After almost three years, I returned to RT Boom/Bust on Tuesday.  There are many changes at RT.  Many new people, and a growing effort to put together an alternative channel that covers the world rather than just the US or just the developed world.  They are bursting at the seams, and their funding has doubled, so I was told.

I get surprised by who watches RT and sees me.  My  congregation is pretty conservative in every way, but I have some friends working in intelligence come up to me and say, “Hey, saw you on RT Boom/Bust.”  And then there is my friend from Central Africa who says, “The CIA has you on their list.  Watch out!”  He’s funny, hard-working, but very earnest.

I’ve never seen anything in what I have done where there is any hint of editorial control.  Maybe it is there, but I think I would be smart enough to see it.

Anyway, the topic at hand was alternative monetary systems, and the thing that kicked it off was the Vollgelt in Switzerland, where they are trying to create a monetary system where the banks can’t lend against deposits.  Here were my notes for the show, with a little more to fill in:

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  1. Mr. Merkel, what exactly is a sovereign money system?

The banks can’t lend against deposits.  Deposits are segregated, and wait for the depositor to use them.  The deposits no longer can be used by the bank but only the depositor.  There would be no need for deposit insurance, because deposits are off of the bank’s balance sheet.

  1. What is the difference between a sovereign system and the way banks handle your money now?

You would have to pay for your transactional account, because the bank can’t make money off of lending against the deposits. Banks would no longer do “maturity transformation” by lending long against short-term deposits.  Long-term lending would have to be other entities in the economy, such as insurance companies, pension funds, endowments, private individuals, foreign lenders, mortgage REITs, and banks funded by matching sources like CDs, bonds, and equity.

  1. Switzerland is poised to vote on a sovereign money system, or Vollgeld in German. How likely is this vote to pass?

Not likely for three reasons.  First, the Swiss turned down a proposal to back the Swiss Franc with 20% gold.  Not one canton voted for it.  Only 22% of the electorate voted for it.  Second, things aren’t that bad now, and the financial system isn’t that levered.  “If it ain’t broke, don’t fix it.”  Third, this is a total experiment with no real world precedents.  Many criticize economists for imagining what the world should be like and then proposing policy off their unrealistic idealized models.  This is another example of that.  We don’t know what the unintended consequences might be.

Some unintended consequences might be:

  • Transition would be difficult
  • Recession during the transition, because middle and small market lending would likely suffer
  • Pay for transactional accounts – no interest even if inflation is high.
  • Increase in savings accounts, which might be short-dated enough to be transactional
  • Gives a lot of power to the SNB, which might be halfhearted about implementation (Regulators dislike change, and risk).
  • Could be subverted if Government becomes dependent on free money, leading to inflation
  • Moves monetary policy from rate targeting to permanent quantitative monetary adjustment. Unclear how the SNB would tighten policy; maybe issue central bank bonds to reduce money supply?
  1. Could something like this rein in credit bubbles? Are we facing another credit bubble?

Yes, it could.  Most credit bubbles result from short-term lending funding long-term assets.  This would rein it in, in the short-run, but who could tell whether it might come back in another unintended way?  If some new class of lender became dominant, the threat could reappear.

We aren’t facing a credit bubble now, because the last crisis wiped away a lot of private debt, and replaced it with public debt.  Perhaps some weak nations with debts not in their own currency could be at risk, but right now, there aren’t any categories of private debt big enough and misfinanced enough to create a crisis.  That said, watch margin loans, student loans, and auto loans in the US.

  1. Are there any modern day equivalents we can compare Vollgeld to?

None that are currently being used.  There are a lot of theoretical ideas still being tossed around, like 100% reserving, lowering bank leverage, strict asset-liability matching, disallowing banks from lending to financial companies, etc.  These ideas get a lot of press after crises, but fade away afterward.  Most of them would work, but all of them lower bank profits.  Concentrated interests tend to win against general interests, except in crises.

  1. You mentioned there is a similar concept for derivatives that no one is talking about. How exactly would that work?

Derivatives are functionally equivalent to insurance contracts, but they are not regulated.  I believe they should be regulated like insurance contracts, and require that those seeking insurance have an “insurable interest” that they are trying to hedge.  Only direct hedgers could initiate derivative transactions, and financial guaranty insurers would compete to fill the need.

This would prevent the unintended consequences of having multiples of protection written on a given risk, where a weak party like AIG is incapable of making good on all of the derivative contracts that they have written, which could lead to its own systemic risk if other derivative counterparties can’t absorb the losses.

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I know that is over-simplified, but I read through the papers of both sides in the debate, and I thought both overstated their cases significantly.

I know fiat money has its problems, and so does fractional reserve banking, but if you are going to propose a solution, perhaps one that fits the basics of how a well-run bank at low leverage would work would be a good place to start.

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Fewer laws protect you now. In some ways, the laws are more virtual than real, and only apply to real situations, and not virtual ones.

Let me explain.

Though checks make up an increasingly smaller fraction of transaction volume in the US, they are still a lot higher here than in Europe.  As such, federal and many state legislators have not caught up with the effects of a hybrid system, where they attempt to regulate electronic banking transactions under the same rules as paper checks.

Many people like making mobile deposits, rather than going into the bank, or snail-mailing the deposits in.  But what happens if a check gets mobile-deposited to two banks?  Or, since many banks don’t actively check mobile deposits closely, what if someone repeatedly deposits a check to his bank, while altering the check number?

The latter scenario happened to me, and I am out a considerable amount of money because I was not following my accounts closely.

  • My soon-to-be former bank would not reimburse the losses, citing the account agreement, even though they facilitated the thefts by not checking the drafts against my account.
  • The same was true of the bank of the fraudster, which accepted the same altered check again and again.
  • The state of Maryland would not prosecute fraud charges against the person, because the crime was not committed inside a bank branch, and they could not conclusively prove that the perpetrator did the crime, even though all of the money went to his account.  And,that is even though the perpetrator admitted it to me, and I have it in writing.
  • Thus, I have an informal agreement with the perp to pay me back or face a tort claim.  His situation is not strong, and you can’t squeeze blood from a stone.  I could force him into bankruptcy, but what good would that for me?  I’m not vengeful.

So what is the best defense?  Check your transactional accounts weekly if not daily.  On that level, the banks will take the losses, if you identify them fast enough.

I began doing that recently, and found someone using one of my credit cards to pay his phone bill.  I have since reversed most of those charges.  GIven that many vendors try to induce you into payment plans that auto-renew, it is wise for that reason to do so, that you would cancel services that you no longer use.

So what can I say?  I could have not written this up, but I am not perfect in my personal money management… better that others learn from my mistakes.  Until the state and Federal governments get their acts together, you are your own best defender.  Check your transactional accounts frequently.  The money you save will be your own.

Photo Credit: Fabio Tinelli Roncalli || Alas, there were so many signs that the avalanche was coming…

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Ten years ago, things were mostly quiet.  The crisis was staring us in the face, with a little more than a year before the effects of growing leverage and sloppy credit underwriting would hit in full.  But when there is a boom, almost no one wants to spoil the party.  Yes a few bears and financial writers may do so, but they get ignored by the broader media, the politicians, the regulators, the bulls, etc.

It’s not as if there weren’t some hints before this.  There were losses from subprime mortgages at HSBC.  New Century was bankrupt.  Two hedge funds at Bear Stearns, filled with some of the worst exposures to CDOs and subprime lending were wiped out.

And, for those watching the subprime lending markets the losses had been rising since late 2006.  I was following it for a firm that was considering doing the “big short” but could not figure out an effective way to do it in a way consistent with the culture and personnel of the firm.  We had discussions with a number of investment banks, and it seemed obvious that those on the short side of the trade would eventually win.  I even wrote an article on it at RealMoney in November 2006, but it is lost in the bowels of theStreet.com’s file system.

Some of the building blocks of the crisis were evident then:

  • European banks in search of any AAA-rated structured product bonds that had spreads over LIBOR.  They were even engaged in a variety of leverage schemes including leveraged AAA CMBS, and CPDOs.  When you don’t have to put up any capital against AAA assets, it is astounding the lengths that market players will go through to create and swallow such assets.  The European bank yield hogs were a main facilitator of the crisis that was to come, followed by the investment banks, and bullish mortgage hedge funds.  As Gary Gorton would later point out, real disasters happen when safe assets fail.
  • Speculation was rampant almost everywhere. (not just subprime)
  • Regulators were unwilling to clamp down on bad underwriting, and they had the power to do so, but were unwilling, as banks could choose their regulators, and the Fed didn’t care, and may have actively inhibited scrutiny.
  • Not only were subprime loans low in credit quality, but they had a second embedded risk in them, as they had a reset date where the interest rate would rise dramatically, that made the loans far shorter than the houses that they financed, meaning that the loans would disproportionately default near their reset dates.
  • The illiquidity of the securitized Subprime Residential Mortgage ABS highlighted the slowness of pricing signals, as matrix pricing was slow to pick up the decay in value, given the sparseness of trades.
  • By August 2007, it was obvious that residential real estate prices were falling across the US.  (I flagged the peak at RealMoney in October 2005, but this also is lost…)
  • Amid all of this, the “big short” was not a sure thing as those that entered into it had to feed the trade before it succeeded.  For many, if the crisis had delayed one more year, many taking on the “big short” would have lost.
  • A variety of levered market-neutral equity hedge funds were running into trouble in August 2007 as they all pursued similar Value plus Momentum strategies, and as some fund liquidated, a self reinforcing panic ensued.
  • Fannie and Freddie were too levered, and could not survive a continued fall in housing prices.  Same for AIG, and most investment banks.
  • Jumbo lending, Alt-A lending and traditional mortgage lending had the same problems as subprime, just in a smaller way — but there was so much more of them.
  • Oh, and don’t forget hidden leverage at the banks through ABCP conduits that were off balance sheet.
  • Dare we mention the Fed inverting the yield curve?

So by the time that BNP Paribas announced that three of their funds that bought Subprime Residential Mortgage ABS had pricing issues, and briefly closed off redemptions, and Countrywide announced that it had to “shore up its funding,” there were many things in play that would eventually lead to the crisis that happened.

Some of us saw it in part, and hoped that things would be better.  Fewer of us saw a lot of it, and took modest actions for protection.  I was in that bucket; I never thought it would be as large as it turned out.  Almost no one saw the whole thing coming, and those that did could not dream of the response of the central banks that would take much of the losses out of the pockets of savers, leaving bad lending institutions intact.

All in all, the crisis had a lot of red lights flashing in advance of its occurrence.  Though many things have been repaired, there are a lot of people whose lives were practically ruined by their own greed, and the greed of others.  It’s a sad story, but one that will hopefully make us more careful in the future when private leverage rises, creating an asset bubble.

But if I know mankind, the lesson will not be learned.

PS — this is what I wrote one decade ago.  You can see what I knew at the time — a lot of the above, but could not see how bad it would be.

Photo Credit: Brent Moore || Watch the piggies run after scarce yield!

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If you do remember the first time I wrote about yield being poison, you are unusual, because it was the first real post at Aleph Blog.  A very small post — kinda cute, I think when I look at it from almost ten years ago… and prescient for its time, because a lot of risky bonds were about to lose value (in 19 months), aside from the highest quality bonds.

I decided to write this article this night because I decided to run my bond momentum model — low and behold, it yelled at me that everyone is grabbing for yield through credit risk, predominantly corporate and emerging markets, with a special love for bank debt closed end funds.

I get the idea — short rates are going to rise because the Fed is tightening and inflation is rising globally, and there is no credit risk anymore because economic growth is accelerating globally — it’s not just a US/Trump thing.  I just have a harder time playing the game because we are in the wrong phase of the credit cycle — profit growth is nonexistent, and debts are growing.

I have a few other concerns as well.  Even if encouraging exports and discouraging imports aids the US economy for a while (though I doubt it — more jobs rely on exports than are lost by imports, what if there is retaliation?) there is a corresponding opposite impact on the capital account — less reinvestment in the US.  We could see higher yields…

That said, I would be more bearish on the US Dollar if it had some real competition.  All of the major currencies have issues.  Gold, anyone?  Low short rates and rising inflation are the ideal for gold.  Watch the real cost of carry go more negative, and you get paid (sort of) for holding gold.

If growth and inflation persist globally (consider some of the work @soberlook has  been doing at The WSJ Daily Shot — a new favorite of mine, even his posts are too big) then almost no bonds except the shortest bonds will be any good in the intermediate-term — back to the ’70s phrase “certificates of confiscation.”  One other effect that could go this way — if the portion of Dodd-Frank affecting bank leverage is repealed, the banks will have a much greater ability to lend overnight, which would be inflationary.  Of course, they could just pay special dividends, but most corporations lean toward growing the business, unless they are disciplined capital allocators.

But it is not assured that the current growth and inflation will persist.  M2 Monetary velocity is still low, and the long end of the yield curve does not have yield enough priced in for additional growth and inflation.  Either long bonds are a raving sell, or the long end is telling us we are facing a colossal fake-out in the midst of too much leverage globally.

Summary

I’m going to stay high quality and short for now, but I will be watching for the current trends to break.  I may leg into some long Treasuries, and maybe some foreign bonds.  Gold looks interesting, but I don’t think I am going there.  I’m not making any big moves in the short run — safe and short feels pretty good for the bond portfolios that I manage.  I think it’s a time to preserve principal — there is more credit risk than the market is pricing in.  It might take a year or two to get there, or it might be next month… I would simply say stay flexible and look for a time where you have better opportunities.  There is no fat pitch at present for long only investors like me.

Postscript

To those playing with fire buying dividend paying common stocks, preferred stocks, MLPs, etc. for yield — if we hit a period where credit risk becomes obvious — all of your “yield plays” will behave like stocks in a poisoned sector.  There could be significant dividend cuts.  Dividends are not guaranteed like bonds — bonds must pay or it is bankruptcy.  Managements avoid defaulting on their bonds and loans, but will not hesitate to cut or not pay dividends in a crisis — it is self-preservation, at least in the short-run.  Even if they get replaced by angry shareholders, the management typically gets some sort of parachute if the company survives, and far less in bankruptcy.

One final note on this point — stocks that have a lot of yield buyers behave more like bonds.  If bond yields rise above current stock earnings yields, the stock prices will fall to reprice the yield of the stock, even if there is no bankruptcy risk.

And, if you say you can hold on and enjoy the rising dividends of your high quality companies?  Accidents happen, the same way they did to some people who bought houses in the middle of the last decade.  Many could not ride out the crisis because of some life event.  Make sure you have a margin of safety.  In a really large crisis, the return on risk assets may look decent from ten years before to ten years after, but a lot of people get surprised by their need to draw on those assets at the wrong moment — bad events come in bunches, when the credit cycle goes bust. Be careful, and don’t reach for yield.

Photo Credit: elycefeliz

Photo Credit: elycefeliz || Duck, it’s a financial crisis! 😉

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Should a credit analyst care about financial leverage?  Of course, the amount and types of financial claims against a firm are material to the ability of a firm to avoid defaulting on its debts.  What about operating leverage?  Should the credit analyst care?  Of course, if a firm has high fixed costs and low variable costs (high operating leverage), its financial position is less stable than that of a company that has low fixed costs and high variable costs.  Changes in demand don’t affect a firm as much if they have low operating leverage.

That might be fine for industrials and utilities, but what about financials?  Aren’t financials different?  Yes, financials are different as far as operating leverage goes because for financial companies, operating leverage is the degree of credit risk that financials take on in their assets. Different types of lending have different propensities for loss, both in terms of likelihood and severity, which are usually correlated.

A simple example would be two groups of corporate bonds —  one can argue over new classes of bond ratings, but on average, lower rated corporate bonds default more frequently than higher rated bonds, and when they default, the losses are typically greater on the lower rated bonds.

As such the amount of operating risk, that is, unlevered credit risk, is material to the riskiness of financial companies.

Credit analysis gets done on financial companies by many parties: the rating agencies, private credit analysts, and implicitly by financial regulators.  They all do the same sorts of analyses using similar underlying theory, though the details vary.

Regulators typically codify their analyses through what they call risk-based capital.  Given all of the risks a financial institution takes — credit, asset-liability mismatch, and other liability risks, how much capital does a financial institution need in order to stay solvent?  Along with this usually also comes cash flow testing to make sure that the financial companies can withstand runs on their capital structure.

When done in a rigorous way, this lowers the probability and severity of financial failures, including the remote possibility that taxpayers could be tagged in a crisis to cover losses.  In the life insurance industry, actuaries have worked together with regulators to put together a fair system that is hard to game, and as such, few life and P&C insurance companies went under during the financial crisis.  (Note: AIG went under due to its derivative subsidiary and that they messed with securities lending agreements.  The only failures in life and P&C insurance were small.)

Banks have risk-based capital standards, but they are less well-designed than those of the US insurance industry, and for the big banks they are more flexible than those for insurers.  If I were regulating banks, I would get a small army of actuaries to study bank solvency, and craft regulations together with a single banking regulator that covers all depositary financials (or, state regulators like in insurance which would be better) using methods similar to those for the insurance industry.  Then every five years or so, adjust the regulations because as they get used, problems appear.  After a while, the methods would work well.  Oh, I left one thing out — all banks would have a valuation actuary reporting to the board and the regulators who would do the cash flow testing and the risk-based capital calculations.  Their positions would be funded with a very small portion of money that currently goes to the FDIC.

This would be a very good system for avoiding excessive financial risk.  Dreaming aside, I write this this evening because there are other dreamers proposing a radically simple system for regulating banks which would allow them to write business with no constraint at all with respect to credit risk.  All banks would face a simple 10% leverage ratio regardless of how risky their loan books are.  This would in the short run constrain the big banks because they would need to raise capital levels, though after that happened, they would probably write riskier loans to get their return on equity back to where it was.

My main point here is that you don’t want to incent banks to write a lot of risky loans.  It would be better for banks to put aside the right amount of capital versus varying classes of risk, and size the amount of capital such that it is not prohibitive to the banking system.

As such, a simple leverage ratio will not cut it.  Thinking people and their politicians should reject the current proposal being put out by the Republicans and instead embrace a more successful regulatory system manned by intelligent and reasonably risk-averse actuaries.

Photo Credit: Daniel Mennerich || A bridge described in fiction to bridge me to the counterfactual argument of this post

Photo Credit: Daniel Mennerich || A bridge described in fiction to bridge me to the counterfactual argument of this post

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I received an email from a longtime reader:

 

David, here is a (possibly useless) thought experiment.

In 2005, PIMCO’s Paul McCulley was begging Ben Bernanke to halt the on- going quarter-point raises in the Fed Funds rate at 3.5 percent. I forget his exact reasoning, but he clearly thought that the financial markets couldnot accommodate short-term rates above 3.5 percent without substantial disruptions.

Suppose that Bernanke had listened to McCulley and capped the Fed Funds rate at 3.5 percent until it was clear how the markets would fare at that level. Would that alone have been sufficient to postpone or even avert the housing crisis? Or would it have made the crash even worse?

According to FRED, the Funds rate reached 3.5 percent in August 2005, and as we know housing prices nationally peaked about one year later, just as the Funds rate was topping out at 5.25 percent. Question is, did the additional 1.75 percent of increases serve to tip the housing market into decline, or was the collapse inevitable with or without the last seven quarter-point raises?

Any thoughts?

Here was my response:

I proposed the same thing at RealMoney, except I think I said 4%.  My idea was to stop at a yield curve with a modestly positive slope.  It might have postponed the crisis, and maaaaybe allowed banks and GSEs to slowly eat up all of the bad loan underwriting.

I had Googlebots tracking housing activity daily, and August 2015 was when sales activity peaked.  I announced it tentatively at RealMoney, and confirmed it two months later.  From data I was tracking, housing prices flatlined and started heading down in 2006.  The damage was probably done by 2005 — maybe the right level for Fed funds would have been 3%.

The trouble is, hedge funds and other entities were taking risk every which way, and a mindset had overwhelmed the markets such that we had the correlation crisis in May 2005, and other bits of bizarre behavior.  Things would have blown up eventually.  Speculative frenzy rarely cools down without the bear phase of the credit cycle showing up.

So, much as it would have been worth a try, it probably wouldn’t have worked.  The housing stock was already overvalued and overleveraged.  But it might have taken longer to pop, and it might not have been as severe.

But now for the fun question.  Is the Fed trying to do something like that now?  Are they so afraid of popping any sort of asset bubble that they have to be extra ginger in raising rates?  It seems any market “burp” takes rate rises off the table for a few months.

I don’t know.  I do know that the FOMC has only 1% of tightening to play with before the yield curve gets flat.  Also, obvious speculation is limited right now.  There is a lot that is overvalued, but there is no frenzy… unless you want to call nonfinancial corporation and government borrowing a frenzy.

Thanks for writing.

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The FOMC is Afraid of its own Shadow

If I were the Fed, I would end the useless jabbering that they do.  I would also end the quarterly forecasts and press conference. I would also end publishing the statement and the minutes, and let people read the transcripts five years later. We would go back to the pre-Greenspan years, when monetary policy was managed better.   Before I did that I would say:

The Fed has three responsibilities: controlling inflation, promoting full employment, and regulating the solvency of the banking system.  We are not responsible for the health and well-being of financial markets.  The ‘Greenspan Put’ is ended.

We will act to limit speculation within the banks, such that market volatility will have minimal impact on them.  We want our pursuit of limited inflation and full employment to not be hindered by looking over our shoulder at the boogeyman that could affect the banking system.  To that end, please realize that we will not care if significant entities lose money, including countries that may get whipped around by our pursuit of monetary policy in a way that benefits the American people.

We are not here as guarantors of prosperity for speculators.  Really, we’re not here to guarantee anything except pursue a stable-ish price level, and to the weak extent that monetary policy can do so, aid full employment.

We hope you understand this.  We do not intend to use our “lender of last resort” authority again, and will manage bank solvency in a way to avoid this.  We may get called ‘spoilsports’ by the banks that we regulate, but in the end we are best served as a nation if solvency concerns dominate over the profitability of the banking industry.

As it is, the present FOMC fears acting because it might derail the recovery or spark a bear market in risky assets.  Going beyond the mandate of the Fed has led to bad results in the past.  It will continue to do so in the future.

The best way for the Fed to maintain its independence is to act independently and responsibly.  Don’t listen to outside influences, particularly when hard things need to be done.  Be the adult in the room, and tell the children that the medicine that you give them is for their good.  Recessions are good, because they clear away bad uses of capital from the ecosystem, and make room for new more productive ideas to use the capital instead.

As it is, the Fed is afraid of its own shadow, and will not take any hard actions.  That will either end with inflation, or an asset bubble that eventually affects the banks.  A central bank like that does not follow its mandate does not deserve its independence.  So Fed, if you won’t act for our long-term good, will you act to preserve your existence in your present form?

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Before I write this evening, I would like to point out what is going on with Horsehead Holdings [ZINCQ].  There was an article in the New York Times on it recently.  It’s an interesting situation where an equity committee exists in a bankruptcy, largely because the management team looks like it is not trying to maximize the value of the bankruptcy estate, but is perhaps instead trying to sell the company off to creditors cheaply in an effort to receive a benefit later from the new owners.  Worth a look, because if the equity committee wins, it will be unusual, and if the debtors win, it very well may take value that legitimately belonged to the equity.

That said, I don’t have a strong opinion because I don’t have enough data.  But I will be watching.

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I received a letter from a reader yesterday on a related topic from my most recent article.  Here it is:

Hi David,

First of all, it’s nice to find you (and Ed Yardeni and Mohamed El-Erian) working when most analysts seem to be at the beach. That said, a question:

In early ’09, as you will recall, the big banks were begging for relief from mark-to-market accounting for their holdings of mortgage-backed securities, on the grounds that these securities weren’t trading at all.

“Ridiculous!” said Jeremy Grantham. “Put 2 percent of your holding out to auction and you will learn its market value quick enough.”

At the time, I thought Grantham had a fair point. Now I’m not so sure.

What was your view on that issue? John Hussman has said repeatedly that it was the FASB’s relaxation of the mark-to-market rules that set off the dramatic resurgence in stock prices that we have seen (and which he deplores).

Was the FASB’s change of policy warranted, under the circumstances?

And should the mark-to-market rule now be restored?

Here was my reply:

Hi,

I wrote a lot about this at the time.  I remain in favor of mark-to-market accounting.  The companies that got into trouble from the effects of mark-to-market accounting had engaged in sloppy risk management practices, and got caught with their pants down.

The difficulty that most of the complaining companies had was a mix of liquid liabilities requiring prompt payment, and relatively illiquid assets that would be difficult to sell.  It was the classic asset-liability mismatch — long illiquid assets financed by short liquid liabilities.  Looks like genius during the bull phase.  Toxic during the bear phase.

On Grantham’s comments: my comments Saturday night are pertinent here for two reasons — anyone selling illiquid CDO tranches, subordinated mortgage bonds, etc., immediately prior to the crisis would find two things: 1) the bids were non-existent or really poor, and 2) if the trade did take place, it would be at levels that reset the pricing grid for that area of the market a LOT lower, leaving the remaining securities looking worse, and a diminution of GAAP equity.

(As an aside, the diminution of GAAP equity might affect the ability to do secondary IPOs of stock at attractive prices, but in itself it did not affect solvency of most financial firms, because statutory accounting allowed for investments to held at amortized cost.  As such the firms could be economically insolvent, but not regulatorily insolvent unless they ran out of cash, or their short-term lending lines of credit got pulled.)

Anyway, this piece is a summary of my thoughts, and provides links to other things I wrote during that era: Fair Value Accounting — It Is What It Is

The regulators were pretty lenient with most of the companies involved — the creditors weren’t.  They enforced margin agreements, and pulled discretionary credit lines.

I’m not of Hussman’s opinion that relaxation of the mark-to-market rules had ANY effect on stock prices.  In general, GAAP accounting rules don’t affect stock prices, because they don’t affect free cash flow, unless the GAAP rules are embedded in credit covenants.  Statutory accounting does affect free cash flow, and can affect the prices of stocks.

Those are my opinions, for what they are worth.

Sincerely,

David

June 2016July 2016Comments
Information received since the Federal Open Market Committee met in April indicates that the pace of improvement in the labor market has slowed while growth in economic activity appears to have picked up.Information received since the Federal Open Market Committee met in June indicates that the labor market strengthened and that economic activity has been expanding at a moderate rate.FOMC shades GDP down and employment up, which is the opposite of last time.
Although the unemployment rate has declined, job gains have diminished.Job gains were strong in June following weak growth in May. On balance, payrolls and other labor market indicators point to some increase in labor utilization in recent months. Sentence moved up in the statement.  Expresses less confidence in the labor market.
Growth in household spending has strengthened. Since the beginning of the year, the housing sector has continued to improve and the drag from net exports appears to have lessened, but business fixed investment has been soft.Household spending has been growing strongly but business fixed investment has been soft.Drops comments on the housing sector and net exports.
Inflation has continued to run below the Committee’s 2 percent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports.Inflation has continued to run below the Committee’s 2 percent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports.No change.
Market-based measures of inflation compensation declined; most survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.Market-based measures of inflation compensation remain low; most survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.No change.  TIPS are showing higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 1.65%, up 0.18% from March.  Undid the significant move from earlier in 2016.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will strengthen.The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will strengthen.No change.
Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.No change. CPI is at +1.1% now, yoy.
The Committee continues to closely monitor inflation indicators and global economic and financial developments.Near-term risks to the economic outlook have diminished. The Committee continues to closely monitor inflation indicators and global economic and financial developments.No change.
Against this backdrop, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent.Against this backdrop, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent.No change.
The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.No change.  They don’t get that policy direction, not position, is what makes policy accommodative or restrictive.  Think of monetary policy as a drug for which a tolerance gets built up.
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.No change.
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.  Gives the FOMC flexibility in decision-making, because they really don’t know what matters, and whether they can truly do anything with monetary policy.
In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.No change.  Says that they will go slowly, and react to new data.  Big surprises, those.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Says it will keep reinvesting maturing proceeds of agency debt and MBS, which blunts any tightening.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Esther L. George; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.Back to a small dissent.
 Voting against the action was Esther L. George, who preferred at this meeting to raise the target range for the federal funds rate to 1/2 to 3/4 percent.Our favorite dissenter returns.

 

Comments

  • This statement was a nothing-burger.
  • Policy continues to stall, as the economy muddles along.
  • But policy should be tighter. Savers deserve returns, and that would be good for the economy.
  • The changes for the FOMC’s view are that labor indicators are stronger, and GDP and household spending are weaker.
  • Equities and bonds rise a little. Commodity prices rise and the dollar falls.  Everything is a little looser.
  • The FOMC says that any future change to policy is contingent on almost everything.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up much, absent much higher inflation, or a US Dollar crisis.

Caption from the WSJ: Regulators don’t think it is the place of Congress to second guess how they size up securities. Fed Chairwoman Janet Yellen said recently that legislation would “interfere with our supervisory judgments.” PHOTO: BAO DANDAN/ZUMA PRESS

PHOTO CREDIT: BAO DANDAN/ZUMA PRESS

March 2016April 2016Comments
Information received since the Federal Open Market Committee met in January suggests that economic activity has been expanding at a moderate pace despite the global economic and financial developments of recent months. Information received since the Federal Open Market Committee met in March indicates that labor market conditions have improved further even as growth in economic activity appears to have slowed. FOMC shades GDP down and employment up.
Household spending has been increasing at a moderate rate, and the housing sector has improved further; however, business fixed investment and net exports have been soft.Growth in household spending has moderated, although households’ real income has risen at a solid rate and consumer sentiment remains high. Since the beginning of the year, the housing sector has improved further but business fixed investment and net exports have been soft.Shades down household spending.
A range of recent indicators, including strong job gains, points to additional strengthening of the labor market.A range of recent indicators, including strong job gains, points to additional strengthening of the labor market.No change.
Inflation picked up in recent months; however, it continued to run below the Committee’s 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports.Inflation has continued to run below the Committee’s 2 percent longer-run objective, partly reflecting earlier declines in energy prices and falling prices of non-energy imports.Shades energy prices up, and prices of non-energy imports down.
Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.No change.  TIPS are showing higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 1.73%, up 0.08% from March.  Significant move since February 2016.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will continue to strengthen.The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will continue to strengthen.No change.
However, global economic and financial developments continue to pose risks.They moved this down two sentences, sort of, as global markets are calmer.
Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.No change. CPI is at +0.9% now, yoy.

Shades inflation down in the short run due to energy prices.

The Committee continues to monitor inflation developments closely.The Committee continues to closely monitor inflation indicators and global economic and financial developments.Adds in monitoring of global economics and finance.
Against this backdrop, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent.Against this backdrop, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent.No change.
The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.No change.  They don’t get that policy direction, not position, is what makes policy accommodative or restrictive.
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.No change.
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.  Gives the FOMC flexibility in decision-making, because they really don’t know what matters, and whether they can truly do anything with monetary policy.
In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.No change.  Says that they will go slowly, and react to new data.  Big surprises, those.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Says it will keep reinvesting maturing proceeds of agency debt and MBS, which blunts any tightening.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.No change. Not quite unanimous.
Voting against the action was Esther L. George, who preferred at this meeting to raise the target range for the federal funds rate to 1/2 to 3/4 percent.Voting against the action was Esther L. George, who preferred at this meeting to raise the target range for the federal funds rate to 1/2 to 3/4 percent.One lonely voice that can think past the current consensus of neoclassical economists.

Comments

  • Policy continues to stall, as the economy muddles along.
  • But policy should be tighter. Savers deserve returns, and that would be good for the economy.
  • The changes for the FOMC’s view are that labor indicators are stronger, and GDP and household spending are weaker.
  • Equities rise and bonds rise. Commodity prices flat and the dollar falls.
  • The FOMC says that any future change to policy is contingent on almost everything.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up much, absent much higher inflation, or a US Dollar crisis.

Photo Credit: thecrazysquirrel

Photo Credit: thecrazysquirrel

Before I start tonight, I just wanted to mention that I was on South Korean radio a few days ago, on the main English-speaking station, talking about Helicopter Money.  If you want listen to it or download it as a podcast, you can get it here.  It’s a little less than 11 minutes long.

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The bravery of Steve Kandarian and the executives at MetLife is a testimony to something I have grown to believe.  Frequently the government acts without a significant legal basis, and bullies companies into compliance.  If a company is willing to spend the resources, often the government will lose, when the laws are unduly vague or even wrongheaded.

This was true also in a number of the allegations made by Eliot Spitzer.  Lots of parties gave in because the press was negative, but those that fought him generally won.  Another tough-minded man, Maurice Raymond “Hank” Greenberg pushed back and won.  So did some others that were unfairly charged.

MetLife won its case against the Financial Stability Oversight Council [FSOC] in US District Court.  The government will likely appeal the case, but though I have been a bit of a lone voice here, I continue to believe that MetLife will prevail.  Here’s my quick summary as to why:

  • The FSOC’s case largely relies on the false idea that being big is enough to be a systemic risk.
  • Systemic risk is a mix of liquidity of liabilities, illiquidity of assets, credit risk, leverage, contagion, and lack of diversity of profit sources.
  • Liquidity of liabilities is the most important factor — in order to get a “run on the bank” there has to be a call on cash.  Life insurers have long liability structures, and it is very difficult for there to be a run.  People would have to forfeit a lot of value to run.
  • Contrast that with banks that use repo markets, and have short liability structures (w/deposit insurance, which is a help).  Add in margining at the investment banks…
  • The only life insurers that suffered “runs” in the last 30 years wrote lots of short-term GICs.  No one does that anymore.
  • Life insurers invest a lot of their money in relatively liquid corporates, and lesser amounts in illiquid mortgages.  Banks are the reverse.
  • Leverage at life insurers is typically lower than that of banks.
  • Insurers make money off of non-financial factors like mortality & morbidity.  Banks run a monoculture of purely financial risk.  (Okay, increasingly many of them make money off of “free” checking, and then kill their sloppy depositors who overdraw their accounts… as I said to one of my kids, “Hey, your best friend “XXX bank” sent you a love note thanking you for the generous gift you gave them.”)
  • That makes contagion risk larger for banks than life insurers — banks often have more investments across the financial sector than insurers do.
  • Life insurers tend to be simpler institutions than banks.  There is less too-clever-for-your-own-good risk.
  • State regulators are less co-opted than Federal regulators.  They also employ actuaries to analyze actuaries.  (At least the better and larger states do.)
  • Finally, life insurers do more strenuous tests of solvency and risk.  They test solvency for decades, not years.  They have actuaries who are bound by an ethics code — the quants at the banks have no such codes, and no responsibility to the regulators.  The actuaries with regulatory responsibility serve two masters, and though I had my doubts when the appointed actuary statutes came into being, it has worked well.  The problems of the early ’90s did not recur.  The insurance industry generally eschewed non-senior RMBS, CMBS and ABS in the mid-2000s, while the banks loved the yieldy illiquid beasties, and lost as a result.

Anyway, that’s my summary case.  I haven’t always been a fan of the industry that I was raised in, but the life insurers learned from their past errors, and as a result, made it through the financial crisis very well, unlike the banks.

PS — there are some things I worry about at life insurers, like LTC and secondary guarantees, but I doubt the FSOC could figure out how big those are as an issue.  A few companies are affected, and I’m not invested in them.  Also, those risks aren’t systemic.

Full disclosure: long ENH NWLI BRK/B GTS RGA AIZ KCLI and MET