsidies to home ownership, particularly those that allow for limited capital gains tax on house sales.
  • Raise down payments.

I was most impressed with Mark Zandi of Moody’s.  He didn’t just look at the housing market, but at bubbles generally.  He noted three ways to discern a bubble.

  • High turnover rates
  • Rise in prices
  • Increased leverage

He had three solutions:

  • Modify Fed policy to incorporate asset signals, such that when high yield spreads are tight, Fed policy should tighten.  (His rules were more complex than that.)
  • Make Risk Based Capital more cyclical
  • Genuinely regulate underwriting standards.

I thought Zandi’s ideas were the most comprehensive — after all it is unlikely that the next bubble will be in residential housing.  Why focus on the last war?  Why not aim for a generic solution?

John H. Makin, of  AEI and Caxton Associates, gave the simplest presentation.  Bubbles will always exist.  Central banks will not see them.  Booms militate against those who want to dampen them, because there are many who look for rewards without work.

A number of the presenters pointed to China and Israel, both of which are trying to run countercyclical mortgage policies.  The jury is out here.  Hopefully we can learn from their successes or mistakes.


I had my disagreements with the presenters.  Rep. Foster think that we lost $17.5 trillion of wealth from the bust.  My view is that we never had that wealth.  That is the nature of bubbles and busts.  Asset values can get pushed ahead by cheap credit.  Once the cheap credit was gone, so was a lot of the “wealth.”

I believe that the way things are financed can help detect bubbles.  It is almost always initially profitable to borrow short and lend long.  Most bubbles have a lot of people buying long-dated assets and financing a lot shorter than the assets useful lifetimes.

Also, bubbles usually start with a good idea, where money can be made at a low level of leverage.  But as prices get pushed up leverage levels rise for new entrants wanting to make money.  As prices are pushed up further, new buyers use cheap short term finance to acquire assets.  This is a sign that a bubble is nearing its end.  Another such sign that a bubble is nearing its reversal is that new owners rely on capital gains to stay afloat.  Owners have to continually feed the asset in order to hold it.  Few can do that, so when you see that, the bubble is nearly complete.  Sell with both hands.

Another disagreement that I had was that none of the speakers was willing to finger the Fed as a major culprit, given their overly loose monetary policy over the last 25 years.

I learned from one of the best, that with bank lending there is quality, quantity, and price.  In good markets, you can get two of the three.  In bad markets, you can get one of three.  In the most recent crisis, lenders ignored that, and assumed that current profits indicated good business.

But, in the finance business, there are “yield hogs.”  Yield hogs take for granted the stability of the financial system, and assume that they can ear an above average yield by taking more risk.

In general that does not work.  Yield hogs take losses.


So, I am not optimistic about preventing bubbles.  But, I can predict them on occasion, as I have described above:

Wrecking Ball Looms for Big Housing Spec
Real Estate’s Top Looms

The way assets are financed tells us a lot about their owners.  Are they here for the long haul or not?  Long term holders augur for positive price action, whereas stock renters argue for negative price action.

Let’s try a thought experiment.  Divide the would into two camps.

1) Countries that are importing more than they export, and are increasing debt levels.

2) Countries that are exporting more than they import, and are acquiring debt claims that will provide future goods and services.

Simple enough.  But now look at the two groups.

Group 1 is the developed world with its common problems:

  • Bad demographics affects public and private pension systems.  Both systems underfund, rather than tax/pay/borrow to fully fund.
  • Sloppy, easy monetary policy in the last 25 years has led to an overage of debt finance which is now difficult to service.
  • Governments were too aggressive in trying to service needs that the tax base and electorate would not validate, leading to more borrowing.

My summary for group 1 is that they became less competitive over time, and tried to maintain expanding living standards for their nations via borrowing, and encouraging borrowing.  Central banks became less willing to sponsor harder downturns that would force the liquidation of bad investments.  Much of that stemmed from a fear that liquidations would cascade, leading to another depression, and so, the central banks provided liquidity to support asset prices but not goods prices.

Group 2 is OPEC and the developing world.  This group is more heterogeneous, and has a different set of problems:

  • They have populations that are generally younger than the developed world, with some notable exceptions, e.g., China.
  • Their laborers are generally less productive than those in the developed world, largely because there has not been the same level of capital investment.
  • They are trying to develop industry, and trying more broadly to create societies that resemble the prosperity that the developed nations have.
  • There are limits in some nations as to what freedoms will be tolerated.  For some nations, the ideal is a creative, clever workforce, that is highly productive, and has no aspirations apart from their jobs.  Call their representative “the new capitalist man,” willing to sacrifice himself for those above him in the economic hierarchy.

While writing at RealMoney, I would often bring up the problem of neomercantilism.  Given what I have already described, the problem is that Group 2 favors their exporters and producers, and sell cheaply to consumers in Group 1.  Who loses?  Consumers in Group 2, and producers in Group 1.  In any case, in aggregate, nations in Group 2 build up financial claims against nations in Group 1.

And there is the problem.  These nations are overly indebted already, and the ability for them to make good on all of their obligations is speculative, regardless of what their bond rating is.  Few of the nations in Group 1 are doing well right now, unless their economies have a large natural resource extraction component to them, such as Norway, Australia, and Canada.  They look at their economies and say, “Loosen monetary policy!  What do you mean we can’t loosen further?  Run deficits!  What do you mean our ability to do that is limited?!”

When governments are overly indebted, and the demographic profile says that things will only get worse if current policy maintains, there is a pressure to head for austerity.  Keynesians will argue against this, but when you can’t easily borrow more, Keynesian remedies die.  “In the long run, we are all dead.”  Well, guess what, the long run has arrived, and those of us living now have to deal with the accumulated debts, malinvestments, and low interest rates that discourage saving.

It is not as if deficit spending really stimulates.  It may shift money from taxpayers to some government employees, but unless that spending somehow increases the economic capacity of the economy, it is a waste.  We would be better off giving money evenly to all of society, than letting the government figure out what to do with it.  They will reward cronies, anyway.

As it stands, the nations of Group 1 are heading into a scenario like that of Japan.  Don’t liquidate.  Don’t take losses.  Refinance them at low rates, and expand the monetary base to do so.  Coddle the unproductive to save jobs.  Turn the credit of the nation into a safety net for politically-connected industries that have grown bigger than is useful for society.

But what the markets are saying to Group 1 is simple.  “You are living beyond your means.  There is no way that you can fund the retirements/healthcare of so many.  Beyond that, your governments spend too much in areas that are worthless.  Fix that.”

The future for Group 1 is a diminution of living standards, or at least a slowdown in their growth, should financing remain available.  That diminution could happen in several ways: increased inflation, bad debt liquidation, currency revaluation, unemployment with lower wages, or a combination thereof.  It is not a happy future, but happiness is often having expectations set properly.  Time to move expectations down.  Time to start liquidating bad debts.

Group 2 is another matter.  A lot depends on how much their financial systems rely on full payment in current purchasing power terms from Group 1.  Defaults from Group 1 are not impossible; does your financial system rely on full repayment?  It is a mistake to lend too much to anyone, particularly if it is sizable relative to your capital.

Remember the Mercantilist era.  The mercantilists sourced gold dearly, and never got the full good of their investment.  The same is true today of those relying on US Dollar-based investments. You are relying on the kindness of strangers.  Under pressure, do you really think that the US will favor foreign creditors over domestic needs?  Some things do change over time: the ethical generation that fought World War II has been replaced by a bunch of sybarites.

So Where Does This Leave Us?

It leaves Group 1  in a Japanese-style scenario, where it stagnates.  It leaves Group 2 reliant on what will likely prove to be bad assets from Group 1, either from default or inflation.  There are  no easy ways out; Group 1 must accept lower living standards, but shows little inclination to do so.  Group 2 needs to rely less on export-led growth, and should try to deepen their internal markets, and accept imports.  Neither fits with the political goals of each group’s leaders.  Thus the problems we face today.

This book review is special to me.  I don’t often get quoted in books, but in this book I get quoted on page 98.  Here is the quotation:

When I asked an insurance analyst whether he thought the credit rating companies would ever rethink MBIA’s top rating, he was skeptical.  “For Moody’s [or Standard and Poor’s] to put a bond insurer on negative watch (indicating a rating cut was being considered) could have extremely negative ramifications” for the entire bond insurance business, said David Merkel with Hovde Capital Advisors in Washington, DC.  “It’s a bit of a confidence game.”

Confidence Game indeed.  I did not see the phrase elsewhere in the book, but I may have missed it. If I inadvertently titled the book, I am honored.

I do not remember talking to the author, Christine Richard, but what she quoted was broadly representative of half of my view on the financial guarantee insurers.  I believed that it would be very difficult for the rating agencies to downgrade the financial guarantors, because they were such a large part of their AAA ratings, and because they would lose money in the short run from doing so.  Though it was written a year later, this article at RealMoney reflected my views.

In the short run, I viewed the rating agencies and financial guarantors as co-dependent.  The rating agencies  would protect the guarantors for as long as they could, and after that, the bottom would fall out, and it would become a “free fire” zone.

All in all, over the next five years I wrote over 30 times about the financial guarantors.  Here is a sample of that (in rough chronological order):

Again, my view was that the financial guarantors would eventually be downgraded, but that the rating agencies would delay it for as long as they possibly could.  That is what happened.

Now, as for Bill Ackman, he was prescient; he saw the problems early — way too early.  As I said about Markopolous and Madoff, it is usually a mistake to obsess over something that is manifestly wrong, but that you can’t affect.  Ackman spun his wheels for years over MBIA, and he was right eventually.  Many other men would have given up, but not Ackman.  And part of that is the nature of shorting; it is normally supposed to be a tactical discipline rather than a strategic one.  There are few companies that one can short into the ground, and Ackman almost went that way with MBIA.

But when you are right, you are right, so long as your funding base sticks with you.  Ackman had loyal investors, because the gains took years to manifest.

As for the author, she has carefully balanced the words of Ackman versus the words of others in the situation.  She has done an admirable job of being neutral while still portraying the victor fairly; would that the heads of MBIA talked to her more.  Sadly, they come off as a bunch of hacks who don’t understand that their models relied on a highly liquid economy, with rising housing prices.

I recommend this book highly.  If you want to buy the book, you can buy it here:  Confidence Game: How a Hedge Fund Manager Called Wall Street’s Bluff.

Who would benefit from this book

Most average investors could benefit from the book.  It would tell them that economic systems that rely on third-party appraisals are inherently fragile.  They can be gamed by those with a concentrated interest for a time, until reality catches up with them.

Full disclosure: Janet Tavakoli told me I was quoted in the book, so I asked the publisher for a copy to review.

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