Category: Asset Allocation

Eight Notes on the Actions of the US Government on the Economy

Eight Notes on the Actions of the US Government on the Economy

1) I have said it before, but what are the limits of the US Government borrowing money?? Aside from God, everything has a limit.? I appreciate finem respice as she says:

Of course, the next bubble (and perhaps the last for a while) is government. The state government bubble is beginning to burst even as you read this. The federal government bubble is next. You might want to open your mouth and plug your ears.

I view the current rise in Treasury yields as an expression of concern over being paid back in the same purchasing power terms.? The further in time you go out, the lower confidence in the US Government gets.? Given the huge deficits, debts, and unfunded liabilities, how could it be otherwise?

2) So what of the Treasury yield curve then?? Does it threaten Obama’s agenda?? Maybe, if it gets materially worse.? At present, no.? I appreciate what Lacy Hunt said to Barron’s:

But, says Lacy Hunt, chief economist of Hoisington Investment Management, an Austin, Texas, manager of $4 billion in assets, “The sharp rise in Treasury yields isn’t a result of an economic recovery. That occurs when income, production, employment and sales, simultaneously, turn higher. Presently, these indicators merely show a lessened rate of decline.”

There are several possibilities here:

  1. The rise in long Treasury yields is just an overshoot of the mortgage market.
  2. Fears of eventual US underpayment in terms of current purchasing power.
  3. A strengthening economy.
  4. Some combination thereof.

I favor a combination of 1 and 2.? I don’t see any significant strength here.? I do see worry, but not panic.? The more one wants to borrow, the higher the yield that will be paid.

3) When I was 14, my brother (then 12) wrote Howard Baker, Senator from Tennessee, to ask him about whether a Value Added Tax [VAT] would make sense for the US.? I read the reply letter once, and I remember much of it.? I was impressed with the erudite response; I am even more impressed today, given the facile answers often given by politicians to constituents.? Baker made three main points:

  • The revenue raising power of a VAT was tremendous.
  • The VAT was “insidious,” in that it took a little here and took a little there, and no one really felt how much was taken.
  • He felt that it would slow the US economy down considerably, and so, it wasn’t an idea worth pursuing.

Now we are seeing articles reopening/opposing the idea of having a VAT:

I agree with Howard Baker — a VAT is insidious.? Taxes should be obvious, and hurt, such that people have an interest in the level of taxation.? Let the government decide what to eliminate in spending, but don’t overtax us.

4) So maybe we get a single regulator for banks?? That will improve consistency of regulation, but will it be consistently good, or will it be a greater regulatory capture?

5) I agree with Felix.? Personally, I don’t think the government should insure anything, even bank deposits, but insuring the senior tranches of securitizations is ridiculous.? It would put the government in charge of subordination levels.? What public interest reason is there for this?? There will always be some sort of relatively safe assets outside of a government guarantee.? If they fail, should the government guarantee them?? Sorry, but AAA, AA, A bonds sometimes fail within a year of issuance.? Not often, mind you, but that’s the way it is.? To do otherwise is to create a flaccid group of creditors that is unwilling? to take modest risks unless they are government-guaranteed.

6) I grew up as a quant, and from my past Pastor who was a Ph. D. in History I learned to appreciate qualitative arguments.? So what value is economic history?? I’m going to stick my neck out here, but I will argue that intelligence is the ability to use analogies validly.? With math, the analogies used are simple, because of the abstraction.? To a lesser extent, the same is true of science.? But by the time we get down to the social “sciences,” the analogies are much more open to question.

Thus all of the articles alleging that the current troubles are akin to: 2001-2, 1994, 1987, 1979-82, 1973-74, 1969, 1962, 1937, 1929-32, etc.? It is easy to make such arguments, and most of them are wrong.? That said, there is a richness in understanding all of the arguments, but not buying them fully.? Listen to Samuel Clemens, “History may not repeat itself, but it sure does rhyme.”? Looking for exactness in analogies fails; analogies are never meant to be exact, just as the parables of Jesus teach one main truth, and subsidiary matters are more questionable.

7) What of inflation?

It boils down to this: how easily can the Fed reduce policy accommodation with out derailing the recovery, and will it take less time than it did/will Japan (they are into two lost decades now, are they trying for three?).? There is no free lunch, leaving aside seniorage from being the world’s reserve currency.? The implicit subsidies that the Fed created will leak their way into the money stock, and inflation, eventually.

8)? Remember 2008, long T-bonds were the rage and high yield was trash.? 2009, those two are flipped.? Personally, I would take at least half of my high yield ( and BBB) trade off the table and leave it in cash.

Don’t Confuse Stupidity with a Bear Market

Don’t Confuse Stupidity with a Bear Market

“So when are we coming out with a tasset fund?”

“A tactical asset allocation fund?” I replied. “Mmm, it’s worth a thought, but you know what it takes to add a new product.? How much demand would there be for this?”

“Are you kidding? In a bear market, people still want to make money.? We need someone smart who can decide when to be in the market and when to take shelter in cash.”

“If it were only that easy,” I replied, “Tell me, who is so reliably brilliant at market timing, and willing to trade for anything other than his own account?”

“You got me there, Dr. Merkel, but we really need a product like this.? It would sell like crazy.”? (Note: they called me Doctor there regularly.? I did not encourage it; I am not a Ph. D.)

“No doubt.? I will consider it, and get back to you.”

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I had that conversation back in 1994 with one of the better pension representatives of Provident Mutual.? As one of the actuaries there, I quickly realized that I had to boil any investment ideas down into very simple terms for the field force.? The best explanations were rich and simple, like a fairy tale, one of Aesop’s fables, or one of the parables of Jesus Christ.? That is a challenge — one worthy of the best investment minds.

The thing is, there is a constant war between two views of the market:

  • Buy and Hold — Bull Market
  • Trade, trade, trade — Bear Market

I don’t think either view has permanent validity.? Of course in a bull market the buy and holders will crow; they are making money.? And in a bear market, those with less exposure to the market will crow.? Big deal.? Those that are accidentally correct boast while their strategy is in favor.

So, when I read this NY Times article about diversification, I yawn.? After a bear market, you decide to reduce equity exposure?? That’s just fear expressing itself in stupidity.? Even worse is this WSJ article, where the author is giving into his fears, and reducing equity exposure.

My point here is a simple one.? Don’t confuse brilliance with a bull market.? Don’t confuse stupidity with a bear market.

Very few people are good traders, such that they can manuever the pulses of the market.? For those that understand how the market works in the long run and on average, the best thing to do is to ride bear markets out.? Own the best companies you can find, and adjust your asset allocation such that you can survive something worse than a bad recession.? Many people over-own stocks, implicitly trusting in the naive view that they always outperform bonds.? Stocks do outperform bonds, but by much less than advertised, say 1-2%/year.

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When I look at the risk cycle now, I am inclined to reduce risk, and add to safe investments.? That said, I might wait a while to see if the positive momentum persists.? I am gratified by the rally in lower-rated corporate bonds, but think that the risk there is growing.? I am presently inclined to do an “up in quality” trade, sacrificing yield for safety.? There.? That is the way to go now.? Reduce risk, and take the loss in yield.

One Dozen More Notes on the Economic Scene

One Dozen More Notes on the Economic Scene

1) I may as well start out the evening with some predictions. I’m not an expert on this, but Chapter 9 of the bankruptcy code applies to municipalities, but not states. Given the problems with state & municipal pensions, we will probably see chapter 9 modified over the next two decades to allows states to default. There will also be some modification to retirement funding laws as applied to municipalities, states, and maybe the US Government, to allow for retroactive negotiation of pensions and healthcare benefits for an insolvent government.

2) California will lead the parade of states in trouble.? They want the US to guarantee their municipal debt.? Schwartzenegger did all he could to try to pass the referenda that might partially close the budget gap, but from what I see now, it looks like most of the important ones have failed.? Having been a California resident for seven years, I went though my share of referenda; the referendum process makes the politicians of California lazy… they pass the tough stuff off to the electorate, who then get to decide off of voters’ guides and soundbites.

3) California is an exaggerated version of the troubles that other states are having.? Social program spending rises, while taxes on wages, corporate profits, real estate, real estate transfers, etc., all fall.? If you can’t print your own money, and must balance your budget, life is tough, kind of like it is for most Americans.

4) Another municipal issue — can financial guarantors split in two?? I have argued “no,” but who cares what I think?? We do care about those that use the courts, and banks are suing to prevent the MBIA split.? It is a simple issue of fraudulent conveyance.

5) One last municipal issue: pension placement agents.? This is very similar to what I experienced in Pennsylvania regarding municipal pensions there.? Pension consultants would gain business through campaign contributions, and the Democratic and Republican consultants would collaborate and share to control the profits jointly.? Insurance companies providing pension services would pay? compensation to the consultants in exchange for business.? It’s a dirty business, and when I raised ethical objections to it, I was told that I was naive.? Perhaps I have more company now.

Anytime you have opaqueness of compensation, politics, and uncertainty of results (investing), there is always room for corruption.

6) Asset allocation.? The belief in a large equity premium led many to overweight stocks.? I have argued against that.? Now there are many who are finding the they have to start over, after bad equity returns.? There is no magic in any asset class.? Yes, equities do better than bonds in the long run, but only by 1-2%/yr, not 5-7%.

As for the arguments of Ayres and Nalebuff, only the most emotionally dead investors can live with levering up 1.9 times perpetually.? Most people panic.? They can barely deal with the volatility of the S&P 500, much less double that.

7) Mmmm… is it time to take on Bill Miller again?? Yeh.? Overweighting financial stocks?? That is quite a bet, and probably irresponsible again.? Here is my free advice — analyze your estimates of intrinsic value with commercial real estate prices 30% lower than today.? Aside from short-tail insurers, I don’t think you want to be overweight financials.

8 ) On the same note, many small and intermediate-sized banks face troubles under stress, particularly from commercial real estate lending.

9) I think we are in the second inning for declines in prices for commercial real estate, but perhaps the seventh inning for residential real estate.? So long as residential properties sell for less than their mortgages there is downward pressure on prices, because negative events lead to foreclosures, not sales.

10) How will derivatives be regulated?? That is the question.? Will it be as transparent as TRACE?? I doubt it.? The market is not that liquid.

11) Will the US Government likely get full value back on TARP buyouts? No, because they lack expertise at analyzing these situations.? They don’t know what a warrant is worth.

12) Will low-rate mortgages rescue the economy?? No, but many middle class people with equity will breathe easier after they refinance.? Also, some will buy homes, but who will have the downpayment necessary to qualify now that underwriting has tightened?? Not many.

Sell Stocks, Buy Corporate Bonds (II)

Sell Stocks, Buy Corporate Bonds (II)

After a sharp bear market rally, people are feeling better about stocks.? But corporate bonds have not bought into the stock market rally.? Aside from noises from the US government, whose actions may or may not pan out, there is little reason for optimism in the real economy, as GDP continues to shrink.

At a time like this, I reissue my call to sell stocks and buy corporate bonds, even junk bonds.? When the advantage of corporate bond yields are so large over the earnings yields of common stocks, there is no contest.? When the yield advantage is more than 4%, bonds win.? It is more like 6% now, so enjoy the relatively stable returns from corporate bonds.

Reasons for Optimism, Or Not

Reasons for Optimism, Or Not

Natively, I tend to be an optimist.? The present environment has given thin gruel for optimism, so I haven’t been as perky as I might otherwise be.? Here are a few reasons for optimism:

  • Credit spreads have been declining, and more corporate bond deals are getting done in the credit markets.
  • Commodity prices have fallen and stabilized.
  • The balance sheet of the Federal Reserve is shrinking.
  • Money market and other short duration funds seem to be safe.
  • Equities might be cheap relative to cash, but are still expensive relative to junk and low investment grade bond yields.

On that last point I want to quote Doug Kass, who I respect as an investor:

On multiple fronts, equities appear to have incorporated the bad news and are undervalued both absolutely and relative to fixed income:

  1. The risk premium, the market’s earnings yield less the risk-free rate of return, is substantially above the long-term average reading.
  2. Using reasonably conservative assumptions (most importantly, a near 50% peak-to-trough earnings decline, which is over 3x the drop in an average recession), the market has discounted 2009 S&P 500 earnings of about $47.
  3. Valuations are low vis-?-vis a decelerating (and near zero) rate of inflation. Indeed, the current market multiple is consistent with a 6% rate of inflation.
  4. Stock prices as a percentage of replacement book value stand at 1x, well below the 1.4x long-term average.
  5. The market capitalization of U.S. stocks vs. stated GDP has dropped dramatically, to about 80%, now at the long-term average. Warren Buffett was recently interviewed in Fortune Magazine and observed that this ratio was evidence that stocks have become attractive.
  6. The 10-year rolling annualized return of the S&P is at its lowest level in nearly 75 years, having recently broken below the levels achieved in the late 1930s and mid 1970s.
  7. A record percentage of companies have dividend yields that are greater than the yield on the 10-year U.S. note. At 46% of the companies, that is over 4x higher than in 2002 and compares against only 5% on average over the last 30 years.

On point 1, I will say that equities are cheap to cash and Treasuries, but not Corporate bonds and bank debt.

For point 2, we have gone through a massive levering up; it would be no surprise to see a leveraging down.

Point 3 — I don’t get it.? Inflation has a small effect on valuations.

Point 4 — This is true but it could go lower because there is no one that wants to buy and hold at present.

Point 5 — In this environment, where there is a lack of buy and hold capacity, why are we satisfied with normal valuations?

Point 6 — True for Treasuries, wrong for corporates.

Point 7 — The 10-year Treasury is artificially low.?? It is not a good metric for dividend yields.

Mr. Kass is a bright man, and probably a better investor than me, but there are reasons to be concerned in this economic environment.? Be careful, and don’t make rash moves in this volatile environment.

Buy and Hold Will Return

Buy and Hold Will Return

I’ve been seeing a bunch of “buy and hold is dead” pieces.? Here’s an example.? Look, my view is that investment methods travel in eras.? I remember the 80s-90s, where buy-and-hold was the rage.? I also remember the 70s where tactical asset allocation returned, as well as gold bugs and other tangential market participants.

The popularity of investment styles is a trailing indicator of investment performance.? Buy and hold will once again be popoular after three years of a rising market, and that should arrive in the next 20 years sometime.

It may take too long, but “buy and hold” will return.

Creating a Black Swan

Creating a Black Swan

How do you create a Black Swan? It’s not that hard.? Start with something that you know is seemingly useful, true or good.? Then slavishly rely on that idea until it fails.? I’ll toss out a few here:

  • The more people that live in houses that they own, the better.? The government should encourage home ownership.? You should own the biggest house you can afford.? (In 1986, a Realtor pitched me with that idea, and I thought it was dumb then.)? Residential housing is an investment for the masses; the prices never go down for the nation as a whole.
  • Continually maximizing return on equity will maximize stock prices.? Optimal capital structures and all times.
  • We all want high, smooth returns from our investments — high Sharpe Ratios, everyone!
  • Proper central banking practice can lead to near-permanent prosperity with moderate volatility.
  • Our government can borrow without limit to promote or common prosperity.? Our central bank can cleverly intervene in markets with their assets, and fix things without getting stuck, or creating inflation.

Many ideas that are good marginally aren’t so good if pressed to their logical absurd.? By duping marginal homebuyers into buying what they could not afford, we create a black swan — I remember commentators who were saying as late as 2006 year end, that home prices never went down across the nation as a whole.? It wasn’t true if you looked at the Great Depression or episodes in the 19th century, but people beieved that housing prices could not go down, so they piled into it creating a boom, a glut, and now a bust and a glut.? Behold the Black Swan!? Rapidly falling housing prices across the nation as a whole.

Consider the buyback craze, now deflated.? Was it good to buy back like mad in 2004-2006?? I would tell insurance management teams to leave more of a buffer for adverse deviations.? But it was always easier in the short run for insurance CFOs to buy back more stock, and earnings would rise.? Stock prices would improve as well, and that’s fine during the boom cycle, for then, but many would issue expensive hybrid junior debt with an accelerated stock repurchase.? Short term smart, long term dumb.

The insurance industry is my example here, but it went on elsewhere.? How many acquiring CFOs wish they had used stock rather than cash for the last major acquisition that they did?? Most, I’m sure.

There is always a boom-bust cycle, and there is ordinary trouble during a normal bust phase.? But when the boom phase has parties abandoning all caution, possibly with government acquiesence, the boom gets huge, and the bust too, where the Black Swan appears — things you thought could never happen.

The craze for smooth, high, uncorrelated returns led to a boom in alternative strategies in the investment business.? Return correlations change not only due to cash flows on the underlying investments, but also due to investor demand.? Not so amazingly, as alternative investments go mainstream, the returns fall and become more correlated.? When an alternative is new, typically only the best ideas get done.? When it is near maturity, only the marginal ideas get done.? Alternative asset prices get bid up along with the boom in conventional assets.

Now we get a Black Swan — all risk assets do badly at the same time.? Investors in private equity don’t want to fund their commitments.? Some venture capital backed firms will fail (here and here).? Many hedge funds raise their gates, all at the same time, because investors want out.? Liquidity is scarce.? Companies pay in kind where they can, whether it is on “covenant lite” loans, REIT dividends, etc.? The era of buying back at high prices gives way to equity issuance at low prices.

Now for my final Black Swan, and perhaps the most controversial.? Monetary policy is “optimal” when it follows the Taylor Rule.? A good central banker, applying the rule, should minimize inflation and macroeconomic volatility.

My argument here, which seems intuitively correct to me, but I can’t yet prove, is that continuous application of the Taylor Rule will eventually lead us into a liquidity trap.? That might be more due to the human nature of sloppy central bankers like Greenspan, who want adulation, and err on the side of monetary lenience.? Or, it might be that the central banker overestimates the productive capacity of the economy.? Whatever the reason, we followed something pretty close to the Taylor rule for 15 years, and now we are in a liquidity trap of sorts.? I’ve suggested it before, but perhaps monetary policy should not focus on (at least solely) price inflation or unemployment, but on the level of total debt relative to GDP.

As with so many things in a complex capitalist economy with fiat money, there may not be a right answer.? Optimizing for one set of variables often leads to unforseen pessimizing (a new word!) another set of variables.? What works in the short run often does not work in the long run.

In closing, consider a Black Swan of the future.? Governments globally nationalize financial institutions, run huge deficits and borrow a lot of money to do so.? They “stimulate” the economy through targeted spending, and ignore the future consequences of the debts incurred.? They do it in the face of the coming demographic bust for the developed nations plus China.? My expectation is that these “solutions” will not do much to deal with the economic weakness induced by the debt overhang.

As Walter Wriston famously said, “A country does not go bankrupt.”? Perhaps what he should have said was the country remains in place, only the creditors get stiffed.? Short of war, it is tough to reorganize or liquidate a country.? But I’lltake the sentiment a different way and say that most people believe “A developed country does not go bankrupt.”? That is the black swan that will be displayed here, and Iceland is the harbinger of what might be a future trend of developed country sovereign defaults, or their close cousin, high inflation.

Liquidity Management is the First Priority of Risk Management

Liquidity Management is the First Priority of Risk Management

This leson goes way back with me, to my graduate student days, where I was assisting the teaching of Corporate Financial Management.? At UC-Davis, this was the class that attracted the bright and motivated students.? I happened to get it as my first assistant role at UCD, not realizing it was a plum role.

One of the things we taught was that most firms suffer financial distress from a failure to manage cash flow properly.? That is a salient lesson in the current environment.? I learned it again as a young life actuary, because life insurance companies can die from credit risk, run-on-the-company risk, or both.? Consider Mutual Benefit, which wrote fixed-rate GICs [Guaranteed Investment Contracts] putable on a ratings downgrade, or General American and ARM Financial, which wrote floating-rate GICs putable on a ratings downgrade.? The downgrades hit.? They were toast.

Illiquid assets must be funded by equity or long-term noncallable debt, where the term is as long as the asset’s horizon.? (Near asset price tops, longer, near bottoms, long enough for comfort.)? This is the first step in orthodox risk management: assuring that you can hold onto your assets under all conditions.

But in this current crisis, this rule has been violated many times:

  1. Taking on mortgages where the payments can reset upward.
  2. Hedge fund investors thinking that their funds were liquid.
  3. Venture capital investors presuming that they would easily have the money to fund future commitments.
  4. Banks financing illiquid assets with liquid deposits.
  5. Pension plans and endowments going overboard to buy alternative assets.? (More on pensions: one, two, three)
  6. General Growth, and other REITs choking on maturing short-term debt.
  7. US states, especially California, presume on continuing good times, and overspending what would be sustainable in the intermediate-term.
  8. Investment banks and mortgage REITs that relied on short-term repo funding.? Bye-bye, Bear and Lehman.? Mear miss to Merrill, protected by Bank of America.? Many mortgage REITs dead, or nearly so.
  9. Derivative counterparties like AIG do not factor in the need for more collateral during times of credit stress.
  10. ABCP and SIVs presume that easy lending terms will always be available.

This is the advantage of the actuarial model of risk over the financial model of risk.? I have previously called it table stability versus bicycle stability.? A table always stands, whereas a bicycle has to keep moving to stay upright.? What happens if markets stop trading in any reasonable fashion?? WIll you be broke?? I submit that that is not an acceptable risk to take, because markets do fail for moderate amounts of time.

Better to manage such that you can buy-and-hold for moderate lengths of time, with enough financial slack to tide over rough patches in the market.? Analyze your cash flows over pessimistic scenarios, and ask whether you can carry your positions with sufficient certainty.? Sell down your positions to levels where you are comfortable.

When I was the risk manager for two life insurance companies, one of the first things that I did was analyze the illiquidity of my assets and liabilities, making sure I had liquidity adequate to fund illiquid assets.? The second was analyzing cash flow needs and making sure there was always more cash available than cash needed, under all reasonable scenarios.

This is risk management at its most basic level.? Many on Wall Street looked at short-term asset/liability correlations, and missed whether they could adequately finance their businesses under stressed conditions.

With that, I ask you:

  • Do you have an adequate liquidity buffer against negative events?
  • Are you only risking money that you can afford to lose in entire?
  • Are the companies that you own subject to financing risks?

Asset allocation is paramount in investing.? Bonds and cash get sneered at, but they play an important role in risk reduction for both individuals and institutions.? As my boss at Provident Mutual taught me, “Never risk the franchise.”? That motto guided me, and I avoided crises that other companies suffered.

Will it be the same for you and your assets?? Analyze your survivability in personal finance, and that of your assets, and make adjustments where needed.

Invest in Strength Amid Weakness

Invest in Strength Amid Weakness

Required reading: a word from my favorite deflationists — bond investors that have beaten all others handily, at Hoisington Investment Management.? They agree with my view that most of the actions taken by our government are useless or even counterproductive.? They cite Kindleberger, Schumpeter, MInsky and Kondratieff.? I would add in the Austrians.? High levels of debt and debt complexity lead to large recessions/depressions eventually.

High levels of debt and debt complexity rob an economic system of flexibility.? So long as the debt is increasing, there can be one tremendous boom.? But when the asset cash flows can no longer carry the debt, the system goes into reverse, with falling asset values. During that time, monetary policy is useless, and fiscal policy is useless, until the debt levels are reconciled.

We are in the midst of a great experiment.? Are the Neoclassical heirs of Keynes right?? Can you prevent a depression via loose monetary and fiscal policy?? Since loose monetary policy led to this crisis, why should looser policy solve it?

Also, fiscal policy has been loose for seven years — should extremely loose fiscal policy solve the problems?? And what of those who lend us money?? Should they be happy with dilution of their claims on the US economy?? What if they stop lending, which is in their long-term interests to do, but not in their short-term interests?

As for the Federal Reserve, with all of their cleverness regarding credit easing versus quantitative easing, the problem sill remains.? The central bank attempting to fix a lending market becomes a new offeror of credit, at rates the private market won’t touch.? As the central bank brings the rates down, grateful borrowers borrow, but private lenders would hang back, unless they became convinced that there was nothing to fear in the absence of central bank lending.? That’s pretty tough to achieve.

I don’t like quantitative or credit easing.? If we are going to be Keynesians here, let’s let the money supply expand, creating real inflation, and raise the nominal prices of homes that are currently underwater.? Rather than trying to be too clever, and trying to solve all problems without inflation, let’s have inflation.? I don’t think the problems can be solved without a rise in the price level, which will also make foreign countries adjust their policies to match US actions.

I don’t find the Federal Reserve exit strategies credible.? As we have learned before, introducing subsidies is easy, removing them is hard, and it doesn’t matter if the subsidies are monetary or fiscal.

My view is that we will go through continued deflation until the pain is too hard, and then we will experience inflation in a big way.? Thus I continue to advocate TIPS, and short corporate debt.? Away from that, I encourage caution — focus on companies that can survive the worst.

Financial History is Valuable

Financial History is Valuable

I’ve said it before, but I came into the investment business through the back door as a risk manager.? Unlike most quantitative analysts, I came with a greater depth of knowledge of economic history, and a distrust of the assumptions behind most quantitative finance models, because things can be much more volatile than most current market participants can imagine. As a result, I often ran my models at higher stress test levels than required by regulation or standards of practice.

Can countries fail?? Sure.? It has happened before.? Can leading countries fail?? Yes, and consider France, Germany and Japan.? Consider earlier history — the failure of a major power has significant effects on the rest of the world.

Understanding economic history can keep one from saying, “That can’t happen.”? Indeed when governments are pressed, they do their best to extract additional revenue out of those that will complain the least.? Qualitative analyses, if done properly, incorporate a wider amount of variation than the quantitative statistics will reveal in hindsight.? Do you incorporate the idea that all novel securities (new industries) go through a big boom bust cycle?? If so, you would have avoided most of the complex debt securities born in the last ten years, and would have been light on risky debt that was the building blocks for those securities.

Though the job should fall to regulators to bar institutions of trust from investing in novel instruments, and they used to do that, the legal codes and regulators, forgetting history, removed those restrictions, and left many financial institutions to their own wisdom in managing their risks.? Some of those institutions were careful and speculated modestly if at all.? Others went whole hog.

The speculators (not called that at the time) pointed to loss statistics that had been generated during the boom phase of the cycle.? They showed how the junk-rated certificates would even be money good under “stressed” conditions.? All of the way through the boom, they pointed to their backward looking statistics, as leverage levels grew, and underwriting quality fell in hidden ways.

We know how it has ended.? In some cases, even AAA securities will not be money good (i.e., principal and interest will not be repaid in full).? Alas for the poor non-US buyers who sucked down much of the junk securities.

This forgetfulness regarding booms and busts affects societies on a regular basis. It happens everywhere, but the freewheeling nature of the US makes it a model country for this exercise (boom period in parentheses):

  • Residential Housing (2002-6)
  • Commodities (2001-8)
  • Financial Innovation — hedge funds, securitization, credit default swaps (1995?-2007)
  • Cetes (1992-1994)
  • Commercial Real estate (20s, 80s, 2000s)
  • Guaranteed Investment Contracts (1982-1991)
  • Negative convexity trade in residential mortgages (think of Orange County, Askin, Bruntjen) 1990-1993
  • Stocks (20s, mid-to-late 60s “Go-go era,” 1982-1987, 1994-2000, 2003-2007)
  • Energy (1973-82)
  • Developing country lending (late 70s)

This list isn’t exhaustive, but it’s what is easy for me to rattle off now.? Cycles are endemic to human behavior.? Governments and central banks may try to eliminate the negative part of a cycle of cycles, but it is at a price to taxpayers, savers, and increased moral hazard.? Why limit risk when the government has your back?

All that said, relying on historical patterns to recur, or simple generalizations that say that “the current crisis will follow the same track as the Great Depression,” are too facile and subject to abuse.? The fine article by Paul Kedrosky that prompted this piece makes that point. Too often the statistics cited are from small data sets, or unstable distributions generated by processes that are influenced by positive and/or negative feedback effects.

Studying economic history gives us an edge by giving us wisdom to avoid manias, and avoid jumping in too soon during the bust phase.? I’m still not tempted by housing or banks stocks yet.

That’s why I write book reviews on older books dealing with economic history (among others).? As Samuel Clemens said, “History doesn’t repeat itself, but it does rhyme.”? It doesn’t give a simple roadmap to the future, but it does aid in developing scenarios.? As Solomon said in Ecclesiastes 1:9, “That which has been is what will be, That which is done is what will be done, And there is nothing new under the sun.”

I’ll close the article here, but I have an application of this for politicians and regulators that I want to develop in part two.

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