1) Start with the big one from yesterday.  On of my favorite monetary heretics, Raghuram Rajan, whose excellent book I reviewed, Fault Lines, pointed out how he had gotten it right prior to the crisis, versus many at the Fed who blew it badly.  Rajan suggests that Fed Funds should be at 2-2.25%, which to me would be a neutral level for Fed Funds.  That’s a reasonable level.  The economy needs to work its way out of this crisis, even if it mean failures of enterprises relying on a low short rate.  Entities that can’t survive low positive rates that give savers something to chew on should die.  Mercilessly.  Monetary policy at present is a glorified form of stealing from savers, who deserve more for their sacrifice.

2) Peter Eavis, an old friend, echoes my points on QE, in his piece Government Clouds Value of Investments.  When the government is actively trying to destroy the willingness to hold short-term assets, and engages in QE, it makes all rational calculations on investments a farce.

3) I agree with John Hussman in a limited way.  QE artificially lowers interest rates, which lowers the forward value of the US Dollar.  That doesn’t mean it will generate a collapse; I don’t think it could do that unless the Fed began to do astounding things, like monetize a large fraction of all debt claims.

4) The US Government is so dysfunctional that the baseline budget has increased 4.4 Trillion over the next 10 years.  This is the beginning of the end of the supercycle, and the reduction of America to the influence level of Brazil.  Earnings levels will converge as well, but more slowly.

5) While we are thinking soggy, think of Japan.  Years of fiscal and monetary stimulus have availed little.  Overly low interest rates have fostered an economy satisfied  with low ROEs.  Low interest rates coddle laziness, and encourage stagnation.

6) There are limits to stimulus, whether monetary or fiscal.  There is no magic way to produce prosperity by government fiat.  Stimulus, by its nature, will run into constraints of default or inflation, if taken far enough.  If not, why doesn’t the Fed buy up all debt?  (leaving aside laws) Isn’t QE a free lunch?

7) Deflation is tough; it weighs upon cities, states and other municipalities, who hide their true obligations.

8 ) Hoisington, the best unknown bond manager.  Where do they think long rates are going?  2% or so on the 30-year.  Makes the current buyers of bond funds look like pikers.  That’s over a 35% gain from here.  If they are right, their fame will be legendary.  Now, that could explain the willingness to fund ultra-long duration debt, because the gains will be bigger still.  What a great confusing time to be a bond investor, until something fails.

9) Or consider the Norfolk Southern 100-year bond deal yesterday.  Quoting the WSJ:

In what bankers hope will be the first in a new round of 100-year bond sales, Norfolk Southern Corp. raised $250 million Monday by selling debt that it won’t have to repay until the next century.

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Investor interest was strong enough that the company increased the size of the new sale from $100 million. Market participants said investors had expressed an interest in buying at least $75 million of the debt before the company decided to announce the $100 million deal.

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The interest rate on Norfolk Southern’s new debt is 6% for a yield of 5.95%, about 0.90 percentage points more than where the company’s outstanding 30 year debt was trading Monday. It was the lowest yield for 100-year debt bankers could recall, breaking through the 6% yield on the company’s 100-year issue in 2005.

—

“There is no question, obviously, that you are giving up a bit of liquidity, but you’re getting a pickup of 90 basis points to move out of the 30-year,” said Jeff Coil, senior portfolio manager at Legal & General Investment Management America. “But you’re getting good income on a stable cash credit in a sector where there are only a handful of rails left.”

Mr. Coil said the firm had a “sizeable” order in the deal. There were approximately 20 investors overall.

Moody’s Investors Service rated the new senior fixed-rate bonds Baa1, and both Standard & Poor’s and Fitch Ratings rated them BBB+.

Is 0.90%/year enough to compensate from going from 30 to 100 years?  I think so. The difference in interest rate sensitivity of a 30 versus a 100 are small at a yield of 5-6%, and if you have a liability structure that can handle it, as a life insurer might, it makes a lot of sense.  After all, a life insurer can’t economically invest in equities because of capital restrictions. You could compare it to investing in long dated preferred stock or junior debt, but then if there is a default, the losses are more severe than with a senior unsecured bond.

10) I’ve never found the yield curve model for recession/recovery compelling.  Limited data set, not covering the Great Depression, etc.

More to come.

Illiquidity is an underrated risk.  Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.  Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don’t trade often.

So where do we see failures due to illiquidity?

• Banks — too numerous to mention, though FDIC insurance restrains it now.
• Life insurers, particularly those that write a lot of deferred annuities.
• AIG and the GSEs — abominations all.
• Bear and Lehman — waiving the leverage limit was one of the stupidest regulatory decisions ever.
• Hedge funds – LTCM was the granddaddy of failures, but many have choked because redemptions forced liquidation of assets at unfavorable prices.
• No colleges, though those college that were too aggressive on illiquid assets got whupped in 2008.  Some were forced to raise liquidity in costly ways.  Same for many overly aggressive pension plans, many of whom came late to the game with Venture Capital, Hedge Funds, Timber, Commodities, etc.

Face it.  Most alternative asset classes involve additional illiquidity.  That is an additional risk, and when evaluating those investments, the expected rate of return must be greater than that for liquid investments.

As an aside, there is another factor to be considered with alternative investments.  That factor is strategy capacity.  Alternative investments do best when they are new.  Here is my version of the phases that they go through:

• New — few know about it except some business-minded investors.  Only the best deals get done.
• Growing — a modest number know about it, and a tiny number of consultants.  Only very good deals get done.
• Comes of age — many know about it, and most consultants pitch it to their clients as the way to go.  Good deals get done.
• Maturity — almost everyone knows about it, and it is a standard aspect of asset allocation for consultants, who have their means of differentiating between different providers, based on metrics that will later be revealed to be useless.  All reasonable deals get done.
• Post-maturity — Late bloomers make it to the party, and beg to get in, thinking that past is prologue, and do not realize that deal quality has eroded severely.
• Failure, which brings maturity — deals fail, leading the market to scrutinize all investments, leading to true risk-based pricing.  Later adopters abandon the market, and take losses.  Earlier adopters sharpen practices, and prepare for a more normal asset class.

So, when looking at illiquid assets, how do you determine how much to invest?  First determine how much of your funding base will never leave over the next 10 years.  When I was a corporate bond manager, that was 25% of the assets that I was managing, because of structured settlements and immediate annuities.

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.  Invest that much in short to intermediate bond investments.  You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

But after that, there is an additional way of controlling illiquidity risk — time once again for the fusion solution! Money market funds run a ladder of maturities.  Stable value funds run a longer ladder, as should commodity ETFs, rather than floating at spot.  Then there are clever advisers who run municipal and other bond ladders for wealthy and semi-wealthy clients.  Running a ladder of maturities is one of the most robust management techniques as far as interest rate risk is concerned.  There is always money coming out and in every year, which slowly leads the portfolio yield in the direction of average rates.

Now, if these bonds are less liquid muni bonds, but the credit risk is low, you don’t care as much about the illiquidity, because the ladder produces its own liquidity as bonds mature.  The key question is sizing the length of the ladder, which comes down to a question of analyzing the liquidity/income needs of the client, combined with a forecast on the secular direction of rates.  The forecast is the least important item, because it is the toughest to get right.  (An aside: who has been right on bond yields consistently for the last 20+ years?  Hoisington, my favorite deflationists.  Wish I had listened more closely.)

The same principle applies to pension funds, endowments, life insurers with a few twists.  Divide your liabilities in two.  What obligations do you know cannot be changed, except at your discretion?  That group of liabilities can have illiquid assets to fund them.  Try to match the payout streams, but if not, try to match them in broad with a ladder, keeping in mind what mismatches you will likely face over the next 1-2 years in order to properly size your cash position.

The rest of the liabilities need more intensive modeling, analyzing what could make them change.  You can try to buy assets that change along with the liabilities, but in practice that is hard to do.  (That said, there are no end of clever derivative instruments available to solve the problem in theory.  Caveat emptor.)  The assets have to be liquid for this portfolio.  Other aspects of portfolio choice will depend on valuation parameters, credit spreads, yield curve shape, market volatilities, as well as macroeconomic factors.

Three Closing Notes

1) Now, all that said, just because you can take on illiquidity doesn’t mean that you should.  A good manager has a feel from history for what the proper liquidity give up is in valuations for stocks and other risk assets, and credit spreads for fixed income assets of all sorts.

Was it worth moving from the:

• Relatively liquid AAA tranche to the illiquid AA, A or BBB tranche for 0.10%, 0.20%, 0.40%/year respectively?  As a bond manager at much larger insurance company said back in 2000 — “It’s free money.”  (That is almost always a dangerous phrase.) My view was there was more illiquidity and credit risk than we could consider.
• Relatively liquid large-issue BBB bank bond to the relatively illiquid small-issue BBB bank bond for 1% more in yield?  Hard to say.  There are a lot of factors involved here, and your credit analyst will have to be at the top of his game.  It also depends on where you are in the speculation cycle.
• Liquid public equities to private equity or hedge funds with lockups?  Tough question.  Try to figure out what the unlevered returns are for comparative purposes.  Analyze long-term competitive advantage.  Look at current deal quality and valuation metrics.  For hedge funds, look at how credit spreads moved over their performance horizon.  Anyone can make money when spreads are tightening, but who makes money when spreads are blowing out?  Analyze them over a full credit cycle.

2) Institutions that did not previously do more liquidity analysis because we had been in near-boom conditions for decades need to at least do scenario testing to assure that they aren’t overplaying their hands, such that they might be forced to make bad decisions if liquidity gets tight.  Safety first.  (This applies to governments and industrial corporations too, as we will experience over the next three years.)

3) Finally, if you decide to make a large illiquid purchase like Mr. Buffett did last year, make triple-sure of your logic and your liquidity positioning.  Nothing lives forever, but you can prolong the life of the institutions you serve by careful reasoning and planning, particularly regarding liquidity.  Get financing when you can, not when you need it. It takes humility to do so, but it yields the quiet reward of continued existence at a modest price.

These three book reviews are for books that I scanned, and did not read in depth.

Quantitative Equity Investing

The first book: Quantitative Equity Investing, is a book for practitioners with strong math skills, not average investors.  It reviews basic econometrics and factor analysis, and then applies these tools in an effort to sort out anomalies in investment markets, tease out important factors driving markets, and find workable trading strategies, considering execution costs, slippage, etc.  It has a brief section on algorithmic and high frequency trading.

On the whole, I didn’t find anything that new or amazing in the book.  Though there were a few things in the book that I hadn’t seen before, they were trivial things that I looked at and said, “Oh, yeah, of course.”

The book is generic in the way that it deals with the topic.  It is no going to give you ideas to pursue, but only tools that you can use if you have ideas tht you want to analyze, and turn into strategies.

Who would benefit from this book?

You have to have a very strong math background, including the type of Matrix Algebra that one would use in graduate-level Econometrics.  To that end, this book would be most useful to grad students wanting an introduction to how to apply their math skills to the markets.

The book is available here: Quantitative Equity Investing: Techniques and Strategies (The Frank J. Fabozzi Series)

The New Science of Asset Allocation

This book uses Modern Portfolio Theory in order to analyze asset allocation decisions.  Those that have read me for a while know that I think that is a flawed paradigm, in need of replacement.  For those that want a reasonable understanding of that paradigm in a short space, the book does that very well.

That said, the book has its virtues.  The chapter on the “Myths of Asset Allocation” shows that the authors have some depth of insight into the foibles and misunderstandings that surround asset allocation.  The book also goes into the importance of qualitative analysis of managers, looking up from the numbers so that you can avoid allocating money to the next Madoff.  It also describes the use of derivatives in order to control risk exposures.

Each chapter ends with a short summary of the takeaways from the chapter, which serves to reinforce the points of the book.

Though the book has the word “new” in the title, I did not find much new in it.  If one is looking for novel implementation methods for asset allocation, best to look elsewhere.

Who would benefit from this book?

This is not a book for average investors.  It is for professionals who want to brush up their asset allocation skills, and young professionals wanting insight into asset allocation.

The book is available here: The New Science of Asset Allocation: Risk Management in a Multi-Asset World (Wiley Finance)

The Economics of Food: How Feeding and Fueling the Planet Affects Food Prices

To me, this was the most interesting book of the three, but I feel it was mistitled.  A better title would have been: “Fueled: The Effects of  Using Food for Fuel” or something like that, because the central question of the book is to what degree has using crops to produce biomass for fuel production (usually ethanol) affected the costs of food and fuel.

I found the book is very even-handed, to a fault.  It argues that the use of crops for fuel production had little impact on food costs, and that there were many other factors that made food prices rise when ethanol production was going gangbusters.  Weather, domestic and foreign demand and many other factors had a role in moving food prices, not just ethanol.

After reviewing the book, I have a better sense of the complexity of the question, and that it will not admit easy answers.

Who would benefit from this book?

Anyone who wants a basic understanding of food economics, and how that is impacted by a wide number of factors including using crops for the production of fuel would benefit from this book.  The book is well written, and seemingly balanced.

The book is available here: The Economics of Food: How Feeding and Fueling the Planet Affects Food Prices

Full disclosure: The publishers sent me copies of these books, hoping that I would review them.  I review about 80% of the books that get sent to me.

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.

I really enjoyed the book Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street (review forthcoming), so when I learned the William Poundstone had written a new book, I went out and bought it.

This book, Priceless: The Myth of Fair Value (and How to Take Advantage of It), covers rationality in decision making, and how markets and marketers take advantage of the deficiencies in rationality in average people.

There are many in the investment community that admire behavioral finance, and many who say that it might be true, but where are the big profits to be made from it?

This book doesn’t cover behavioral finance per se, but it does cover its analogue in pricing and marketing.  In a negotiation, the first person to put a price on the table tends to push the final price agreed to closer to his price.  Leaving aside no-haggle dealerships, why do car dealers post high prices for vehicles?  Because only a minority does the research to understand what the minimum price is that a dealer will accept.  The rest pay more, often a lot more.  Personally, I do a lot of research before I buy a car, and it helps me spot dealer errors in pricing.

The book is replete with examples of how there is no “fair” way to price things out.  What are the proper damages for a jury settlement?  The attorney for the plaintiff is incented to come up with the highest believable amount for the jury, because they will render a verdict less than that.  Make the ceiling as high as possible, and the plaintiff will get more.

We call placing the first price on the table “anchoring,” because it pulls the final result toward itself.  The book is filled with experiments dealing with anchoring.

The book also spends a lot of time on the “ultimatum game,” where a person gets $10, and must offer some of it to a second person, but if the second person turns him down, the first person gets nothing.  The main lesson here is that pride is stronger than greed.  Yes, it can be construed as a question of fairness, but when someone gives up money to deny money to someone else, it is not fairness but envy.  Why pay to make someone else worse off?  To teach him a lesson?  What an expensive lesson.

Much of this book was a walk down memory lane for me.  I discovered Kahneman and Tversky in the Fall of 1982, and I found their ideas to be more cogent than much of the “individuals maximize utility” cant that was commonly heard from most professors teaching microeconomics.  People are far more complex than homo oeconomicus.  Small surprise that most tests of microeconomics as a system are not confirmed by the data.

Kahneman and Tversky showed via a wide array of examples that the decisions people make are affected by the way they are presented to them.  People can be manipulated in limited ways in order to affect the decisions that they make.

The book deals with many marketing tricks, particularly the powerful word, “free,”  and how it dupes people into buying something to get something for free.  For another example, why companies sell really expensive items that few will want, because people will buy the next most expensive item with greater probability, versus less expensive items of the same class.

Other topics covered include:

• The virtue of complex billing
• Why nines work well in pricing.
• Alcohol, and its value in bargaining
• How changing symbols can affect willingness to deal.
• Why to keep a ‘neutral’ friend with you in bargaining.
• And much more.

I really enjoyed the book.  It won’t be of as much value to investors, but it will be of great value to consumers.  Learn how marketers trick you.

If you want to buy the book, you can buy it here:  Priceless: The Myth of Fair Value (and How to Take Advantage of It)

Who would benefit from this book

Most people would benefit from the book.  We all need to understand our thinking biases better, so that we make smarter purchases, and avoid wasting money.  If the ideas of the book are applied well, you could pay for the book many times over in a year.

Full disclosure: I bought my copy with my own money.

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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Preventing the Next Bubble

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

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

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

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

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

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

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

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

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

• High turnover rates
• Rise in prices
• Increased leverage

He had three solutions:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

This idea is applicable to many fields, but in the era of the internet, this is a cheap idea that should gain broad acceptance.  Academics would benefit from the creation of a journal of failed research.  Rather, many journals of failed research, Chemistry, Economics, Biology, Sociology, Finance, etc.  There should be buoys in the harbor saying this way does not work; go another way.  There would be three salutary effects:

1) Researchers would learn of ideas that don’t work and would avoid them.

2) Researchers would conclude that your process does not work, but they have a better way to proceed and act on it.

3) Academics would get credit for doing honest research, and not twisting research through falsifying data or tweaking formulas in order to get significant coefficients.

It is almost as valuable to know that something doesn’t work, than to know that is does work.  How much time could be saved, and new avenues acted on, through journals that record failed research.  Who knows, but that it might improve honesty among scientists, if they get credit for publishing failed research that is honest, versus falsifying data or engaging in a specification search in order to tweak coefficients to make them significant.

This would be a big improvement for every academic discipline worth writing about, where data and fair results matter.  Let it happen then.  I am willing to set up online journals for failed research.  Let the submissions begin.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why are short-term rates positively related to returns?

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

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

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

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

I did not ask for this book, but I am glad the publisher sent it to me for free.  There is a lot of concern over inflation in the present era, but not a lot of structured thought about what drives inflation.

This book takes the long term perspective, and looks at the wide array of monetary arrangements, and analyzes which arrangements produced more or less price inflation.  The author shows that there is generally an inflationary bias in all currencies.  Currencies that are backed by precious metals tend to experience less inflation, but many governments using such currencies debase the metals or clip the coins.  That said, it does restrain inflation, because inflating a  metallic-based currency takes a lot of work.

To have significant inflation, one must have unbacked paper money.  The same is true of defaults in bonds.  In order to have a crisis, much debt must be issued relative to the assets and earning power of the companies.  The debt is not backed by sufficient repayment capacity, and thus there are some defaults.

A fiat currency in and of itself, is not sufficient to create hyperinflation.  Hyperinflation only happens when the government finances itself by printing money with abandon.

The book further distinguishes itself by explaining situations where foreign currencies come in to act as shadow currencies inside nations.  Further, the book describes how inflationary situations end.  One constant is that people quickly analyze where purchasing is declining, and seek stability through metals or relatively stable fiat currencies.

One strength of the book is that at the end of each chapter, the author summarizes all of the main points.  I recommend this book.

Quibbles

The book is not dry, but it has a distinctly academic feel.  Not everyone will take to the book easily.

Who would benefit from this book?

Economists would benefit from the book, and also those that like reading about the history of inflation.  Few things truly change in History; the names may change, but we make the same mistakes.

For those who want to buy the book, you can buy it here: Monetary Regimes And Inflation: History, Economic And Political Relationships.

Full disclosure: Though I get books for free from publishers, I burn time to read books in full, and write reviews that are balanced.  Those entering Amazon through my site and buying anything will end up sending me a small commission, but they will not pay more in order to do that.