Banks – Page 23 – The Aleph Blog

The Value of Fair Accounting

Posted on 8 December 2010 by David Merkel

I was a reluctant convert to fair value accounting, because I like standardization in accounting that allows for comparisons across corporations.? Also, unlike the complaints that emanate from financial companies that argue that fair value is procyclical, my experience has been that financial companies mismark their assets high, no matter what.

But when I read this article in the New York Times, it hit me.? The reason that the banks complain about fair value accounting being procyclical, is that they are mismatching assets and liabilities.

Think about it.? The argument that the banks make is that they are solvent.? Unfavorable temporary asset price changes should not be reflected in the accounting.? But if liabilities are marked to market at the same time, the difference should be minimal if the cash flows of the assets and liabilities are matched, unless there is a credit problem with the assets.

The thing is, with most banks, they have a large amount of their financing through deposits, savings accounts, CDs, and repo funding, all of which is short-dated, relative to the length of their assets.? (For floaters, look at the maturity, not the reset period.)

Thus, it should be no surprise when a bank is mismatched short versus its assets that it would squawk during times of crisis, and complain about fair value accounting.? But the problem isn’t the fair value accounting; it is the cash flow mismatch.? Banks try to make extra money off of that mismatch in good times, only for it to become a deadly risk in times of bad credit and liquidity.

Let the banks do what the insurers do, and come close to matching assets and liabilities.? If they do that, the financial system will become a lot more stable, and financial crises will be much less common.

And at that point, it won’t matter what accounting system is used, so long as those using book value impair assets fairly.? Still, I would prefer fair value.? Investors deserve the best information, even if it complicates life for corporate managements.

Queasing over Quantitative Easing, Part VI

Posted on 9 October 20109 October 2010 by David Merkel

I am no fan of quantitative easing, as readers may know.? One aspect of the dislike comes from the one-sided view of how low interest rates benefit the economy.? They do not benefit the economy, at least not as far as the following are concerned:

Endowments spend less, as their spending rules lead to less spending when interest rates are low.
Pensions find that their liabilities are more expensive than they thought.
Virtually every long-term financial plan fails, because they assumed far higher return assumptions.

Does the Fed ask what entities they might be hurting through quantitative easing?? They hurt any entity that has to make payments over the long term.

Now, that might change should inflation return.? There is a huge psychological barrier to be overcome there.? Given the willingness of almost all of the central banks to inflate, inflation will probably return.? The question is when?

Aside from that, banks aren’t lending.? In order for inflation to return, bank lending has to recover.

Quantitative easing requires the central bank to buy longer-duration fixed-income assets than is prudent for a central bank to buy.? That crowds out other natural buyers, like endowments, pension plans, and life insurance companies.? Flattening the yield curve is not costless.? It affects those that need to fund long duration obligations.

Capitalism is complex.? There are many nooks and crannies that central bankers ignore.? They are focused on the short-term.? Do central bankers realize that they are making life tough for endowments and pension plans?? Do they care?

To the extent that central bankers lend long to the US government, I would tell them that they are in a long-term bad bargain, though the short run might be different.

I don’t know the future, but I favor ideas that favor effort over passivity.

Who Dares Oppose a Boom?

Posted on 2 October 20102 October 2010 by David Merkel

Sometimes, I’m behind the curve.? I told myself that I had to get the essay to the Society of Actuaries by today, but now it’s evening time and I still haven’t done it.? So, with your permission, I’m going to write it now.? They asked for the following:

The U.S. Congress recently passed the most sweeping financial reform measure since the Great Depression. The purpose of this legislation is to prevent the risky behavior and decision-making that led to the financial crisis, and to prevent future crises.

Does this legislation solve the problems of the past?
Are there other significant issues not addressed?
Does this legislation cause other concerns?
In reflecting on the events of the last two years, is it possible to effectively develop early warning indicators that trigger intervention in advance of a complete collapse of an entire financial system or market?
Does it make sense to have a chief risk officer of, say, the United States of America, whose role it would be to manage/mitigate this risk?

Given these five questions as a charge, here is my essay:

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At the very heart of financial regulatory reform, an error was made at the very beginning.? As is common in American culture, the assumption was made that our laws and regulations were inadequate, rather than existing laws and regulations were inadequately enforced.? As such, the law that was eventually passed largely strengthened the strictures against the crimes that happened.

But, the same regulators were left in place.? Almost no one was fired for the incompetence demonstrated in not using the regulations that already existed for preventing shoddy loan underwriting.? The SEC had the right to set capital ratios at 12 to 1, but waived that right and allowed the investment banks to be unlimited in their leverage.? The GSEs took far too much credit risk, but who, if anyone, was fired for allowing them to do so?? Or, who was fired for doing so?

The trouble is this: during boom times, it is virtually impossible to get regulators to oppose politicians who are being lobbied by financial services organizations when they are making gobs of money, and it all seems riskless, as the bubble expands.? This is endemic to human nature; it is politically impossible to oppose booms.? I for one wrote extensively about the coming housing bust, but all I received was derision.? I wrote about the blowup coming in subprime residential mortgage bonds, but all I got was a yawn.

So, unless we get a new set of regulators that are willing to be junkyard dogs, I don’t care what laws we put in place.? Laws are only as good as those that are willing to enforce them.

Problems with the Financial Regulatory Reform Bill

Aside from a lack of change in the regulatory apparatus and personnel, my biggest difficulty with financial regulatory reform bill was a lack of change dealing with risk-based liquidity.? We don’t get runs on banks because of the insurance from the FDIC.? But banks often find themselves facing a run if they use a lot of repo funding.? Funding long-term assets short term is a recipe for disaster.? The bill made no effective change with respect to this.

And though there will be higher levels of capital required of banks, which is good, there was not enough thought given toward the riskiness of assets and how much capital they require.? Basel III basically kept the same structure as Basel II, but did not make significant corrections to the differences in risk regarding assets.? Further, they still allow companies to evaluate their own risks, rather than having a conservative and standardized approach for evaluating risk.

And to the degree that Americans believe that the financial regulatory reform bill will it prove the situation, it has given them a false sense of security.? And that could be the worst problem of all.

Creating an Early Warning System

There is great demand for an early warning system that could highlight whether systemic risk is getting too high for the financial economy overall, or whether risk is getting too high for any given subclass of financial risks in the economy.? I am happy to say that creating an early warning system would be easy.? Consider the differences between fresh produce and financial assets:

Time horizon ? fresh produce is perishable, whereas most risky assets are long-dated, or in the case of equities, have indefinite lives.
Ease of creation ? New securities can be created easily, but farming takes time and effort.
Excess Supply vs. Excess Demand ? With a bumper crop, there is excess supply, and the supply is typically high quality.? Now to induce buyers to buy more than they usually do, the price must be low.? With financial assets, demand drives the process.? Collateralized Debt Obligations were profitable to create, and that led to a bid for risky debt instruments.? The same was true for many structured products.? The demand for yield, disregarding safety, created a lot of risky debt and derivatives.
Low Supply vs. Low Demand ? With a bad crop, there is inadequate supply, and the supply is typically low quality.? Prices are high because of scarcity.? With financial assets, low demand makes the process freeze.? What few deals are getting done are probably good ones.? Same for commercial and residential mortgage lending.? Only the best deals are getting done.

Fresh produce is what it is, a perishable commodity, where quantity and quality are positively correlated, and pricing is negatively correlated.? Financial assets don?t perish rapidly, quantity and quality are negatively correlated, and pricing is often positively correlated to the quantity of assets issued, since the demand for assets varies more than the supply.? Whereas, with fresh produce, the supply varies more than the demand.

When I was a corporate bond manager, one of the first things that I learned was that when issuance is heavy, typically future performance will be bad.? Whenever there is high growth in debt in any sector of the economy, it is usually a sign that a mania is going on.? But it is very hard for a corporate bond manager who is benchmarked to an index to underweight the hot sector.

It is also very hard for a loan underwriter at a bank to stay conservative when he is being pushed for volume growth from his superiors, and most of his competitors are being liberal as anything.? It is hard for anyone in the financial services arena to not follow the prevailing tendency to lower credit standards during a boom.

So if I were to give advice to the new office studying systemic risk, I would give this one very simple bit of advice: look for the sector where debt is growing faster than what is ordinary.? It’s that simple.

If they want to get a little more complex, I would tell them this: when a boom begins, typically the assets in question are fairly valued, and are reasonably financed.? There is also positive cash flow from buying the asset and financing it ordinarily.? But as the boom progresses, it becomes harder to get positive cash flow from buying the asset and financing it, because the asset price has risen.? At this point, a compromise is made.? The buyer of the asset will use more debt and less equity, and/or, he will shorten the terms of the lending, buying a long-term asset, but financing it short-term.

Near the end of the boom, there is no positive short-term cash flow to be found, and the continuing rise in asset prices has momentum.? Some economic players become willing to buy the asset in question at prices so high that they suffer negative cash flow.? They must feed the asset in order to hold it.

It is at that point that bubbles typically pop, because the resources necessary to finance the bubble exceed the cash flows that the assets can generate.? And so I would say to the new office studying systemic risk that they should look for situations where people are relying on capital gains in order to make money.? Anytime an arbitrage goes negative, it is a red flag.

The new financial regulatory reform bill did create an office for analyzing systemic risk, and created a council that supposedly will manage it.? Would it be smart to concentrate the efforts into one leader who will both analyze and control systemic risk?

For better or worse, Americans tend to look for one strong leader who will lead them out of their problems.? Anyone who might be chief risk officer of the United States, would have to have control over the Federal Reserve, which creates most of the systemic risk that we have through its monetary policy, and its lack of leadership in overseeing the banks.? I don’t think it’s politically possible to put a risk manager in charge of the Fed, it might be desirable to do so.? The Federal Reserve always gets what it wants.

Summary

I don’t have a lot of hope that the current financial regulatory reform bill will improve matters much.? The same regulators are in place, who did not use the laws that they had available to them to prevent the last crisis.

Systemic risk can be prevented if regulators focus on areas where debt is growing dramatically, and where cash flow from buying and borrowing is diminishing dramatically.? But it is intensely difficult to stand in the way of a boom, and tell everyone ?Stop!? ?The politics just don’t favor it.

Finally, it would be difficult to create a chief risk officer the United States.? The current politics do not favor creating such a strong office, because it would have to control the Federal Reserve.

My Interview with David X. Martin

Posted on 27 September 201028 September 2010 by David Merkel

I had the pleasure today of interviewing David Martin who wrote the book Risk and the Smart Investor.? Unlike most of my book reviews, I have the fun of doing a voice interview and doing a written Q&A as well.? This piece will go over my voice interview.

Before I start, why did I decide to do so much with this book?? I did this because I have a love of risk management.? As I read through his book, I sensed a kindred soul who really got what is behind risk management.? I will not put out this much effort for an ordinary book.? I really liked this book, and after my voice interview I can say that I really liked David Martin.

My first question to David Martin was to ask you what motivated him to write the book.? He replied to me that as he had gone through life and learned things, his satchel filled up more and more.? The book was a way of emptying his satchel and giving back to average people.

If I might interject, that is my reason for writing this blog.? I’m not in it for the money; I don’t think David Martin is either.? But for some of us, when you have learned a lot, you feel a need to share it with others, not so much for your ego, but that others can benefit.

My second question to him was, ?If you could make a few key changes to the way we do risk management at financial firms in the United States, what would they be?”? After a pause, and saying that’s a big question, he gave me the following answer:

1) Risk management must be holistic.? It must look to the strategy being pursued, the risk involved, and then the capital needed to pursue such a strategy.

2) The risk manager must not only have a seat at the table but must have a voice at the table, with an independent channel to the Board of Directors like the internal audit function.? The Directors have to be aware of the risks that the company is taking.

3) Risk control must be grounded in reality.? It’s fine to have a quantitative model, but after his run for a while, do you test to see how it has performed?? (David Merkel: It is similar to what happens good insurance firms.? Good firms take the results of their valuation work and feed it back into their pricing, so that they do not under- or over-price their products.)? Testing is key.? Was the model truly predictive?? Did it really work?? Did you compare the results to half a dozen alternative models?

4) There are two visions on risk management.? Vision one is the huge screen in front of the risk manager, with advanced math and analytics, that takes in all the data, and allows the risk manager to make simple adjustments in real time to the quantitative feedback.? Vision two is having people with good business judgment look at the state of the markets and the positioning of the financial institution and making informed decisions.? Like me, David Martin favors the second vision.? Models will never be so good that a businessman with good judgment will be inferior.? This is one place where John Henry will beat the steam drill.

He added his experience the time that he met Peter Drucker.? He asked Drucker how one could predict the future.? Drucker answered that one could predict the future by attempting to create the future.

Now what Drucker said was not dumb, in my opinion.? And David Martin followed that advice by helping to create principles for risk management for buy side firms and for directors of mutual funds.? After all, why wait for the problems to come to you?? Why not create best practices now, and do better business for your clients, making yourself more immune to future lawsuits?

David Merkel: As Cordwainer Smith said in his short story ?Mother Hitton?s Littul Kittons,? “Bad communications deter theft; good communications discourage theft; perfect communications stop theft.”? The idea here is that good business practices are best for the client and the business in question.? Before you get sued, why not put something into place that minimizes your probability of getting sued, by maximizing the probability of doing business right?

My third question was: “Most of my readers are amateur investors.? What would you want to take away from your book?”

He began by talking about process and learning.? There are no magic ideas.? You’ve got to do the dirty blocking and tackling of learning about investments so that you can make intelligent and informed decisions about what you do.? Further, you have to be disciplined about your decision-making.? Don’t be haphazard in making choices.? (As David Merkel has said for a long time: Decision triumphs over conviction.? Discipline yourself to make your investment decisions businesslike.)

He added that all of us need an internal Board of Directors.? Friends who can counsel us when we are stumped.? He himself has such a Board of Directors ? trusted advisors will help when he can’t figure the situation out.? If David Martin needs such a group of men, how much more how much more do average investors like you and me need such advice?

My fourth question was, “What potential problems are under followed in the present financial environment?”

He paused and explained to me that his ideas here are tentative.? Many have been asking him this question, but he is less certain about what the right answer is here.? He then talked to me about information risk.? There are risks to financial systems being hacked. ?Financial companies need to verify the validity of transactions before executing on them.? He mentioned a parallel about the noise the present environment when you get so much spam relative to legitimate mail.? He himself hired a hacker at one point to see how the financial systems of the firm he was working for could be compromised.? He was surprised on how easy it was to do.

As for financial reform, he expressed some skepticism because most of financial reform is fighting the last war.? They are not looking through the windshield, they are looking through the rear view mirror.? They need to look at what the next set of problems might be.

He then said that we have not learned our lessons from the current crisis.? We have beliefs of our country, for which we have not counted the costs.? “Everyone deserves a house.”? “Everyone deserves quality healthcare.”? But what of the costs?? Can society as a whole bear the costs of what many believe are entitlements?

He closed with the comment that somehow Main Street and Wall Street must have some sort of rapprochement.? If the two don’t work together, life will be tougher for both.

My final question was, “If you were to write a follow-up book, what would you write about?”

To my happy surprise, he is considering writing a follow-up book.? It is a book that would focus on risk management for the individual investor by looking through the windshield.? Keep moving on; embrace risk.? Develop processes that will help you embrace risk.? Spend more time thinking and less time slaving.

After that we had a bit of a discussion about liquidity, and how difficult it is to explain as well as how it can throw monkey wrenches into the best financial plans.? He felt that most problems from liquidity could be solved through business judgment, but that it would often cut across the short term goals of many financial firms.

What I have not captured in my comments here are the number of times that he emphasized how risk control must be a whole firm process, and how senior management must be committed to risk control.

To close this off, I will say that I found the interview refreshing.? David Martin has a very intelligent view of risk.? Risk must be embraced, but only at reasonable costs, and in view of decent returns.

So with that I once again recommend the book Risk and the Smart Investor. If you want to, you can buy it here: Risk and the Smart Investor.

Full disclosure: I was asked if I would review a copy of the book.? It sounded interesting, so I said I would consider it; I was e-mailed an advance copy of the book.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Book Review: Risk and the Smart Investor

Posted on 25 September 2010 by David Merkel

Not every book grabs me at first.? “Risk and the Smart Investor” was one such book.? But it grew on me.? Having been through many exercises in risk control inside insurance companies, I can sympathize with the much more complex job that it is to control risk inside investment banks.

I was fascinated with the structure of the book, which I found tedious and hokey at first, but I grew to like the intriguing and novel approach.? The author introduced the topic through his experience, then explained the theory, then showed how neglect of it led to failure, and then gave stories of Max and Rob, two very different men whose lives illustrated risk management, and the lack thereof.

Risk control has to be realistic.? You can’t eliminate all risks.? You shouldn’t even want to eliminate all risks.? Anyone who tries to eliminate all risk will end up killing the profitability the business.? As that great moral philosopher James Tiberius Kirk once said, “Risk is our business.”? (For the jobs were I was explicitly a risk manager, I kept that quote on my wall.)

I am going to touch on the themes of the book as I understand them.? In order to control risk, one must first be able to control himself.? Without self-control, there is no risk control.? That process requires humility.? Almost every action of risk control involves limiting the behavior of those that have the power to commit money for investment or to sell assets to raise cash.

Part of that comes down to understanding what are reasonable goals, and what aren’t.? Nothing grows without limit.? Almost every business has a maximum growth rate, which if exceeded materially raises the probability of insolvency.? This is true for individuals as well.? Peter Drucker once said something like, “Jobs should be big enough to be challenging, but not so big that they require superhuman effort.”? In the same way, efforts to grow your personal assets too quickly will lead to decisions with a high probability of large losses.

For risk control the context of large firm, the critical question is cultural issues.? That involves instilling the idea of risk control in every person if the firm ? making it a part of the firm DNA.? It must extend to the very pinnacle of management, and not let it be seen as something that is a tradable issue.? It is similar to the idea of a reputation.? You only get one reputation.? Your reputation is your brand.? If your reputation is harmed or destroyed, rebuilding it is desperately tough.? Granted, America is the land of unlimited second chances, but rebuilding is still tough.

We can diversify lines of business.? We can diversify assets.? We can diversify funding sources.? We can’t diversify our reputation.? We only have one reputation.? It is as one of my favorite bosses of the past said, “I’m willing to take lots of moderate risks, but not willing to take an action that has a material probability of destroying the firm.”? This is just another way to say that there are things that can be diversified and things that can’t.

Corporate culture cannot be diversified; it flows from the top and affects all employees.? Good risk control cultures inculcate checks and balances.? They make sure that no one has too much power, such that the work cannot be checked.? They insist on transparency within the firm and transparency outside to the degree that it facilitates business and satisfies regulators.

Such a corporate culture monitors continuously the factors that affect profitability future risks.? It also learns from mistakes, but keeps the risks small early in the process so that learning from mistakes is not an expensive and surprising endeavor.

The structure of the book contrasts financial risks and life risks through the lives of Rob and Max.? They are two very different people, one of whom is careful about risk, and one of whom ignores risk.? Just as we have seen firms that were careful about risk, during the present crisis, and firms that ignored risks, so we have seen the same in ourselves and our friends.? The stories of Rob and Max on the risks that we go through life and the risk that we go through markets.? In my opinion it richens the book a great deal.

Risk is inherent to life.? And, the ultimate risk is death.? You can’t diversify death.? You can’t pay a certain spread over LIBOR in order to engage to death swap on your own life.? The most you can do is build something that may last for some small to moderate amount of time after your death.? Even the great Warren Buffett is trying to do something like this, as I explained in my piece Moat, Float, Growth.

Quibbles

None.? It’s a really good book; very well-thought out.

Who would benefit from this book:

This book would benefit anybody who deals with the question of risk, whether personally or corporately, and that means all of us.? Not only do you get a lucid perspective on the causes of the financial crisis, but you get to see firsthand how corporations deliberately the word sound risk management principles in order to make money in the short term.

The reader also gains perspective on how to deal with risk in his or her own life.? Will you go the way of Rob, or will you go the way of Max?? Or, as most of us, will you do little of both?

I read lots of books on asset allocation, but relatively few books on risk control, because few accessible books get written on that topic.? This in my opinion was a very good book on risk control.? It has my highest recommendation.

If you want to, you can buy it here: Risk and the Smart Investor.

Full disclosure: I was asked if I would review a copy of the book.? It sounded interesting, so I said I would consider it; I was e-mailed an advance copy of the book.

Twenty Answers from the Author of Risk and the Smart Investor

Posted on 25 September 2010 by David Merkel

A little bit ago, I published Twenty Questions for the Author of Risk and the Smart Investor.? Well, David X. Martin got back to me, and here are his thoughtful answers.? I will have more commentary on this as I write the book review, which I am doing immediately after posting this.

1. Q: Imagine you are talking to a bright 12-year old girl.? How would you explain to her why and how the financial crisis happened?

A: Think of what happens when you blow up a balloon. First it expands, but eventually, if you continue to add more and more air, it bursts. The air going into the balloon in the years leading up to the recent financial crisis was either ?borrowed? air, that is air that was bought on credit, or air that was highly leveraged. In other words, only a small part of the air was paid for, and the rest was borrowed. And when the balloon burst most of those that had borrowed air, or had lent air to others, were left with nothing.

2. Q: I was fascinated with the structure of your book, which I found tedious and hokey at first, but I grew to like it.? The way I see it, you introduce the topic through your experience, then explain the theory, then show neglect of it led to failure, and then you give us the stories of Max and Rob.? How did you hit upon this intriguing and novel way to write your book?

A: I first thought about the decision process, and described the continuous process of risk management in relatively simple steps?i.e., assessment (know where you are and what you do not know); rules of the game (know your risk appetite, transparency, diversification, checks and balances); decision-making (alternatives, responsibilities, reputation and time frame); and finally, reevaluation (monitor and learn from your mistakes ). My goal was not to write a “how to book” but rather to help readers build frameworks?to make good decisions, and it seemed it would be helpful, and entertaining, I hoped, to see the process in action through the fictional risk story.

3. Q: Why do you suppose so few people in risk management, and senior management at major financial firms, were unwilling to consider alternative views of the sustainability of the risks being taken as the risks got larger and larger relative to the equity of individual companies, the industry as a whole, and the economy as a whole?

A: People get lulled into seeing the world from a particular viewpoint, particularly if they have never been through the worse case scenario. I?ve been through many of them.

4. Q: As a risk manager, bosses would sometimes get frustrated with me when they wanted a simple answer to a complex question that had significant riskiness.?They did not like answers like, ?I don?t know, it could have six significant effects on our company.?? How can we convey the limits of our knowledge in a way that management can get the true uncertainty and riskiness of the environment that we work in?? How can we get management to consider scenarios that are reasonable, and could harm the company, but few others in similar situations are testing for?

A: Scenarios are a great way of thinking about the future in terms of the realm of possible outcomes. Thinking now about what you can/should be doing about those possible outcomes, is an excellent way to communicate risk potential to management. and engage their interest.

5. Q: In your experience, how good are the managements of financial companies at establishing their risk tolerances?? Better, how good are they at enforcing those limits, such that they are never exceeded?

A: Not very good. Businesses have strategies, strategies entail risks, and risks require capital. Very few companies take a holistic view of risk, capital, and strategy.

6. Q: How do you create a transparent risk culture in a firm?? How do you get resisters to go along, even if it is management that does not see the full importance of the concept?

A: Cultures do not change rapidly, they migrate. Transparency starts at the top and it will never spread through a company if management doesn?t recognize its importance, and communicate its importance to everyone in the firm.

7. Q: Are most cases where a person or a company fails to diversify intentional or unintentional?? Do we put too many eggs in one basket more out of ignorance or greed?

A: Diversification is a strategy that requires discipline. Take the case where you start with a diversified portfolio, and then one position takes off and acquires a disproportionate weight in your portfolio. Regardless whether the cause is ignorance (you did not monitor your portfolio?s balance) or greed (you rode the stock up ), the root problem is a lack of discipline.

8. Q: Why do you suppose that checks and balances for risk management are not built into the cultures of many financial companies?

A: When does a problem exist? Even if it has always been there, it comes into existence only when you recognize that it is a problem. Many times checks and balances do not exist because no one recognizes the risk/problem and therefore no one evaluates the checks, and balances, and controls needed to manage it.

9. Q: I have a friend Pat Lewis who developed a risk management system for Bear that could have prevented the failure of the firm, but it was ignored because it got in the way of profit center manager goals.? Was it the same for you at Citigroup when your ?Windows on Risk? got tossed out the window?

A: See pages 124-5 in my book. You never have to ask a portfolio manager what he or she thinks, just look at their portfolio. When I found out Citibank was no longer using Windows on Risk I sold my entire position that day. I recall it was at $51.75.

10. Q: Can culture and personal judgment work in risk management ever?? Take Berkshire Hathaway ? risk control is embedded in the characters of a few people, notably Warren Buffett and Charlie Munger.?If the culture is really, really good, and it comes from the top, can risk management work when it is seemingly informal?? (Remember, you don?t want to disappoint Warren.)

A: Risk management is all about culture and personal judgment. I remember pondering the question, “How high is up” at a Windows on Risk meeting at Citibank. The most senior management were sitting around the table. We came to our answer by asking the following question: What was the amount of loss we would be embarrassed to read about in the WSJ? That number, it turned out, was not very high, at least in the judgment of the people sitting around that table. News of that decision got around and had an impact on the company culture.

11. Q: How can you teach younger people in risk management intuition about risk that helps them have a healthy skepticism for the results of impressive complex modeling?

A: I co-wrote an article with Mike Powers from the London School of Economics titled “The End of Enterprise Risk Management.? Models are just one input; they are not a substitute for good judgment.

12. Q: Is it possible to do effective risk management in a financial firm if management is less than wholeheartedly committed to the goal?

A: I forgot where I first heard the expression, but it explains my feelings. “A fish starts to stink from its head first.?

13. Q: Aside from AIG, and other financial insurers, the insurance industry came through the crisis better than the banks because they focused on longer-term stress tests, and not on short-term measures like VAR.? Should the banking industry imitate the insurance industry, and focus on longer-term measures of risk, or continue to rely on VAR?

A: VaR is one measure. It has deficiencies. For example, the loss amounts predicted in the tails (that is, the extreme cases) are the best case scenarios, not the worse case. Institutionalizing this one measure, or relying on the measurement of “risk based capital,” has not worked.

14. Q: Seemingly the big complex banks did not analyze their liquidity risk, particularly with repo lines.? Why did they miss such an obvious area of risk management?

A: Liquidity is a very difficult concept. If you decide to sell your house in the suburbs at 2AM in the morning and put a “for sale” sign on your lawn at that hour, how quickly do you think it will sell. Liquidity, therefore, has to be thought of in terms of time. If, for instance, you see high average daily volume in a stock what is your real liquidity if the volume is the result of a nano second of high speed trading?.

15. Q: How much can risk management be shaped in financial firms by the compensation incentives that employees and managers receive?

I saw Walter Wriston six months before he died. He asked me how things were going. I said, nothing wrong with risk as long as you manage it. He smiled at me from ear to ear because those were his words, from his book Risk and other Four Letter Words. I think it is all about matching responsibility and authority, having the right culture, learning from errors, and promoting ethics. Incentives are on the list, but not at the top.

16. Q: I have often turned down shady deals in business, saying that you only get one reputation in this world.? How do you encourage an attitude like this in financial firms among staff?

A: If you go to sleep in s–t, you will most likely wake up covered with flies. I would start with an ethics committee, and make sure the most important people in the firm were on it.

17. Q: A lot of portfolio management and risk management is juggling different time frames.? Is there a good structure for balancing the demands of the short-, intermediate-, and long-terms?

A: A poor investment decision is still the same poor investment decision irrespective of the time frame. If you always try to do the right thing, time frames become less important.

I am not saying to forget about the timeframe, just that you shouldn?t let it lead you to a poor decision.

18. Q: Most developed country economic players assume that wars will have no impact on their portfolios.? Same for famine, plague, or environmental degradation.? What can you do to get investors to think about the broader risks that could materially harm their well-being?

A: Great question, but this one is outside my realm of expertise.

19. Q: Are Rob?s more common in the world than Max?s? That?s my experience; what do you think?

A: I purposely made Rob and Max pretty different in order to illustrate the principles in the book. I think we are all human and have a little bit of each.

20. Q: At the end of your book, one of your friends dies.? Did you mean to teach us that even if we manage our risks right, we still can?t overcome problems beyond our scope, or were you trying to say something else, like creating a system or family that can perform well after you die?

A: My first draft of the book began with what is now the concluding chapter?the one in which I discuss the courage necessary to face death. The developmental editor at McGraw-Hill, of course, didn?t like it up front, so I moved it to the end, where I wrote: ?It is at that moment, when death is imminent, and there is no possibility of escape, that courage comes into the picture.?

My view is that this mindset can be useful long before we consider our mortality, by helping us understand that there are realities that must be faced and not avoided. In investing as in life, long term success results from thoughtful, timely preparation. Or in other words, the best decisions are made before we are forced to make them. The best decisions are made before certain inevitabilities, so long on the horizon, appear unexpectedly in front of us, and we no longer have the time to consider the alternatives; when we can still calmly and intelligently assess our circumstances, consider alternatives, and make informed decisions, monitoring the results as we go.

This is what I refer to as ?de-risking,? and although the principles set out here are drawn from my experience as a risk manager at a number of leading investment firms, they apply not only to financial matters, but to almost every decision you?ll make over the course of your life.

So to my way of thinking, ?when lightning strikes–the processes that you have put in place make courage less necessary. Put another way, if you embrace risk by following an orderly process you will have constructed a framework that will help you make the right decisions

Redacted Version of the September 2010 FOMC Statement

Posted on 21 September 201021 September 2010 by David Merkel

August 2010	September 2010	Comments
Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months.	Information received since the Federal Open Market Committee met in August indicates that the pace of recovery in output and employment has slowed in recent months.	No real change.
Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.	Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.	No change.
Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls.	Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls.	Shades its view down on business spending.
Housing starts remain at a depressed level.	Housing starts are at a depressed level.	No change.
Bank lending has continued to contract.	Bank lending has continued to contract, but at a reduced rate in recent months.	Shades up bank lending a little.
Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.	The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term.	No real change.
Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.	Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.	The FOMC will try to inflate, and let it into the goods and services markets, rather than merely using it to prop up the prices of assets backed by debt.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.	No change.
To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.¹ The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature.	The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings.	No real change.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.	The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.	The change is from price stability, to returning inflation to levels consistent with its mandate, which means they will try to inflate, and let it into the goods and services markets, rather than merely using it to prop up the prices of assets backed by debt.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.	Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.	Oops, Kohn is gone.? I will not miss him not being on the FOMC.? Can we bottle up the replacements until after the 2012 elections?
Voting against the policy was Thomas M. Hoenig, who judges that the economy is recovering modestly, as projected. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and limits the Committee’s ability to adjust policy when needed. In addition, given economic and financial conditions, Mr. Hoenig did not believe that keeping constant the size of the Federal Reserve’s holdings of longer-term securities at their current level was required to support a return to the Committee’s policy objectives.	Voting against the policy was Thomas M. Hoenig, who judged that the economy continues to recover at a moderate pace. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and will lead to future imbalances that undermine stable long-run growth. In addition, given economic and financial conditions, Mr. Hoenig did not believe that continuing to reinvest principal payments from its securities holdings was required to support the Committee?s policy objectives.	No real change here; if anything, Hoenig is more firm in his opinions.
1. The Open Market Desk will issue a technical note shortly after the statement providing operational details on how it will carry out these transactions.		Sentence dropped, since the announcement is over.

Comments

The FOMC makes a major step in policy change.? The question is this: will the mechanisms of credit transmit inflation to goods and services?? So far, it has not.? Lowering the policy rate does little to incent borrowing when enough people and financial institutions are worried about their solvency.
Beyond that, if they succeed, how will it be received on Main Street, especially if price inflation is not accompanied by increases in employment, and is accompanied by higher interest rates and lower stock prices.
Aside from that, there was little change from August to September in the FOMC Statement.
Hoenig still dissents; hasn?t gotten bored with it yet.
That said the economy is not that strong.? In my opionion, policy should be tightened, but only because I think quantitative easing actually depresses an economy.? It does the opposite of stimulate; it helps make the banks lazy, and just lend to the government.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.

Queasing over Quantitative Easing, Part IV

Posted on 31 August 2010 by David Merkel

In my last post on this topic, I went over the orthodox and unorthodox monetary policy responses to the crisis in the US.? Here were the orthodox options:

Lower the Fed funds rate into lower positive territory.
Offer language that says that the Fed Funds rate will be low for a long time.
Buy more long-dated Treasury bonds.

And the unorthodox options:

Lend directly to classes of private borrowers.
Create negative interest rates for Fed funds.
Debase the currency by expiration dates, lotteries, etc.

On orthodox policy: I’m not sure there is that much difference between Fed funds at 0.25% and 0.10%, except that money market funds will find themselves in further trouble, as yields are too low to credit anything. That the Fed will be on hold for a long time seems to be the default view of the market already, so an explicit declaration would likely prove superfluous.? On buying long-dated Treasury bonds, that will benefit the US Government by pseudo-monetizing the debt, but won’t help the real economy much.

Yes, some high-quality corporate and mortgage bond rates will be pulled down with it, but so will discount rates for liabilities.? The same applies to spending rules for endowments, and how much retirees can get if they go to buy an annuity.? The effects of QE are mixed at best, and on balance, might be depressing, not stimulating.? But what practical proof, if any, do we have that QE has ever worked?

We need policymakers to understand the bankruptcy of the theories they are working with.? So many macroeconomic models work with one interest rate.? But in the real world there are many rates, and duration and quality of lending make a huge difference in what rate is charged.? I would urge that every person who would be on the FOMC work at a buyside firm managing bonds and money market instruments.? Let them see how the markets really work, and it might disabuse them of their false neoclassical views of how the lending markets work.? Better still, if their P&L is less than the cost of capital, revoke their appointment.? It’s time to kick out the academics, with their failed ideologies, and let those who have worked in the markets successfully manage the economy.

Direct Lending

But then there are the unorthodox methods.? When Social Security came into existence, they argued over where the money would be invested.? It was decided that the only fair investment was in government bonds, because it was neutral.? Investing in other assets, like the S&P 500 would be unfair, because they would be favoring a sector of the economy.

The same argument applies to direct lending by the Fed, because it would smack of favoritism.?? Going back to my last article, favoritism undermines confidence in the system, and makes people less willing to invest unless the government gives them an edge — cash for clunkers, $8,000 tax credit, etc.? We are Americans, after all.? Why buy from the retailer now, when you know that there will be another sale coming soon?? Economic policymakers should not rely on people to behave “as usual” when policy becomes unpredictable and unfair to the average person.

So I don’t see direct lending by the Fed, or buying high yield bonds, or offering protection on baskets of bonds as wise moves.? It may temporarily goose an area for a time, and make an area of the economy QE-dependent, or stimulus-dependent, but at best it is helping a few, while discouraging the rest.

Negative Fed Funds

I’ve been thinking about negative rates for Fed funds, and I think that they will have the following effects:

Banks will drop their excess reserves at the Fed to zero, and vault cash (or its short-term debt equivalents) will increase.
Banks will try to borrow from the Fed at negative interest rates, if they allow it, and just sit on the cash, park it in T-bills, Top-top CP — it’s free money, after all.? Of course, some point free money may be construed as valueless money, but that is another thing.

Required reserves are not a large percentage of liabilities.? Unless Fed funds goes deeply negative, it’s not going to affect bank profitability that much.? Banks may just view it as a cost of doing business, and pass it on to customers.

Destructive Creative Currency Debasement

With apologies to Schumpeter, who popularized the concept of creative destruction, I’ll try to define a new concept that is the opposite — destructive creativity.? Destructive creativity is when bureaucrats or regulators get too clever, and in an attempt to solve a lesser problem, end up creating a bigger problem.

I’ve heard proposals for further debasement of the currency via placing expiration dates on currency, or randomly canceling currency through lotteries based on the serial numbers on the bills.? The idea is that people will change their behavior: save less and spend more.

I can’t say that I can see every unintended consequence with these proposals, but according to Keynes, Lenin said, “The best way to destroy the capitalist system is to debauch the currency.”? These creative means of debasing the currency might do it.

Who gets to be the one holding the Old Maid card as expiry draws near.? How much time would be wasted scanning currency at registers as money is handed over and change is handed out?? Is the money cancelled or expired?? Close to expiration?? Quick, put it into the pile to give as change to the next customer.? There may be legal tender laws, but I can tell you that there would be fights over things like this.? Would all of the dollar bills used as a shadow currency overseas come trotting home?

If the Fed wanted to write its own death warrant, it should implement schemes like these.? The Fed is already viewed with enough skepticism by average people, that it wouldn’t take much to tip the scale from “Audit the Fed,” to “End the Fed,” where it gets replaced with the currency board tied to a commodity standard.

This leaves aside ideas like expiring/canceling a certain amount of monies in savings or checking accounts.? After all, why stop with the paper money?? Move onto the blips that we transfer day after day, silently, quietly choking the economic well-being of people, making them feel less safe, less secure, more paranoid.? Would we set up checking/savings accounts in other currencies to avoid this trouble?? Would that even work, such that we would have to set them up in foreign countries, and access funds that way?? What’s that you say?? Exchange controls?? Destructive creation indeed.? To “solve” a smaller problem, a dud economy, create a much larger problem…

Want to kill the economy/country?? Taxation is one thing, confiscation is another.? There are more than enough people who have question marks in their heads over what the government is doing with monetary policy and stimulus.? Aggressive actions to debase the currency can turn those question marks in to exclamation points.

This has gone longer than I thought.? Time to hit publish, and I will finish this tonight.

Managing Illiquid Assets

Posted on 23 August 201023 August 2010 by David Merkel

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

So where do we see failures due to illiquidity?

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

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

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

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

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

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

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

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

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

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

Three Closing Notes

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

Was it worth moving from the:

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

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

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

Odds and Ends Stemming from a Question from a Friend

Posted on 17 August 201017 August 2010 by David Merkel

“How can I beat the Lehman Aggregate?” a bond manager friend recently asked me.? Tough question in this environment; I’m still musing about it.? It’s a tough market.

Start with Treasuries — they are the bedrock of the market.

Here is the Treasury yield curve at 4 polar moments in the last two years.? Two times where no one doubted that the economy was bouncing back: 6/10/2009 and 4/5/2010. One time where everyone thought the end was near: 12/18/2008.? Then there is now; the front five years of the curve is like the panic.? 7-20 years is like 75% of the panic.? 30 years is half of the panic, relative to the last two years.

So what to make of it?? Despite the Fed’s willingness to buy twos through tens, I think the thirties look attractive versus twenties and tens.? The curve typically peaks near 20 years, and that’s not true now.

Are things as bad as at the panic point in December 2008?? No, but the front-end thinks so.? I would be inclined to try a barbell where thirties and bills are overweighted, and twos through twenties are underweighted.? How big to make the bet?? That is up to your risk appetite.

Now remember, this is a trade, not a long-term investment.? Sometimes I think that government policy tends to turn us into speculators and traders… the first intentionally, the second by accident.

Now all of this is amid China lightening the boat on Treasuries.? That did not stop the rally.? As the article said:

For one thing, Japanese investors have steadily bought more U.S. debt as China has shrunk its portfolio. Japanese holdings rose to $803.6 billion in June and have increased by $82.7 billion since last July.

Domestic buyers have also helped fill the gap. U.S. household ownership of Treasurys in the first quarter was $795.7 billion, the highest in a decade, according to the latest Federal Reserve data available. Private pension funds, life-insurance companies and commercial banks have also raised their holdings to record or multiyear highs.

China favoring the Euro at this point is an interesting move, contrarian from an investment standpoint, but seeking European favor from a political standpoint.? Politics and economics go together in China, given the crude top-down planning they impose on the economy.

But what kind of market is it when both long Treasury bonds and gold rally at the same time?? It is a fear market that does not know what to fear.? “We fear ‘flation!!!”? Which kind of ‘flation, they are not sure, but things look bad.? Makes me want to short them both, but let the momentum die first…

Agency mortgages are problematic because of the weakness in home prices leading many mortgages to be not refinancable.? Thus the bonds trade at low interest rates, but high spreads to Treasuries.? Personally, I don’t think a mega-refinance is possible legally, but that makes the bonds a little cheap to Treasuries.? This would be an area to analyze collateral, and buy selectively.

One thing that is different from the panic in December 2008 is that corporate spreads are tighter now.? BBB bonds still look attractive, but with junk, you have to be selective.? I would focus on highest quality, and BBBs, and underweight the rest.? Consider buying the bonds of Moody’s.? Quite a spread at 3%, and unless something weird happens, it is still quite a franchise.

Beyond that there are always issue-specific bonds that seem to be undervalued.? Those are worth tossing in, and adusting the rest of the portfolio to adjust duration and credit quality.

Some closing notes:

Why is Google issuing commercial paper?? Please, tell me.? They have no lack of short-term liquidity.? Are they aiming for financial profits like a hedge fund would?? In some ways they are already– take note that they are doing securities lending to pick up additional yield (see my comment after the article). If this becomes a large part of Google, the P/E multiple on Google should come down, because financial entities arbing credit spreads do not deserve high multiples.? Better Google should pay out the excess cash to policyholders as a special dividend in 2010.
As an aside, I would add that the financialization of profits in general brings down the P/E multiples of industrial companies.? It looks so easy at the beginning.? Just finance the purchases of your own products through a captive subsidiary, and the extra profits roll in, with a small drop in the P/E.? That’s fine as far as it goes, but it usually doesn’t stop there; the division head of the finance sub seeks new vistas — if he can lend successfully in one area, he can do it in others.? We’ve got the infrastructure; why not use it?? The result at best is a GE or a Textron — two stocks that have gone nowhere over the last 14-15 years.
Many people in the US are selfish and want to decrease spending on others, but not themselves.? We see that through both of our clueless parties arguing over priorities, and people who want to see the deficit cut, but not in their prized areas.? The logic of shared pain has not yet arrived.? Things haven’t gotten bad enough to drive real spending or tax reform yet.
Last note: this is a period where people are demanding certain yield, thus bidding up bond prices versus stocks.? It reveals a lack of certainty about the future.? It makes some stocks look attractive — in many cases corporate bond yields are below stock earnings or cash flow yields, and even below dividend yields in some cases.? This article is an example of this phenomenon.? The key question is how long profit margins can remain elevated.? With labor plentiful relative to work, that could be a while, leaving aside risks in the financial system.

So, what should I tell my friend?? Maybe this:

Duration: emphasize short and long.
Credit: emphasize highest quality and some BBBs
Underweight financials with weak liability structures (I.e., the too big to fail banks) for now.
Mortgages: play carefully, but play.
If you don’t get a big yield premium for illiquidity, don’t play in illiquid bonds.
Can you do a little foreign? If so, diversify a little into the developed world fringe currencies outside of the US Dollar, Euro, UK Pound and Yen.

These are tentative conclusions that I would have to work out further — I don’t have my thoughts together on CMBS, Munis, etc.? That’s all for now.