23 February 2011 – The Aleph Blog

Consider the Boom in the Bust; Consider the Bust in the Boom

Posted on 23 February 201124 February 2011 by David Merkel

When you are in the bust phase of the credit cycle, there are no good solutions.? Do you try to reflate?? You can try to, and you will succeed (sort of), if the Fed Funds rate maintains a respectable positive value that does not kill savers.? But you might not succeed, because there is not enough interest margin available to capitalize today.? That is where we are today, and so the Fed moves on to QE, where any asset can be financed via the Fed’s fiat.

The best policy focuses on the booms, and seeks to limit excesses.? It seeks to deliver pain in the bust phase to those who made bad lending decisions.? Had the Fed allowed real pain to be delivered to the banks in the late 80s and early 90s, we wouldn’t be having our current problems.? The Fed lowered rates far lower than was needed, and kept them there until a crisis erupted, forcing change.

Had the Treasury and the Fed let Mexico fail in 1994, and let the stupid Americans who had put money into cetes lose money, we would have been better off now.? If losses are not delivered to those who deserve them imbalances build up.

The same applies to the 1997 Asian crisis, Russia/LTCM, the popping of the tech bubble, and the response of the Fed flooding the system with liquidity.? Too much, and too long — it set us up for the housing/financial bubble of which we are now in the aftermath.

So, when the latest crisis hit in 2008, I took up the lonely position of suggesting failure was the better solution.? If the government had to get involved, let it be a DIP lender.? If it had to meddle in the creation of credit, create a bunch of new mutual banks.

But as I mentioned in the first paragraph, when the big bust hits, and Fed funds drops to zero, all solutions are pretty useless.? At that level, normal monetary policy can no longer cause revaluations of asset prices (and liabilities), allowing the reflation of assets with low ROAs.? That is, until QE appears, leading to temporary inflation of assets through sucking in a decent chunk of the safest part of the intermediate fixed-income universe, forcing a temporary increase in risk taking.

I would argue that the best thing one can do in the bust, whether as an individual/policymaker is to ask what you would like the next boom to look like. Parallel examples (Individual/Policymaker)

What level of safety will you maintain? / are you willing to see the economy grow more slowly in the short-run, if it leads to better long-term growth?
How will you avoid getting caught up in euphoria? / how will you resist the political pressure from concentrated interests asking you to twist regulation/legislation their way?
Will you avoid too much debt, particularly short-term debt? / Will you fight to keep systemic leverage low, and keep the asset-liability mismatch at the banks low?

And more for policymakers:

Do you want the unaccountable (to the voters, and also Congress) Fed to have such influence?
Will you adopt policies that discourage steep yield curves?
Will you raise FDIC fees to economically fair levels, till you begin to see a few banks walk away?
Are you willing to invest in a regulatory structure that can and will say no to the banks?
Or, are you willing to break the banks up, end interstate banking, and let the states regulate the banks?? (Remember, state insurance regulators did relatively well through this crisis… AIG was mainly a derivatives failure.)
Are you willing to regulate derivatives as insurance contracts, with something similar to an insurable interest doctrine?
Do you really want to continue to farm out credit policy to the rating agencies?
Are you willing to create a better accounting system based on current net worth, rather than dated historical cost figures?

In the same mold, I would add that it is during the boom that you want to consider what you want the next bust to look like. For example, will you accept more frequent and sharper small busts in order to avoid a big bust?

You can limitedly control your own exposure to the next boom/bust; it depends how much you want to manage your time horizons, and limit your potential outcomes.? As for policymakers, I am less optimistic due to regulatory capture, and short-term opportunism.? Regardless, you are better off if you plan for the longer term; society as a whole would be better off if policymakers did the same.

Problems with Constant Compound Interest (5)

Posted on 23 February 2011 by David Merkel

This is a continuation of an irregular series which you can find here.? Maybe if I were more scientific, I would have called it “All Exponential Growth Processes Run Into Constraints and Threats,” or if I were more poetic, “Nothing Lasts Forever — Nothing Grows to the Sky.”

Regardless, simple modeling is the bane of long-duration financial calculations.? I remember talking with some friends who served on a charitable board with me, about some investment grade long bonds (11-30 years) that I had purchased for a life insurance client that yielded 7-9% in late 1999.? They said to me that it was foolish to lock up money for so long in bonds, when you could earn so much more in stocks.? My three comments to them were:

Prohibitive for life insurers to hold equities
At current levels of the market, the yield of these bonds more than compensates for the possibility of capital growth in equities (valuations are stretched)
The risk in the bonds is a lot lower.

And, I said we ought to shift shift our charity’s asset allocation to more bonds, as we were invested past the maximum of our guidelines in equities.? They looked in the rearview mirror and said that we were doing fabulous.? Why change success?

I was outvoted; I was a one-man minority.? There are a lot of people who would have loved to make that change in hindsight, but done is done.? I ended up leaving the board a year later over a related issue.

Now, don’t think that I am advising the same in 2011.? We may be headed for significant inflation or deflation; it is difficult to tell which.? Bonds offer little competition to equities here.? Commodities and cash may be better, but I am reluctant to be too dogmatic.? If the economy turns down again, long Treasuries would be best.

Here’s the difficulty: most people have been trained to think at least one of a few things that are wrong:

That we can use simple models to forecast future outcomes.
That average people are capable of avoiding fear and greed when it comes to investing.
That financial markets are random in the sense that last period’s return has no effect on the returns of future periods.
Over long periods of time, average investors can beat long Treasuries by more than 2%/year.? (Corollary to the idea that the equity premium is 4-6% versus 0-2%/year over high quality bonds.)
That financial markets are expressions of what is going on in the real economy.
That the real economy tends toward stability
That government actions make the real economy more stable

I’m prompted to write this because of two articles that I ran across in the last day: Retiring Boomers Find 401(k) Plans Fall Short, and Stay Out of the ROOM (registration required).

I’ve written about this before in many places, including Ancient and Modern: The Retirement Tripod.? And yet, when I wrote about these issues 20 years ago, one of the things that I tried to point out was that as the demographic bulge retired, it would be difficult for homes and asset markets to throw off the returns necessary, because there would not be enough buyers for the assets/homes.? If a large portion of the population wants to convert assets into a stream of income — guess what?? They are forced sellers, and yields that they will get will be compressed as a result.

In a situation like that, those that are better off, and can delay turning all of their assets into an earnings stream should be disproportionately better off.? As with corporations, so with individuals/families: those with slack assets and flexibility are able to deal with volatility better than those for whom the environment must be stable/favorable for the plan to succeed.

Now, the Wall Street Journal article points at the problems of 401(k) plans.? What they say is true, but the same is true of other types of defined contribution and defined benefit plans.? When assets underperform, and/or investors make bad choices, guess what?? The pain has to be compensated for somehow:

401(k): They will work longer, maybe all of the rest of their lives, and cut back on expenses and dreams.
Non-contributory DC: maybe the employer will ask them to kick in voluntarily, or he might give more.? Also same as 401(k)…
Private sector DB plans: employers may contribute more, or they may terminate them.
Public sector DB plans: Taxes may rise, spending cuts enacted, forced contributions to retiree plans negotiated, plans terminated for a 457 plan, partial plan termination, job cuts, funny accounting practices (worse than the private sphere), brinksmanship over debts, etc.

Note that one of the answers is not “take more risk.”? First, risk and return are virtually uncorrelated in practice.? Only when enough people realize that might risk and return become positively correlated.? Second, there are times to increase and decrease risk exposure.? Typical people won’t want to do that, because of euphoria (the example of my friends above) and panic.? The time to add to high risk assets is when no one wants to touch a high yield bond.? More broadly, always look for asset classes that throw off the best cash flow yields, conservatively estimated, over the next ten-plus years.? Be sure and factor in the likelihood for economic regime changes and capital loss, inflation, deflation, etc.

Good asset allocation marries the time horizon of an investor to the forecasts for future returns, conservatively stated, and considers what could go wrong.? At present, investment opportunities are average-ish.? I would be wary of stretching for yield here, or raising my risk exposure in equities.? Stick with high quality.

And, for those that are retired, I would be wary of taking too much into income.? I have a simple formula for how much one could take from an endowment at maximum:

10 Year Treasury Yield
Plus a credit spread — 2% if spreads are sky-high, 1% if they are good, 0.5% if they are tight.
less losses and fees of 0.5% — higher if investment expenses are over 0.25%.

Not very scientific, but I think it is realistic.? At a 3.5% 10-yr T-note yield, that puts me at a 4% maximum withdrawal rate, given a 1% credit spread.? This attempts to marry withdrawals to alternative uses for capital in the market.? You may withdraw more when opportunities are high, and less when they are low.? (But who can be flexible enough to have a maximum spending policy that varies over time?)

Now some of the advanced models that calculate odds of retiring successfully are a step in the right direction, but they also need to reflect demographics, time-correlation of returns, regime-shifting returns/economics, etc.? Things don’t move randomly in markets; that doesn’t mean I know which way things are going, but it does mean I should be cautious unless the market is offering me a fat pitch to hit.

These statements apply to governments as well, and their financial security programs.? In aggregate, investments can’t outgrow growth in GDP by much, unless labor takes a progressively lower share of national income.? (And who knows, but that the pressure on union DB plans to earn high returns might lead to takeovers/layoffs in private firms…)? The real economy and the financial economy are one over the long haul, but can drift apart considerably in the intermediate-term.

In summary, any long promise/analysis/plan made must reflect the realities that I mention here.? We’ve spent years on the illusions generated by assuming high returns off of financial assets.? Now with the first Baby Boomers trying to retire, the reality has arrived — sorry, not everyone in a large birth cohort can retire comfortably.? Wish it could be otherwise, but the economy as a whole can’t generate enough to make that proposition work.

I don’t intend that this series have more parts, but if one strikes me, I will write again.