Q: So what is an asset worth?

A: I thought we talked about that.

Q: Yes, but we never really got through it.  Suppose on a nonvolatile day I want to sell $100 in shares of an open end mutual fund.  Now suppose I want to sell 5% of the total shares of the same fund.  What are my mutual fund shares worth?

A: This problem isn’t any different than that for an individual stock.  Liquidity carries a price.  If you want to buy or sell a lot at any given time, and you are the one demanding the trade be done, you will have to pay up for that privilege.  People who are less motivated than you will have to receive compensation for taking the other side of the trade.

Q: But on a mutual fund, why should the price move on a big trade?  Shouldn’t everything be tradable at the closing NAV?

A: Can you sell the whole world at the close?  To whom?  Where will you get all of the cash?

Q: Huh?

A: Only a tiny fraction of all the assets in the world trade on any given day.  There isn’t a lot of reason for most assets to trade — in the long run, we make money when we hold , not when we trade.  Trading itself is a small net economic loss, with money paid to brokers.

This is why there are primary markets, secondary markets, and within secondary markets, block trades.  Any big trade in stocks or bonds requires special handling — either a trader has to break it up into a bunch of little trades, or he has to hand it off to a specialist who finds someone willing to take the other side as a whole for a price concession, or the block trader takes the trade himself for a concession and tries to cover the position through small trades.

The thing is, there is not one price for an asset at any given point, but many prices — and they change depending upon how many want to buy or sell, and how quickly.  More buyers?  Crawl up the supply curve.  More sellers?  Slide down the demand curve.  There is no one price — and when we do name one price, it is a shortcut — a convenience.

Q: I find that confusing.

A: Look, economics has almost always moved in the direction of greater subjectivity over time.  An asset does not necessarily have the same value to you as it does to someone else.  Consider my house as an example.

Q: I’ve been to your house — it’s a bit of a hovel.  You couldn’t pay me to live there.

A: And I love it.  I have a lot of happy memories there.

Q: Aren’t we off track?  There’s a lot of difference between a unique house, and a share of a mutual fund.

A: That is only true because we sell identical tiny slices of a mutual fund.  If you wanted to sell all of the assets of the mutual fund as a whole, it is the same problem.

Liquidity in markets is always limited.  Always.  A small stream of trades helps validate prices for a given asset and related assets, but is inadequate to answer the question of what happens to the price when you want to do a big trade in a short period of time.  After all, supply and demand curves are theoretical constructs — it’s not as if you can look them up in the daily newspaper.

Q: What’s a newspaper? 😉

A: Humph.  Are we done yet?

Q: I guess for now.  Are you going to write anything regarding the SEC’s proposal on open end mutual funds and ETFs regarding liquidity?

A: Probably.  I had a knee-jerk response to it, but as I read more about it, I became convicted that I had to study it more before I birthed bits and bytes into the cold abyss of the internet.  Remember, last time I wrote, I sent it to the SEC, and even talked with their legal staff.  Off the cuff most of the difficulties could probably be solved by loads that get paid to the mutual funds any time shares are created or liquidated, but that’s just a bias.  I like simple solutions because perfect regulations are a terror — perfection is impossible, so write something simple that covers 90% of it, and ignore the rest.

But all for now — my main question to myself is whether I have enough time to do it justice.  There’s their white paper on liquidity and mutual funds.  The proposed rule is a monster at 415 pages, and I may have better things to do.   If I do anything with it, you’ll see it here first.

Q: Until then.

diy-financial-advisor-3842593-f00

I am generally not a fan of formulaic books on investing, and this is particularly true of books that take unusual approaches to investing. This book is an exception because it does nothing unusual, and follows what all good quantitative investors know have worked in the past.  The past is not a guarantee of the future, but if the theories derived from past data make sense from what we know about human nature, that’s about as good as we can get.

The book begins with a critique of the abilities of financial advisors — their fees, asset allocation, and security selection.  It then shows how models of financial markets outperform most financial advisors.

Then, to live up to its title , the book gives simple versions of models that can be applied by individuals that would have outperformed the markets in the past.  You can beat the markets, lower risk, and “Do It Yourself [DIY].”  It provides models for asset allocation, stock selection, and risk control, simple enough that a motivated person with math skills equal to the first half of Algebra 1 could apply them in a moderate amount of time per month.  It also provides a simpler version of the full model that omits the security selection for stocks.

The book closes by offering three reasons why people won’t follow the book and do it themselves: fear of failure, inertia, and not wanting to give up an advisor who is a friend.  It also offers three risks for the DIY investor — overconfidence, the desire to be a hero (seems to overlap with overconfidence), and that the theories may be insufficient for future market behavior.

This is where I have the greatest disagreement with the book.  I interact with a lot of people.  Most of them have no interest in learning the slightest bit about investing.  Some have some inclination to learn about investing, but even the simple models of the book would make their heads spin, or they just wouldn’t want to take the time to do it.  Some of it is similar to seeing a Youtube video on draining and refilling your automatic transmission fluid.  You might watch it, and say “I think I get it,” but the costs of making a mistake are sufficiently severe that you might not want to do it without an expert by your side.  Most will take it to the repair garage and pay up.

I put a knife to my own throat as I write this, as I am an investment advisor, but there is more specialized knowledge in the hands of an auto mechanic than in an investment advisor, and the risk of loss is lower to manage your own money than to fix your own brakes.  That said, enough people after reading the book will say to themselves, “This is just one author, and I barely understand the performance tables in the book — if right, am I capable of doing this?  Or, could it be wrong?  I can’t verify it myself.”

The book isn’t wrong.  If you are willing to put in the time to follow the instructions of the authors, I think you will do better than most.  My sense is that the grand majority people are not willing to do that.  They don’t have the time or inclination.

 

Quibbles

The book could have been clearer on the ROBUST method for risk control.  It took me a bit of effort to figure out that the two submodels share half of the weight, so that when submodels A & B flash green — 100% weight, one green and one red — 50% weight, both red — 0% weight.

Also, the book is enhanced by the security selection model for stocks, but how many people would have the assets to assemble and maintain a portfolio with sufficient diversification?  The book might have been cleaner and simpler to leave that out.  The last models of the book don’t use it anyway.

Summary / Who Would Benefit from this Book

I liked this book, and I recommend it for those who are willing to put in the time to implement its ideas.  This is not a book for beginners, and you have to be comfortable with the small amount of math and the tables of financial statistics, unless you are willing to trust them blindly.  (Or trust me when I say that they are likely accurate.)

But with the caveats listed above, it is a good book for people who are motivated to do better with their investments.  If you want to buy it, you can buy it here: DIY Financial Advisor.

Full disclosure: I received a copy from one of the authors, a guy for whom I have respect.

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.

Photo Credit: Mike Beauregard || Frozen solid, right?

Photo Credit: Mike Beauregard || Frozen solid, right?

The talk regarding an illiquid public corporate bond market goes on, and if you’ve read me over the past year on this topic, you know that I don’t think it is a serious issue.  One of the reasons why it is not a big issue is that the public bond market is designed to be low liquidity.

It starts with how bonds are originally issued.  New bonds and new stocks are issued in similar ways, but with a few differences:

  • IPOs of stocks have a higher retail component.  Bonds, aside from muni bonds, are typically almost entirely institutional
  • IPOs are typically priced cheap, but with bonds the cheapness is smaller and more frequent.
  • Bond IPOs usually happen with companies that have issued other bonds before
  • Bond IPOs happen more frequently, except in a bear market
  • Bond IPOs typically happen more rapidly, minutes to a few days, except in a bear market

IPOs on Wall Street get allocated if they are oversubscribed.  When they are oversubscribed, the deal is typically good, and everyone wants more, so they put in huge orders.  The dealer desks on Wall Street solves this problem by allocating proportionate to the size that they have come to understand the managers in question typically buy and sell at, with some adjustment for account profitability.

Those that flip cheap bonds for a quick profit typically get penalized, and their allocations get reduced.  Those that buy bonds in the open market when the deal breaks and becomes “free to trade” can become eligible for larger allocations.  The dealer desks work in this way because they want the buyers to be long-term holders, and not seekers of easy profits from flipping.  That doesn’t mean you can never trade a bond you have bought — just not in the first month, subject to a few exceptions like a small allocation, your credit analyst rejected it, etc.  (Oh, and if one of those exceptions exists, the primary dealers want to do the secondary trade.  If the exceptions don’t exist, they don’t want to know about it.)

If flippers ever get big, despite the efforts of the dealer desks, they will price a deal very tight, and let the flippers take a big loss, with no one wanting to buy the excess bonds unless they are much, much cheaper.

The main effect of this is that once a deal is allocated, it is typically “well-placed,” with few secondary trades after the IPO.  This is even more pronounced with mortgage bonds, which aside from the AAA tranches, have very small tranche sizes, making them very illiquid.

In this environment, where yields have fallen over the past few years, it is difficult for financial companies that have bought bonds to replace the income if they sell the bond.  Thus, few bonds will be sold unless they are in the hands of buyers that don’t have a formal balance sheet, or, when credit quality is deteriorating badly.

Add in one more factor, and you can see why the market is so illiquid — the buy side of the market is more concentrated than in prior years, with big buyers like PIMCO, Blackrock, Metlife, Prudential, etc. being a larger portion of the market.  Concentrated markets with few holders tend to be less liquid.

All Good/Bad Things Must Come to an End

Some of these factors can be reversed, and others can be mitigated.

  • There’s no reason why the buy side has to stay concentrated.  Big institutions eventually break up because diseconomies of scale kick in.  Management teams typically do worse as companies get more complex.
  • Eventually interest rates will rise.  Once bonds are in a nearly neutral to negative capital gains positions, parties with balance sheets will trade bonds again.
  • Even mutual funds that own a lot of yieldy bonds can have a strategy for dealing with the illiquidity.  Yieldy bonds have excess yield relative to bonds of similar duration and credit quality, and are often less liquid because there is something odd about them that makes some portion of the market skeptical, which reduces liquidity.  A mutual fund holding a lot of less liquid bonds, can deal with illiquidity by selling opportunistically, selling more liquid bonds in the short-run, while discreetly inquiring on a few less liquid issues to see where real bids might be.  Remember, the amount of underperformance is likely to be limited, if any, so a run on a mutual fund is not likely, but in the unlikely case of a run, this can mitigate the effects.  Personally, I would not be concerned, so long as you keep your pricing marks conservative if cash outflows become a rule in the short-run.

In closing, don’t worry about illiquidity in the bond markets.  If there is a need for liquidity, the problem will solve itself as sellers lose a little bit in order to gain cash to make payments.  It’s that simple.

Photo Credit: DonkeyHotey

Photo Credit: DonkeyHotey

Here are two ideas for the Fed, not that they care much about what I think:

1) Stop holding regular press conferences and holding regular meetings.  Only meet when a supermajority of your members are calling for a change in policy.  Don’t announce that you are holding a meeting — perhaps do it via private video conference.

Part of the reason for this is that it is useless to listen to commentary about why you did nothing.  You may as well have not held a meeting.  Another reason is that governors could act more independently if a meeting can’t be called unless a supermajority of voting members calls for it.

Yet another reason is that the frequent and long communication has not eliminated the Kremlinology that exists to interpret the Fed.  When changes to the FOMC statement are small, they get over-interpreted — remember the “taper” comment?  Far better to say nothing than to repeat yourself with small meaningless variations.

Along with that, you could eliminate issuing statements altogether, and go back to the way things were done pre-Greenspan.  Need it be mentioned that monetary was executed better under Volcker and Martin?  We don’t need words, we need to feel the actions of the Fed.  That brings me to:

2) Stop trying to support risky asset markets.  It is not your job to give equity or corporate bond investors what they want.  If you do that, too much liquidity gets injected into the system, creating the financial bubbles of 2000 and 2007-9.

Instead, give the risk markets some negative surprises.  Don’t follow Fed funds futures; make them follow you.  Show them that you are the boss, not the slave.  Let recessions do their good work of clearing out bad debts, and then the economy can grow on a better basis.  Be like Martin, and take away the punchbowl when the party gets exciting.

Do these things and guess what?  Monetary policy will have more punch.  When you make a decision, it will actually do something.

Realize that policy uncertainty is not poison for risk markets. It forces businessmen to avoid marginal ideas — things that only survive when the weather is fair.  The accumulated underbrush of bad debts doesn’t keep building up until the eventual fire is impossible to control.

If were going to have fiat money, do it in such a way that bubbles do not develop, which means not caring about the effects of policy on risky asset markets.  This might not be popular, but it would be good for the economy in the long run.

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As a final note let me end with one chart from the recent data from FOMC participants:

central tendency_1915_image001

I suspect the FOMC will tighten in December, but remember that the FOMC doesn’t have a roadmap for the environment they are in, and they are acting like slaves to the risky asset markets.  Another burp in the markets, and lessening policy accommodation will be further delayed.

 

Photo Credit: Day Donaldson

Photo Credit: Day Donaldson

July 2015September 2015Comments
Information received since the Federal Open Market Committee met in June indicates that economic activity has been expanding moderately in recent months.Information received since the Federal Open Market Committee met in July suggests that economic activity is expanding at a moderate pace.No real change.
Growth in household spending has been moderate and the housing sector has shown additional improvement; however, business fixed investment and net exports stayed soft. Household spending and business fixed investment have been increasing moderately, and the housing sector has improved further; however, net exports have been soft. No real change. Swapped places with the following sentence.
The labor market continued to improve, with solid job gains and declining unemployment. On balance, a range of labor market indicators suggests that underutilization of labor resources has diminished since early this year.The labor market continued to improve, with solid job gains and declining unemployment. On balance, labor market indicators show that underutilization of labor resources has diminished since early this year.No real change. Swapped places with the previous sentence.
Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports.Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports.No real change.
Market-based measures of inflation compensation remain low; survey‑based measures of longer-term inflation expectations have remained stable.Market-based measures of inflation compensation moved lower; survey-based measures of longer-term inflation expectations have remained stable.No change.  TIPS are showing lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 1.90%, down 0.20% from July.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
 Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.New sentence.  Nods at the recent volatility in risky asset markets here and abroad.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.Nonetheless, the Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.No real change.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring developments abroad. Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.CPI is at +0.2% now, yoy.  Notes influence of foreign market factors on their actions.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.No change.

No rules, just guesswork from academics and bureaucrats with bad theories on economics.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No Change.

“Balanced” means they don’t know what they will do, and want flexibility.

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.Still a majority of doves.

We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

 Voting against the action was Jeffrey M. Lacker, who preferred to raise the target range for the federal funds rate by 25 basis points at this meeting.Lacker dissents, arguing policy has been too loose for too long.

Comments

  • This FOMC statement was another great big nothing. Only notable change was the influence of risky asset markets and foreign markets on the decision-making process on the FOMC.
  • Don’t expect tightening in October. People should conclude that the FOMC has no idea of when the FOMC will tighten policy, if ever.  This is the sort of statement they issue when things are “steady as you go.”  There is no hint of imminent policy change.
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Equities flat and long bonds rise. Commodity prices rise and the dollar falls.
  • The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
  • We have a congress of doves for 2015 on the FOMC. Things will continue to be boring as far as dissents go.  We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Photo Credit: Nate Steiner || There is always enough time to panic. ;)

Photo Credit: Nate Steiner || There is always enough time to panic. 😉

Today, I happened to stumble across an old article of mine: Easy In, Hard Out (Updated).  It’s kind of long, but goes into the changes that have happened at the Fed since the crisis, and points out why tightening policy might be tough.  Nothing has changed in the 2.4 years since I wrote it, so I am going to reprint the end of the article.  Let me know what you think.

-==-=-=–==-=–=-==-=-=-=-=-

In normal times, central banks buy only government debt, and keeps the assets relatively short, at longest attempting to mimic the existing supply of government debt.  Think of it this way, purchases/sales of longer debt injects/removes liquidity for longer periods of time.  Staying short maintains flexibility.

Yes, the Fed does not mark its securities or gold to market.  Under most scenarios, it is impossible for a central bank which can issue its own currency to go broke.  Rare exceptions — home soil wars that fail, or political repudiation of the bank, where the government might create a new monetary standard, or closes the bank because of inflation.  (Hey, the central bank has been eliminated twice before.  It could happen again.)

The only real effect is on how much seigniorage the Fed remits to the Treasury, or, if things go bad, how much the Treasury would have to lend/send to the central bank in order to avoid the bad optics of negative capital, perhaps via the Supplemental Financing Account.  This isn’t trivial; when people hear the central bank is “broke,” they will do weird things.  To avoid that, the Fed’s gold will be revalued to market at minimum; hey maybe the Fed at that time will be the vanguard of market value accounting, and revalue everything.  Can you imagine what the replacement cost of the NY Fed building is?  The temple in DC?

Or, maybe the bank would be recapitalized by its member banks, if they are capable of doing so, with the reward being the preferred dividend they receive.

Back to the main point.  What effect will this abnormal monetary policy have in the future?

 

Scenarios

1) Growth strengthens and inflation remains low.  In this unusual combo, it will be easy for the Fed to collapse its balance sheet, and raise rates.  This is the dream scenario; and I don’t think it is likely.  Look at the global economy; there is a lot of slack capacity.

2) Growth strengthens and inflation rises.  The Fed will likely raise the interest on reserves rate, but not sell bonds.  If they do sell bonds, the market will back up, and their losses will be horrible.  If don’t take the losses, seigniorage could be considerably reduced, or even vanish, as the Fed funds rate rises, but because of the long duration asset portfolio, asset income rises slowly.  This is where the asset-liability mismatch bites.

If the Fed doesn’t raise the interest on reserves rate, I suspect banks would be willing to lend more, leaving fewer excess reserves at the Fed, which could stimulate more inflation. Now, there are some aspects of inflation that remain a mystery — because sometimes inflationary conditions affect assets, rather than goods, I think depending on demographics.

3) Growth weakens and inflation remains low.  This would be the main scenario for QE4, QE5, etc.  We don’t care much about the Fed’s balance sheet until the Fed wants to raise rates, which is mainly a problem in Scenario 2.

4) Growth weakens and inflation rises, i.e. stagflation.  There’s no good set of policy options here. The Fed could engage in further financial repression, keeping short rates low, and let inflation reduce the nominal value of debts.  If it doesn’t run wild, it could play a role in reducing the indebtedness of the whole economy, though again, it will favor debtors over savers.  (As I’ve said before, in a situation like this, or like the Eurozone, all creditors want to be paid back at par on the bad loans that they have made, and it can’t be done.  The pains of bad debt have to go somewhere, where it goes is the argument.)

I’ve kept this deliberately simple, partially because with all of the flows going back and forth, and trying to think of the whole system, rather than effects on just one part, I know that I have glossed over a lot.  I accept that, and I could be dead wrong, as I sometimes am.  Comment as you like, with grace and dignity, and let us grow together in our knowledge.  I’ve been spending some time reading documents at the Fed, trying to understand their mechanisms, but I could always learn more.

 

Summary

During older times, the end of a Fed loosening cycle would end with the Fed funds rate rising.  In this cycle, it will end with interest of reserves rising, and/or, the sale of bonds, which I find less likely (they will probably be held to maturity, absent some crisis that we can’t imagine, or non-inflationary growth).  But when the tightening cycle comes, the Fed will find that its actions will be far harder to take than when they made the “policy accommodation.”  That has always been true, which is why the Fed during its better times limited the amount of stimulus that it would deliver, and would tighten sooner than it needed to.

Far better to be like McChesney Martin or Volcker, and be tough, letting recessions do their necessary work of eliminating bad debt.  Under Greenspan, and Bernanke to a lesser extent (though he persists in pushing the canard that the Fed was not too loose 2003-2004, ask John Taylor for more), there were many missed opportunities to stop the buildup of bad debts, but the promise of the “Great Moderation” beguiled so many.

Removing policy accommodation is always tougher than imagined, and carries new risks, particularly when new tools have been used.  Bernanke can go to his carefully chosen venues and speak to his carefully chosen audiences, and try to exonerate the Fed from well-deserved blame for their looseness in the late 80s, 90s, and 2000s.  Please, Mr. Bernanke, take some blame there on behalf of the Fed — the credit boom could never have happened without the Fed.  Painting the Fed as blameless is wrong; the “Greenspan put” landed us in an overleveraged bust.

I’m not primarily blaming the Fed for its current conduct; we are still in the aftermath of a lending bust — too much bad mortgage debt, with a government whose budget is out of balance.  (In the bust, there are no good solutions.)  I am blaming the Fed for loose policies 1984-2007, monetary policy should have been a lot tighter on average.  But now we live with the results of prior bad policy, and may the current Fed not compound it.

Postscript

The main difference between this time and the last time I wrote on this is QE3.  What has been the practical impact since then?  The Fed owns more MBS and long maturity Treasuries, financed by more reserve balances at the Fed.

Banks use this cheap funding to finance other assets.  But if they want to make money, the banks have to take credit risk (something the Fed is trying to stimulate), and/or interest rate rate risk (borrow short, lend long, negative convexity, etc).  The longer low rates go on through interest on reserves, the greater the tendency to build up imbalances in the banking system through credit and interest rate risks. 1992-1993 where Fed funds rates were held at 3%, was followed by the residential mortgage backed security market melting down in 1994, not to mention Mexico.  Sub-2% Fed funds rates from 2002 through mid-2004 led to massive overinvestment in residential housing, leading to the present crisis.

Fed tightening cycles often start with a small explosion where short-dated financing for thinly capitalized speculators evaporates, because of the anticipation of higher financing rates.  Fed tightening cycles often end with a large explosion, where a large levered asset class that was better financed, was not financed well-enough.  Think of commercial property in 1989, the stock market in 2000 (particularly the NASDAQ), or housing/banks in 2008.  And yet, that is part of what Fed policy is supposed to do: reveal parts of the economy that are running too hot, so that capital can flow from misallocated areas to areas that are more sound.  At present, my suspicion is that we still have more trouble to come in banking sector.  Here’s why:

We’ve just been through 4.5 years of Fed funds / Interest on reserves being below 0.5% — this is a far greater period of loose policy than that of 1992-1993 and 2002 to mid-2004 together, and there is no apparent end in sight.  This is why I believe that any removal of policy accommodation will prove very difficult.  The greater the amount of policy accommodation, the greater the difficulties of removal.  Watch the fireworks, if/when they try to remove it.  And while you have the opportunity now, take some risk off the table.

This should be short. There are a lot of good reasons not to worry about the FOMC raising Fed funds or not.  If they raise Fed funds:

  • First, savers deserve a return.  Economies work better when savers get rewarded.
  • Second, investors do better on the whole when there is a risk free asset earning something to allocate money to, because otherwise investors take too much risk in an effort to generate income.
  • Third, the FOMC should never have let Fed funds rates go below 1% anyway — the marginal stimulus is limited once the yield curve gets slope enough for the banks to lend.  They don’t really need more than that.
  • Fourth, it’s not as if monetary policy has been doing that much.   Outside of the government and corporations, most entities have not shown a lot of desire to lever up after the financial crisis.
  • Fifth, long Treasury yields will do what they want to do — they won’t necessarily go up… it all depends on how strong the economy is.

But if the they don’t raise Fed funds, no big deal.  We wait a little longer.  What’s the difference between having zero interest rates for 6.5 years and 7.5 years?  Either one would build up enough leverage if the economy had the oomph to absorb it.

As it is, corporate borrowing has been the major place of debt expansion through both loans and bonds.  Watch the debt of energy firms that are allergic to low crude oil prices.  Honorable mention goes to auto, student, and agricultural lending.  May as well mention that underwriting standards are slipping in some areas for consumers, but things aren’t nuts yet.

I’ve often said that the FOMC stops tightening rates when something big blows up.  Can’t see what it will be this time — the energy sector will be hurt, but it isn’t big enough to impair financials as a group.  Subprime lending is light at present outside of autos.

Watch and see, but in my opinion, it is a sideshow.  Watch how the long end behaves, and see if the market reflates.  We need more confusion and less concern over what the next crisis is, before any significant crisis comes.

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Can you explain to a non-technical reader how software works?  It depends on what you mean by “software” and “explain.”

With respect to software, this particular book focuses on a few areas that are hot today, and not computing in general. Take a look at the following list.  What would it be like to not have the following technologies?

  • Graphic display, both for pictures and video
  • Security — whether in the form of passwords, encryption, including public key cryptography
  • Data compression techniques to reduce the amount of data sent, whether for text, pictures, or video
  • Web Search
  • Maps that help us find the most efficient driving route
  • Concurrency — allowing multiple parties to use the same application at the same time

The web and the internet generally would be a dramatically different place, and much smaller, as it was in 1990 slightly after Tim Berners-Lee created HTTP (Hypertext Transfer Protocol).

The topics here are important and affect our daily lives.  The author of “How Software Works” makes a significant effort to explain programming in a way that teenagers and adults could understand, using pictures, tables, flowcharts, simplified numerical examples, and more.

Now, reading this book will give you a top-level view of how these technologies work, but not much more.  It will help you understand some of the tradeoffs that go on in computing.  How do you balance:

  • Richness of data delivered versus resource use and speed of display.
  • Security versus ease of use
  • Reduction of size of data versus loss of fidelity in an image or video
  • And more, there are a lot of tradeoffs in programming.

The ideal audience for this book is bright adults who aren’t programmers, but want some appreciation of the hidden complexity behind much of what goes on on the internet.  The second ideal audience would be teenagers and young adults who might want a career in computer science, who might benefit from exposure to these varied areas of software.  Who knows?  One area might catch their fancy, and then they can study it for real, and put it into practice.  (I’m giving this book to my second daughter who is interested in programming.)

Quibbles

On page 39, the author suggests that there is no way to do square roots, that it is just a guesswork procedure.  There are algorithms to do square roots — whether those are used in computing, I don’t know, but it wouldn’t be hard to implement.  I was doing it when I was 10.  (I’m not much of a programmer presently, but I am good at math.)

Summary / Who Would Benefit from this Book

I liked this book.  Give it to friends who want to learn about how much of the web is designed.  Give it to interested teenagers to expand their horizons in computing.  If you want to buy it, you can buy it here: How Software Works.

Full disclosure: I received a copy from a friendly PR flack.

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.

9781137390448

 

Liquidity is ephemeral, and difficult to define.  The first real article at my blog was about liquidity, and the three things that liquidity can mean, notably: the ability to:

  • Enter into large or exit from commitments to risk assets cheaply (cost)
  • Borrow at tight credit spreads compared to the safest borrowers
  • Make large adjustments to their asset allocations rapidly (speed)

Most of these phenomena can be observed without complex models.  Ask yourself:

  • Is credit growing rapidly?
  • Are the exchanges moving turning over stocks more rapidly?
  • Are credit spreads tight?
  • Have credit terms and conditions deteriorated?
  • Do lenders care more about volume of lending than quality of lending?

My bias is that I think most of the academic mathematical models of liquidity risk are overly technical, and tend to obscure liquidity conditions rather than reveal what is going on.  You may disagree with that view.

But unless you disagree with that view and you like math, this book will not be worth a lot to you.  Yes, there are qualitative sections, and they are good.  For example, the beginning of chapter 2 is very good at illustrating the paradoxical nature of liquidity.  Chapters 1-3 would have made a very good qualitative monograph on liquidity — but it would be so small that you couldn’t charge $80+ for it.

Chapters 4-6 will only be useful to the mathematically inclined.  I’m dubious that they even be useful then, because much of it is calculus, which does not do well with discontinuous events such as market panics.  (You would have thought that the quants on Wall Street would have learned by now, but no…)  Even if the models did work, there are simpler ways to see the same things, as I pointed out above.

As such, I really can’t recommend the book, and at $80+ the price is a lot more expensive than the free Monograph from the CFA Institute “The New Economics of Liquidity and Financial Frictions.” [PDF]  Read that, not this, and save liquidity.

Quibbles

The book could have used a better editor.  Too many typos in the introductory chapters.

Summary / Who Would Benefit from this Book

If you are a math nerd, and want to pay a lot of money to buy a book that I think will at least partially mislead you on liquidity risk, then this is the book for you.  If you want to buy it, you can buy it here: Market Liquidity Risk.

Full disclosure: I received a copy from a friendly PR flack.

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.

Photo Credit: Kevin Dooley || At the Ice Museum, ALL of the assets are frozen!

Photo Credit: Kevin Dooley || At the Ice Museum, ALL of the assets are frozen!

This article is another experiment. Please bear with me.

Q: What is an asset worth?

A: An asset is worth whatever the highest bidder will pay for it at the time you offer it for sale.

Q: Come on, the value of an asset must be more enduring than that.  You look at the balance sheets of corporations, and they don’t list their assets at sales prices.

A: That’s for a different purpose.  We can’t get the prices of all assets to trade frequently.  The economic world isn’t only about trading, it is about building objects, offering services… and really, it is about making people happier through service.  Because the assets don’t trade regularly, they are entered onto the balance sheet at:

  • Cost, which is sometimes adjusted for cost and other things that are time-related, and subject to writedowns.
  • The value of the asset at its most recent sale date before the date of the statement
  • An estimated value calculated from sales of assets like it, meant to reflect the likely markets at the time of the statement — what might the price be in a deal between and un-coerced buyer and seller?

Anyway, values in financial statements are only indicative of aspects of value.  Few investors use them in detail.  Even value investors who use the detailed balance sheet values in their investment decisions make extensive adjustments to them to try to make them more realistic.  Other value investors look at where the prices of similar companies that went private to try to estimate the value of public equities.

Certainly the same thing goes on with real estate.  Realtors and appraisers come up with values of comparable properties, and make adjustments to try to estimate the value of the property in question.  Much as realtors don’t like Zillow, it does the same thing just with a huge econometric model that factors in as much information as they have regarding the likely prices of residential real estate given the prices of the sparse number of sales that they have to work from.

Financial institutions regularly have to estimate values for variety of illiquid assets in a similar way.  I’ve even been known to help with those efforts on occasion, though management teams have not always been grateful for that.

Q: What if it’s a bad day when I offer my asset for sale?  Is my asset worth less simply because of transitory conditions?

A: Do you have to sell your asset that day or not?

Q: Why does that matter?

A: If you don’t need the money immediately, you could wait.  You also don’t have to auction the asset if you think that hiring an expert come in and talk with a variety of motivated buyers could result in a better price after commissions.  There are no guarantees of a better result there though.

The same problem exists on the stock market.  If you want the the money now, issue a market order to sell the security, and you will get something close to the best price at that moment.  That said, I never use market orders.

Q: Why don’t you use market orders?

A: I don’t want to be left at the mercy of those trading rapidly in the markets.  I would rather set out a price that I think someone will transact at, and adjust it if need be.  Nothing is guaranteed — a trade might not get done.  But I won’t get caught in a “flash crash” type of scenario, or most other types of minor market manipulation.

Patience is a virtue in buying and selling, as is the option of walking away.  If you seem to be a forced seller, buyers will lower their bids if you seem to be desperate.  You may not notice this in liquid stocks, but in illiquid stocks and other illiquid assets, this is definitely a factor.

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That’s all for now.  If anyone has any ideas on if, where, or how I should continue this piece, let me know in the comments, or send me an e-mail.  Thanks for reading.