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My Visit to the US Treasury, Part 7 (Final)

Posted on 10 November 2009 by David Merkel

Things have been busy for me, so this final part should be short.? What did I learn that I did not already know?? Not much, except:

The Treasury wants to convince? the public that it is doing its best, but that Congress is a slave to the Financial Services industries.
When asked about the latest bailout of GMAC, they said that didn’t qualify as a financial — the aid was to help the auto companies.? (If so, send it directly, and let GMAC expire.)
They said that they worried about the same things we did, though they had to maintain public confidence, and did not think it was as likely as we thought.
They did not bring up the GSEs.
They pointed at the financial markets as evidence of recovery, and did not speak of the real economy, which is weak.
There is no acknowledgment of what could go wrong in the long-run.? They are only playing for the next 3-7 years, at most.? Everything is done to goose the next year.
That the Treasury is trying to reduce its footprint in the economy is welcome news to me.
They said that they were trying to be wise stewards of the economy, but that Congress had questionable motives.

May I go back to my original questions:

Haven?t low interest rates boosted speculation and not the real economy?
We are looking at big deficits for the next seven years, but what happens when the flows from Social Security begin to reverse seven years out?? What is your long-term plan for the solvency of the United States?
We talk about a strong dollar policy, but we flood the rest of the world with dollar claims.? How can we have a strong dollar?
None of your policies has moved to reduce the culture of leverage.? How will you reduce total leverage in the US?
Why did you sacrifice public trust that the Treasury would be equitable, in order to bail out private entities at the holding company [level]?? People now believe that in a crisis, the government takes from the prudent to reward the foolish.? Why should the prudent back such a government?
If we had to do bailouts, why did we bail out financial holding companies, which are not systemically important, instead of their systemically critical subsidiaries?
We are discussing giving tools to regulators for the tighter management of the solvency of financials.? There were tools for managing solvency in the past that went unused.? Why should we believe the new ?stronger? tools will be used when the older tools weren?t used to their full capacity?? (The banks push back hard.)

I’ve answered 1 and 2.? The rest are unanswered.? Here are the brief answers.

3) No, there is no strong dollar policy.? Wait for the day when we are net exporters (and our relative wages will be lower then.)

4) They are doing nothing to? reduce total leverage in the US.? My own guess is that it is increasing.

5) And there is the question, aside from fairness, were the bailouts Constitutional?? A narrow reading of the Constitution says no, but our government does many, many things that violate a narrow reading of the Constitution.? The fairness question was not raised either, the bloggers there were attacking effectiveness, not fairness.

6) This is my guess — we bailed out holding companies because it was the simplest way to do it.? More thought would have led to a cheaper solution, but thought is rare during a panic.

7) I have no answer to point 7.? There is no good reason to hand over stronger tools to a culture that has not used weaker tools.

Aside from all that, we could have spent more time on international issues.? There was the joke at the beginning of the session that one fellow tasked with raising money was “fluent in Mandarin.”?? From the chuckles, I gauged it to be a joke.

But that might prove to be the most significant point economically.? The Treasury is putting pressure on the Dollar through high debt issuance, and the Fed through the creation of short-term credit to heal various debt markets.? The benefits are going to debtors, not creditors.? What value should the creditors assign to the Dollar?? The simple answer should be less than previously.? Yet, nations follow many noneconomic goals, many of which benefit the US as the reserve currency in the short-run.

The ultimate answers are complex, because they rely on how other nations will act.

Final Note

I have found interesting the commenters that automatically assume that being willing to go to the Treasury and eat one cookie equals compromise.? There are a lot of scared and frustrated people in the US, and they see their prosperity ebbing, and are looking for someone to blame.

Let me try this — as the world has gone capitalist, the edge of the US has been eroded.? Now we face a world where doing certain jobe should pay the same, regardless of where they are located.? Wages in the US will converge with those from the rest of the world, adjusted for capital investments.

Throughout human history, “middle classes” have been abnormal.? The current adjustment in the US may be showing the once large middle class that it is not a normal thing, and is hard to maintain.

There is no conspiracy.? The US Government is up against economic forces larger than it can combat.? The rest of the world is out-competing the US, and the US? has a shrinking portion of the pie as a result.

My Visit to the US Treasury, Part 6

Posted on 7 November 20098 November 2009 by David Merkel

Now, none of us knew when we came that only bloggers were invited.? Personally, I expected it to be a broader press briefing that some bloggers could come to as well.? “Deep background” is well understood to the press, but new to bloggers.? My blogging friends at the meeting can correct me, but all of us were surprised that it was only bloggers at the meeting.

My only clue that they might have treated us nicer than some other gatherings, was that some staffers not at the meeting came in after the meeting to raid some cookies.? Now, maybe that is normal regardless there.? I’ve seen the same things in corporate settings.? The e-mail announcement, “Open season in room 406!”? That said, the chocolate chip cookies were all gone. :(? I had one, as did Tyler, I think.? Maybe the Treasury officials had the rest.

Personally, I am comfortable with the restrictions on reporting from the meeting.? The Treasury’s high-level staff sound the same tune.? It doesn’t matter if we identify them or not, they reflect the policies of the Obama Treasury.? With restrictions on not identifying who said what, to me it does not matter, because they were senior Treasury officials.? We can quote, or approximately quote.? We can’t tie it to a single person.? That doesn’t affect us much.? We know what they think, and we can write about it.? We just can’t say exactly who said it, or whether they were there.

Making Money or Not

Few areas of the US government are designed to make money.? One of the main points that Treasury made to us was that the TARP would cost little, or might make money.? TARP is a piece of a larger puzzle.? My question is this, counting in all of the bailouts, including all stimulus programs, what is the cost to the taxpayer?? Now, I ask my readers what they know here. E-mail me with any comprehensive pieces that you have seen, or put it in the comments, so that all can see.

When I look at the bailouts, AIG, Fannie, and Freddie have sucked up /are sucking up resources.? With respect to the GSEs, I appreciate the view that the Administration views Fannie and Freddie as a hole in the system that they can use to funnel money to housing without asking Congress for approval.? Certainly their financial result show it.? Fannie lost a lot of money last quarter and is begging for help.? Freddie lost less, but is not asking for money now, but they likely will in the future.? As for the Treasury, they have opted to not maximize the value of Fannie by allowing her to sell of tax credits to others, notably Goldman and Berky.? They are not interested in maximizing the value of the GSEs, only of using them for their policy goals.

One slide the Treasury showed us was that they thought they were making money across all of the TARP bailouts that they did.? Also, that their guarantee programs had made money as well.

True, so far the guarantee programs have made money.? That does not mean that the government should be in that business, as it may encourage greater risk taking later, because they think the government will rescue them in times of trouble.? In England, at least some think it is a bad precedent.

TARP may be doing okay, but the same moral hazard argument applies.? Also, bailouts may come after shareholders have lost a lot, but management teams may (and seem to be now) benefit disproportionately from the bailout.? Away from that, the losses from the GSEs, Auto companies, and AIG swamp other gains.? That’s what it seems to me.? Does anyone else know better?? Please put it in the comments, for all to see.

Away from that, consider how the FDIC is basically broke, and that the FHA is not far behind.? This crisis is not over.

A Place of Agreement

One place where I can agree with the Treasury is that there should be only one regulator of depositary institutions.? The insurance industry can choose among states, but for the most part there are states for big companies,and states for small companies.? The states willing to regulate the big insurance companies have done a great job relative to the banking regulators.? There are few failures.? AIG died for non-insurance reasons.? Penn Treaty was a basket case long before the crisis.? Who else died?

Having one regulator for banks will remove the ability of the banks to choose the weak regulator.? It raises the risk that the one regulator will be corrupted.? That’s a lesser risk, because with many regulators, the odds that one will be corrupt are high, and corrupt institutions will go to them to be regulated.? With one regulator, politicians can more easily watch the troubles, and can more easily assign blame.

I have no objection to one national insurance regulator either.? That said, many states will object, because they have differing standards.? But does Congress really want to do insurance law?? It takes up a lot of time and is complex.

The Final Note for Now

Things always look best for a borrower immediately after his most recent loan.? So it is for most programs in our economy that favor giving loans in this crisis to stimulate demand.? So it was in the 70s and 80s with lesser developed countries.? The finances looked great after the loans, but after they had spent it away on consumption, things looked much, much, worse.

So it is with government programs that interfere with the free market through offering cheap lending terms.? They give a temporary lift that leads to greater problems once the subsidy is spent away.? So it is now with government subsidies and loans.

Other Posts

Two more posts on the meeting, one from a blogger who was there:

A Sit Down With Senior Treasury Officials – Part II

and one who was not, somewhat critical, but constructively so:

Treasury and the?Blogs

As for me, I’m glad I went.? I have a better zeitgeist of the US Treasury.? I am not more impressed, nor less impressed with them.? I do want the Federal Reserve to consider inviting us to meet with them.? They are far less accountable than the Treasury, and many of us would like to counsel them on their behavior that seemed smart at the time, but will likely prove destructive to the republic.? Dare you invite us, Ben, or do you have less courage than the Treasury?

My Visit to the US Treasury, Part 5

Posted on 7 November 20097 November 2009 by David Merkel

One other blogger took his nameplate with him — I’m not sure who; the rest left theirs.? But this is what was in front of each one of us as we sat down to discuss matters at the US Treasury.? Treasury officials had similar nameplates.? It dictated where we would sit as well.? From the front of the room on the left, for bloggers it was Financial Armageddon, (Megan McArdle — not there), Accrued Interest, and Across the Curve.? On the right, Naked Capitalism, Kid Dynamite, Interfluidity, Me, and Marginal Revolution.? Aside from putting the two bloggers with the most traffic at the front, there did not seem to be any rhyme or reason to the seating.

The Treasury officials presenting generally sat in front, a few sat to the side and behind us.? It made for an interesting dynamic during the portion of the meeting where some bloggers disagreed over whether derivatives should be exchange traded or not.? The folks from the Treasury grinned.? See?? These aren’t easy questions to answer!? For me, with a middle view (bring interest rate swaps to exchanges first and see how they work, then try other instruments that are less liquid), I found the exchange to be a waste of precious time, but it was revealing of the attitudes of those in the Treasury.? I knew what the bloggers thought already.

The Biggest Financial Problem

I’ve written a number of pieces on why debt matters. (Or, where is the breaking point?)? I am in the process of reviewing This Time is Different: Eight Centuries of Financial Folly — a book that deals with the reality of sovereign defaults over the last 800 years.

Surprise! Over-indebted countries do default on their debt more often than less-indebted countries.? During the current crisis, we have two mechanisms running to blunt the troubles.? The government is running a large deficit, and the central bank is sucking in longer-dated bonds to lower interest rates.? I talked about why lower interest rates are not necessarily a blessing yesterday.? Today’s thoughts are on deficits.

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?

Would that I could do that with the present situation.? The long term problems are too numerous, and the present crisis saps attention from what is arguably a larger problem.? Medicare, Social Security, unfunded Federal pensions and retiree healthcare, underfunded state pensions and unfunded retiree healthcare, and underfunded corporate pensions (flowing to the PBGC) are the crisis of the future.? We are talking underfunding and debts equivalent to 4x GDP in total.

The deficits may be helping out areas of our economy for which there is already too much capacity — autos, banks, housing, but isn’t aiding the parts of the economy that don’t have excess capacity.? The one advantage to Americans is that a decent amount of the debt is absorbed by the neomercantilists, who will get paid? back in cheaper dollars (if at all) than the goods that they provided originally.

This all feels like the Japan scenario.? Low interest rates, low growth if any in non-protected sectors, soggy debt-laden protected sectors, excess capacity in areas not salable to the rest of the world, high government debt, and a demographic crisis.? Also speculation using cheap leverage for carry trades.

I’ll try to tie this up in another post or two.? Sorry if this is verbose.

My Visit to the US Treasury, Part 4

Posted on 6 November 2009 by David Merkel

So, who did I recommend for the next meeting at the Treasury? (I think there will be one.)

Economists View http://economistsview.typepad.com/
Cafe Americain http://jessescrossroadscafe.blogspot.com/
Market-Ticker http://market-ticker.denninger.net/
Econbrowser http://www.econbrowser.com/
Greg Mankiw?s Blog http://gregmankiw.blogspot.com/
Carpe Diem http://mjperry.blogspot.com/
Credit Writedowns http://www.creditwritedowns.com/
Gregor Macdonald http://gregor.us/
Jeff Miller http://oldprof.typepad.com/
Floyd Norris — NYT http://norris.blogs.nytimes.com/
Market Beat — WSJ and their real time economics blog, deals, and real estate blog… http://blogs.wsj.com/marketbeat/
FT Alphaville — http://ftalphaville.ft.com/
James Pethokoukis — Reuters http://blogs.reuters.com/james-pethokoukis/ (also Matt Goldstein and Rolfe Winkler at Reuters)
Curious Capitalist — Time http://curiouscapitalist.blogs.time.com/
Matt Taibbi — http://trueslant.com/matttaibbi/ (And others at the same site)
Trader Mark http://www.fundmymutualfund.com/
Dealbreaker http://www.dealbreaker.com/
The Epicurean Dealmaker http://epicureandealmaker.blogspot.com/
Ultimi Barbarorum http://ultimibarbarorum.com/
Zero Hedge http://www.zerohedge.com/ (ask for Tyler Durden or Marla Singer)
The Reformed Broker http://thereformedbroker.com/
Crossing Wall Street http://www.crossingwallstreet.com/index.html
Cody Willard http://cody.blogs.foxbusiness.com/

Add to that good ideas from my readers:

Warren Mosler
Bill Cara

Now, Treasury responded to me, thanking me for the list, but said that the mainstream media bloggers already have access.? Fine with me — I was just gauging talent and reach.

The Nature of a Liquidity Trap

Go back in history over the last 25 years.? How did the Fed manufacture recoveries?? They lowered interest rates enough so that borrowers would be willing to borrow and refinance assets that had cash flow streams that were not financable in the higher interest rate environment, but financable in the lower interest rate environment.

With each successive rescue, interest rates at the trough were lower than before, inviting borrowers that were increasingly marginal to buy assets, borrowing money at cheap rates to pay them off over time.? We thought we saw the bottom, 2002-2004, but no.? The Fed Funds rate can go to zero, and what’s more the Fed can buy longer dated Treasuries, Agencies, and Mortgage Bonds, lowering interest rates on the longer end of the yield curve.? This allows even more marginal borrowers to buy assets. If they face some hiccup in their cash flow, they will default, and quickly.? If you doubt this, consider the high currently expected rate of default on FHA loans originated over the last two years.

Yes, low rates can get them to buy, but it cannot get them to hold on.? But wait, these are criticisms of the Fed, not the Treasury.? Mostly so, but what of the expensive housing tax credit? and cash for clunkers.? Those belog to the Treasury.? They are not economic programs — the costs far outweigh the benefits.? But wait.? Those shouldn’t be pinned on the Treasury; Congress, bought and paid for, are pushing these programs on behalf of their lobbyists.

If so, where is the administration to shame Congress over such behavior?? Where is the President who should press for a line-item veto?? (I like Wisconsin’s version. 😀 )? Let the Treasury, backed by Obama, ascend to the bully pulpit, and say that such programs are a waste of taxpayer dollars.

The Fed and Treasury have been able to touch of a speculative rally in financial assets, which benefits financials, but with weakness in? end-user demand, the lower rates do nothing to stimulate investment in plant and equipment.

All that said, there are three things that could go wrong here:

Contrary to the expectations of the Fed, inflation could rise, and cause the Fed to tighten.
All of the excess dollar claims could lead to greater depreciation of the dollar.
Defaults could cause credit spreads to widen.

Those have not gone wrong yet, but they are all threats.? More tomorrow, when I discuss difficulties with entitlement programs.

My Visit to the US Treasury, Part 3

Posted on 5 November 2009 by David Merkel

Going back to bank stress-testing for a moment, one interesting thing that a Treasury official said at the meeting was that unemployment did not have a big effect on foreclosures.? Unemployment has a big effect on credit card defaults, but not foreclosures.? I disagree.

As a multi-purpose quant, I have learned over the years that it is impossible to estimate an option curve/function when the variable in question has only been “in the money” or “out of the money.”? (As an example, one can’t estimate the withdrawal function on deferred annuities because haven’t had a large sustained rise in interest rates since the product was created.)? With mortgage debt, over the last 70 years, real estate values? have never fallen enough to make default a reasonable choice until now. Thus in the past, when unemployment hit, one could sell, rather than default.? As I have said before, foreclosure typically occurs when someone is inverted on their mortgage, and a life event happens: death, divorce, disability, disaster, disemployment, change in financing terms, or deciding that it is worthless (and doing a strategic default).

But now residential real estate values have fallen.? When someone loses their job, the option to default becomes real.? Do a short sale, and give the bank a hit.

With stress-testing, the devil is in the details.? How do you turn unemployment, housing prices, etc., into losses tailored for each individual company?? Different underwriting standards can make quite a difference in the results.? I would have been more than happy to dig through detailed stress testing models.? That was my job once.

When the Treasury announced the stress-testing results, it was at? a time when the gloom was thick.? It was a positive to the market that the government would not require huge amounts of extra capital, and in most cases, no extra capital.? Thus the market rallied.

With many simple asset classes that were under stress, the Fed and Treasury offered guarantees that would enable them to easily survive the panic.? Absent the guarantees, most short assets would have been “money good,” but there would have been significant doubt for a brief time.

As I commented to a Treasury staffer after the meeting, with financing rates so cheap to buy financial debts, regardless of what kind, it is no surprise that corporate bond spreads have tightened, while there is still little lending to finance growth in the real economy.? That is why there is such a gap between Wall Street and Main Street.

Main Street sees unemployment and low capacity utilization.? Wall Street looks at bond spreads and P/Es.? Those are not the same things.? The current stimulus has emphasized healing the financial sector in an effort to avoid contagion and depression.? It does not directly address slack in the real economy.? The real economy funds the bailout of financials, but does not directly benefit.? Thus the disconnect between Main Street and Wall Street.

Many financial? measures and companies have rebounded, but little expansion has occurred in the real economy.? Even with companies that have done bond offerings, they have often used the proceeds to bolster the balance sheet, rather than expand capacity.? Safety first is the watchword.

Perhaps a change happens when companies with a lot of cash appear as takeover targets in a sluggish market.? Easier to grow market share through acquisition rather than organically, and what’s better, their cash helps pay for the deal.

Housing Initiatives

It seems that the low end of the housing market has bottomed.? Government programs have something to do with it.? The tax credit has made a difference in the short run, as has the efforts of the Fed to support the mortgage markets through the purchase of RMBS.

Mortgage modifications are advertised by the Treasury, but the results are small.? Away from that, I will say that successful modifications occur more likely when there is some degree of principal forgiveness.

Tonight, I will pick up on the risks of low interest rates in part 4.

Who was Invited?

I’ve been in touch with staffers at the Treasury.? One of them gave me a list of the invitees.? Here is the list of those invited that did not come:
Abnormal Returns
Alea
Barry Ritholtz
Clusterstock
Free Exchange at The Economist
Paul Kedrosky
Andrew Leonard
Calculated Risk
Yglesias
Megan McArdle
Mike Konczal
Baseline Scenario
Mish
The Audit at Columbia Journalism Review
Credit Slips
Prudent Investor
Brad Delong
Felix Salmon

If you were in the Treasury’s shoes, who else would you have invited?? E-mail me, or put it in the comments.? Tomorrow I will mention who I thought would have been good additional guests.

Continuing Coverage

Here is a list of posts to date on the meeting:

Friday in Vegas (Kid Dynamite):
“A Sit Down With Senior Treasury Officials – Part I”

Naked Capitalism:
“Curious Meeting at Treasury Department”

The Aleph Blog:
“My Visit to the US Treasury, Part 1”
“My Visit to the US Treasury, Part 2”

Across the Curve:
“Bond Market Open November 04 2009”

Accrued Interest:
“Financial Regulation: How Would You Have It Work?”

Michael Panzner
Treasury Officials Meet With Financial Bloggers

A Few Observations of My Own

Interfluidity
Sympathy for the Treasury

That’s all for now.? Until this evening and part 4.

My Visit to the US Treasury, Part 2

Posted on 4 November 20094 November 2009 by David Merkel

Before I start this evening, to all my fellow bloggers out there, if you were invited to the gathering at the US Treasury and did not come, I have a request and a question:

If you were invited, send me an e-mail.
Tell me why you decided not to come, if you would.

If present trends continue, I can tell you that bloggers are not pushovers for the US Treasury, but neither are they deaf or heartless.? Since my last post, here are the responses to the gathering:

As all bloggers there will note, those from the Treasury were kind, intelligent, funny… they were real people, unlike the common tendency to demonize those in DC.? As for me, I live near DC, and I am an economic libertarian, but I have many friends at many levels inside our bloated government.

They have to do their jobs.? If there is a conspiracy, it is well-hidden.? There are simpler ways to understand the mess that comes out of national politics.? We get the result that is least offensive to the most, and pleasing to few.

We had a good discussion, but I am not the one to put myself forward.? I made some comments, but did not get to ask my questions.? My personality was not the dominant one.

What I propose to do in this series of articles is go through the main arguments of the US Treasury from the handouts that they gave us (sorry, I can’t scan them and put them out for view), and try to give a fair rendering of what they have done.? My audience is dual: I am addressing those who read me in the blogosphere, and those at the Treasury.

-=-=-=-=-==–=-==–==-=–=-==-=-=-=-=-=-

Treasury officials said that they were trying to reduce the footprint of the rescues/bailouts as much as possible, doing it at a rate that would not jeopardize the recovery.? Their goal is to put in place? regulations that will prevent future disasters once the current disaster is past.

David: Well, yeah, that’s what to do if you can.? The question is what will happen to the markets when you start to remove significant stimulus from critical areas, as I said to my pal Cody a year ago.? Much of that is not in the domain of the Treasury, but the Fed.

The Treasury understands that the troubles of 2008 came from poor credit regulation and tight coupling in the financial system.

David: we over-encouraged single family housing as a goal for Americans.? When debt was too high for cash flows from average American households to afford residential housing, the prices of housing began to fall, and the foreclosure process began, as foreclosures happen once someone is inverted on their mortgage.? Residential real estate prices overshot by a lot.? We should be surprised that there are problems now?

I would not only eliminate the tax credit for new buyers, but I would phase out the interest deduction for mortgage interest.? Get people financing with equity, not debt, even if it means the economy is sluggish for a few years.? It will bring a longer-lasting self-sustaining recovery.? Debt-based systems are inherently fragile because fixed commitments remove flexibility from the system.

To the Treasury I would say, “Markets are inherently unstable, and that is a good thing.”? They often have to adjust to severe changes in the human condition, and governmental attempts to tame markets may result in calm for a time, and a tsunami thereafter.

Those that understand chaos theory (nonlinear dynamics) were less surprised by the difficult markets that we have faced.? We saw it coming, but could not predict exactly when the system would face crisis.? Bears are often right, but with significant delays.

The government is not the majority player in the system, but is the biggest player.? At critical points their willingness to offer support helped lead to a market rebound.

Now in the actions of the government, there is some “making virtue out of necessity.”? In supporting Fannie & Freddie in February 2009, they did not have much choice, unless they were to let them fail, which might have been a good thing.? As it is, F&F seem to be black holes where the government is unlikely to recoup their investments.

As for the bank stress-testing, one can look at it two ways: 1) the way I looked at it at the time — short on details, many generalities, not trusting the results.? (Remember, I have done many such analyses myself for insurers.) or, 2) something that gave confidence to the markets when they were in an oversold state.? Duh, but I was dumb — the oversold market rallied when it learned that the Treasury had its back.

I’m tired, and that’s enough for the evening.? I’ll pick this up tomorrow.

My Visit to the US Treasury, Part 1

Posted on 3 November 2009 by David Merkel

This will have to be brief, because I am tired.? I have had to deal with family and work issues today, and only now have time to blog.

You might have seen my fanciful post, Fallowhaven, Part 1.? I wrote that because I thought I could reveal almost nothing of my visit to the US Treasury today.? As it is, I can talk about it, but not quote any officials there, nor say who was there from the Treasury.

My surprise was that only bloggers were there.? I expected reporters from major papers, but that was not the target audience.? The closest to mainstream media would have been Megan McArdle, who presumably said she would be there (there was a placard for her), but did not show.? The rest of us were independents:

As I write now, only John Jansen has commented on the meeting, and only briefly.? I have a lot to say about the meeting, but I can’t get it into one post.? I will spread it out over several posts, and try to explain the? views of the Treasury, are where they make sense, or not.

I appreciated being able to meet my fellow bloggers.? Putting faces to the names is special.? Would that I could bring all of the major investment/finance/economics bloggers together for a gathering.? There would be many disagreements, but it would sharpen us all.

More tomorrow –? I want to talk about the successes and failures of the current rescue, and how the Treasury views them.

The Best of the Aleph Blog, Part 12

Posted on 3 November 2011 by David Merkel

This portion goes from November 2009 to January 2010.

Yes, I was one of the eight bloggers that made it to the first meeting with the US Treasury:

My Visit to the US Treasury, Part 1

My Visit to the US Treasury, Part 2

My Visit to the US Treasury, Part 3

My Visit to the US Treasury, Part 4

My Visit to the US Treasury, Part 5

My Visit to the US Treasury, Part 6

My Visit to the US Treasury, Part 7 (Final) (if you have to read only one of these, read this one)

How to Regulate the Banks, and other Financials

It comes down to diversification, leverage, and liquidity.

Notes from Recent Travels

Commentary on the health care bill, and also the AIG Bailout, and the Fed’s reprehensible actions.

Problems with Constant Compound Interest (4) (and more)

Retells my story interacting with the Federal Reserve bank of Richmond, and makes the application to commodity investing.

Post 1100 ? On Thanksgiving

Points out where we need to be thankful.? Even amid crisis, we have many things going well.

The Right Reform for the Fed

Criticizes a lame editorial that Ben Bernanke wrote in the Wall Street Journal.

On Sovereign and Quasi-Sovereign Risks

Talks about the relative riskiness of foreign debts, and the value of being able to tax.

Where the Rubber Meets the Road at Home

Explains how I teach my children about economics and other matters.

Uncharted Waters

Laments the low return on equity culture the US Government creates by trying to keep interest rates low.? (Sound familiar?)

My TIPS, Treasuries, and Inflation Model

An amazing model that describes the forward inflation and real yield curves.

On Contrarianism

“With markets, it doesn?t matter what people say.? What matters is what they rely upon.”

Not so Cheap Trills

One of a number of pieces that I wrote to fight the concept of trills, a form of debt more dangerous than any other I have seen

One Dozen or so Books on Economics

Many clever books on economics that major on history, and minor on theory.

Yield = Poison (2)

The perils of reaching for yield.

Fat Fed Profits Do Not Create a Healthy Economy

Large Seniorage profits for the Fed are not a positive for the economy as a whole.

R Bonds R Bad 4 U

A veiled attempt to raid pension assets to fund the US Government by those aligned with the Obama Administration.

Rationality versus Time Horizons

To come back to the beginning of this article, the fetish of rationality exists in economics because the math doesn?t work without it.? Many tests of rationality have failed, yet the profession does not give up, because their skills are useless if man is not economically rational.

Cram and Jam

There are many distortions of accounting data, and this gives you two of them.

Double Down Institutional Investing

Deals with the asset-liability mismatch in much of endowment investing.

Fear the Boom and Bust ? an Economics Lesson

My commentary on the Keynes vs Hayek videos up to that point.

In Defense of Home Bias

It is very rational to invest closer to home and this article explains why.

The Forever Fund

One of my best pieces ever, where I defend Buffett’s purchase of Burlington Northern, because it is irreplaceable.? This helps to explain how Buffett manages for the very long term, and does well at it.

More on Sovereign Risk and Semi-Sovereign Risk

Posted on 26 February 2010 by David Merkel

When does a sovereign or semi-sovereign government default?? I have seen three answers:

1) When debt is greater than future seniorage revenue (central bank profits) plus future debt repayments.? (Kind of a tautology, but what is implied is that if future debt repayments are onerous, a government would default.)

2) When the interest rate a government pays is greater than the likely growth rate of revenues. (I.e., if you are paying more than your revenue growth rate, the indebtedness will continue to grow without bounds?)

3) When the structural deficit is high, and total interest paid exceeds the size of the structural deficit.? (In that case, default would bring the budget into balance, at the cost of being shut out of the bond market.? But, given the situation, in the short run, being shut out of the bond market isn?t a problem.? There would be problems if the day comes when they need to borrow again; negotiations would begin over paying old debts.)

I will propose a fourth idea: governments can lay claim to a percentage of the GDP of their country/state/municipality.? How large that can be will vary by culture.? Beyond a certain point, attempts to take more than the natural limit for that culture will not result in higher revenues, because people will hide income, and/or leave the country/area.? When debts and unfunded obligations exceed the present value of maximum GDP extraction by the government, default is likely, the only question is when it will happen ? when does cash flow prove insufficient?? Perhaps the earlier three rules can help with that.

Tough Time to be a Municipality

Revenue is declining for almost all states and municipalities.? Given the need to run balanced budgets (on a cash basis), and not having a central bank to fall back on, the problems are much deeper for States and Municipalities than for the Federal Government.? This report from the Rockefeller Institute shows how widespread the loss of revenues is.

But what should larger governments do for smaller governments in this crisis?? Oddly, the best answer is nothing, and even some of the Europeans recognize this.? Smaller governments need to grasp that they have to solve their own problems, and not rely on the Federal government to help ? it has enough problems of its own.

So, if I had any great advice for strapped municipalities in California, or any other place in the US, one of the first things I would recommend is that you assume you aren?t going to get any help.? Those that could help you are in worse shape.? Such does the Pew Institute indicate.? Few states have their pension and retiree healthcare benefits funded.? They won?t have excess funds to aid municipalities, and my even compound the problem by reducing revenues shared with municipalities in order to stem their own budget shortfalls.

The Federal Government Won?t Be Much Help Either

The politics of the US are dysfunctional enough with opaque congressional earmarking benefiting local and special interests.? It will be yet more dysfunctional if states and municipalities ask the US Government for aid.? Besides, the US Government has issues of its own.? Tonight, it will release the 2009 Financial Report of the United States Government, somewhat behind schedule.? With all of the chaos, who could blame them for being late?? My suspicion is that when one adds up the explicit debts of the US Government and its unfunded obligations, it will add up to a figure near four times GDP.? If the US dollar were not the global reserve currency, we would have long ago slipped into chaos.

What would it take to make the US?s debt to GDP ratio stop rising permanently?? We would need to run surpluses of around 8% of GDP, if I understand the charts on page 5 right.? Absent some major shift in governing philosophy, that?s not even close to being on the table.

As I wrote in my seven part article, My Visit to the US Treasury, Part 5: 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.?

Now, with interest rates so low on the short end, there is one further risk: that the Fed would keep rates low simply to keep? the US Government?s financing costs down.? As the Kansas City Fed?s President Hoenig said recently,

?Depending on your assumptions about the economy, that federal debt will grow at an unsustainable level starting immediately, or in a very few years,? Hoenig said. ?We do have significant private debt, so that?s in place, so what worries me about that [is] that puts pressure on the Fed to keep interest rates artificially low as you try to deal with that debt.?

The US Government is in a tough spot financially, and if inflation rises (which is not impossible, consider stagflation in the 70s), its ability to continue to finance itself cheaply will erode.? On the bright side, the US is still viewed as a safe haven, so if there are troubles in Europe or Japan, the US will benefit from additional liquidity in the short run.

Back to the States

For another summary of how tough things are at the states, consider this piece from the Center on Budget and Policy Priorities.? Because many state budgets assume a better economy than they actually got, and some were quite optimistic, the average state has a 6.6% gap to fill as a percentage of its 2010 budget.? The gap projected for 2011 is 17% of the 2010 budget.? Not pretty, and if you want to look at it from a bottom-up perspective, this article offers a lot of links to the various emerging troubles.

One further wrinkle in the matter is Vallejo, California, which is in Chapter 9 now.? In the past, muni bond investors and insurers felt assured that in defaults by cities and counties that they would eventually be paid back in full.? With Vallejo, that may not happen; bondholders may have to take a haircut.? If that happens, and it establishes a precedent for Chapter 9 cases, yields will rise for cities and counties that can file for Chapter 9, in order to reflect the increased risk of loss.? Higher future borrowing costs will further burden city and county budgets.? There is no free lunch in the muni bond market.? (For more good articles by Joe Mysak of Bloomberg, look here.)

Conclusion ? Why do I Write This?

This is a pretty gloomy assessment, but it is consistent with the deleveraging process that is rippling through the US economy.? All sorts of hidden leverage have been revealed including:

Reliance on optimistic economic assumptions in budgets.
Reliance on a robust housing sector.
Reliance on financial guarantee insurers.
Reliance on increasing leverage at banks, and sloppy underwriting of loans.
Reliance on Fannie and Freddie to absorb poorly underwritten mortgages.
Reliance on large pension and retiree healthcare promises to keep wages low, and not funding those promises to keep taxes low.
Reliance on high stock returns to pay for pensions.
Reliance on increasing debt levels in households.
Low bond yields make it difficult to invest for pensions.

And there may be other things we have relied on that may fail.? Banking crises often lead to financial crises, as is pointed out in the excellent book, This Time is Different.

The US government can always borrow more.
The Treasury and Federal Reserve can stimulate the economy out of any crisis.

My main message is that this is a serious situation almost everywhere in the US.? We have borrowed ourselves into a corner.? I write this so that all parties can understand the dynamics going on, so that when muni defaults happen, and the normal dynamics in the bond market shift, you won?t be surprised at the results.? Also, now you have links to a wide number of reports indicating how serious the problems are with Federal and State debts and unfunded liabilities, so that you can do your own digging on the topic.

The Land of the Setting Sun?

Posted on 27 January 2010 by David Merkel

Before I begin, I want to tell all of my friends in Japan that I have a great love for their country.? I have not traveled much, but if I were to travel abroad, Japan would be my first choice.? Plus, I have many friends in Kobe, Japan.

Japan is at the leading edge of the demographic wave where many developed countries have a shrinking population.? But beyond that, Japan has high government budget deficits and a very high government debt.? Consider this graph from Bill Gross’ latest missive:

Japan is in the awkward spot of having high government debt, though much is internally funded, and is still running high government budget deficits.

What a mess.? I happened across a blog I had never seen before today, and it gave a simple formula for when government debts would tend to become unsustainable.? It was analyzing Greece, but I looked at it and said to myself: “What about Japan?”

The main upshot of the equation in the article about Greece is that you don’t want the rate your government finances at to get above the rate of GDP growth.? If so, your debt will increase as a fraction of GDP, even if your deficits drop to zero.

So, what about Japan?? Can we say two lost decades?

Oooch! 0.2%/yr average growth of nominal GDP?!? That stinks.? But here is what is worse.? The Japanese government? finances itself at an average? rate of 0.6%.? The debt is walking backward on them unless GDP growth improves.? No wonder S&P has put Japan on negative outlook.

Japanese interest rates could rise.? Like the US. Japan has an average debt maturity around 5.5 years.? Unlike the US, 23% of its debt reprices every year, which makes them more vulnerable to a run on their creditworthiness.

Here are three more links on the Pimco piece, before I move on:

We can think of central banks as equivalent to a margin desk inside an investment bank in the present situation.? Though I can’t find the data on the web, what I remember from the scandal at Salomon Brothers that led Buffett to take control, there was a brief loss of confidence that led the investment banks margin desk to raise the internal borrowing rate by 3-4% or so. Within a day or so, the trades expected to be less profitable of Salomon were liquidated, and Salomon had more than enough liquidity to meet demands.

But this is the opposite situation: what if the margin desk were to drop the internal lending rate to near zero?? Risk control would be hard to do.? Lines of business and people get used to used to cheap financing fast.? If it were just one firm that had the cheap finance, say, they sold a huge batch of structured notes to some unaware parties, it would be one thing, because after the easy money was used up, the margin rate would revert to normal, and so would business activities.

But let’s expand the paradigm, and think of the Central Bank as a margin desk for the nation as a whole.? Pre-2008, before the Fed moved to less orthodox money market policies, this would have been a more difficult claim to make, but the claim could still be made.

Pre-2008, the Fed controlled only the short end of the yield curve, which, with time, is a pretty powerful tool for making the economy rise and fall.? Short, high-quality interest rates move virtually in tandem with the Fed funds rate, but during good times, with the Fed funds rate falling, economic players seek to clip interest spreads off of longer and lower quality fixed claims, causing their interest rates to fall as well, with an uncertain timing, but it eventually happens.

And when Fed funds are rising, the opposite happens — funding rates for those clipping interest spreads rise, and the expectation of further rises gets built in, leading some to exit their trades into longer and riskier debts, which makes those yields rise as well, with uncertain timing, but eventually it happens.

I like to say that every tightening cycle ends with a crisis.? Let’s see it from an old RealMoney CC post:

		David Merkel
		Gradualism
		1/31/2006 1:38 PM EST

One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

2000 — Nasdaq

1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed

1994 — Mortgages/Mexico

1989 — Banks/Commercial Real Estate

1987 — Stock Market

1984 — Continental Illinois

Early ’80s — LDC debt crisis

So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.

But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it.

Position: None

Or, these two posts, which you can look at if you want… one suggested that housing was the next bubble (in 2004), and the other critiqued Bernanke’s reasoning on monetary policy.? (Aaron Task has an interesting rejoinder to the latter of these.)

Things are a little different now, because the Fed is not limited to the Fed funds rate any more.? They have a wider array of tools, and the Treasury is in the act as well through the TLG program.? The Fed owns over $1.5 Trillion of longer dated debts, mostly residential MBS.? The Fed as the margin desk has itself become involved in clipping interest spreads, using its cheap short-term funding to buy longer dated paper, directly forcing long rates down.? The Fed may innovate in other ways as well, offering/receiving term financing as well as overnight financing via Fed funds.

But, here’s the rub.? If the Fed brings the margin rate down to near zero and leaves it there, while actively creating expectations that it will stay there “for a considerable period,” and does so in a lesser way for long-dated paper as well, it can manufacture lower interests rates seemingly everywhere for a time.? It’s amazing how fast bond managers can shift from fear to yield lust.? (I leave aside the effects of foreign players for now.)

But as I pointed out in my visit to the US Treasury, you can change the financing rate, but the underlying cash flows don’t change.? The margin desk drops the financing rate, and prior good trades look better, marginal trades look doable, but there are investments that are still losers at a discount rate of zero.? No way to help those.

So what happens when the next crisis arises?? It could be commercial real estate, inflation, a war, a sovereign default (e.g., Greece, Japan, UK, Italy), another wave of corporate defaults, or, a very weak economy, with banks that are willing to clip spreads, but not take any significant financing risks.

Back to Japan.? Two lost decades.? Debt walking backwards on them.? All of the Keynesian remedies they applied.? Government spending and deficits ultrahigh.? Interest rates ultralow.? Start with a government with little debt; end with a government that is the most indebted among developed nations.

This developed world in Bill Gross’s “ring of fire” is pursuing the same strategies that Japan did over the last two decades.? They should expect the same results, until sovereign defaults begin.? Then the game will change — mercantilists like China will see their strategies blow up, and the nations that default will see their living standards decline.

This has gotten too long, but one thing that I will try over the next few days is estimate Nominal GDP growth rates for nations in the “ring of fire,” and their Government’s financing rates.? If I find anything interesting, I will let you know.

Final note: Ben Franklin at the Constitutional convention in 1787 commented that the half-sun on Washington’s chair was a rising sun, not a setting sun.? Though my title plays on a name for Japan, all nations in this predicament may find that their sun is setting as well.? Unwillingness to take short run pain in trading leads to failure in trading — even so, it is the same for nations.