Category: Banks

Queasing over Quantitative Easing

Queasing over Quantitative Easing

Posted on by David Merkel

The world’s largest hedge fund, the Federal Reserve, is trying to decide whether it should expand its operations.? Unlike most hedge funds, the Federal Reserve has a big advantage in that it can fund itself cheaply, and for the most part, at its own discretion.

  • Unlike most hedge funds, it issues 0-day 0% Commercial Paper, which is accepted almost everywhere as a means of completing transactions.
  • Banks affiliated with them must place reserves with the Fed, on which they earn interest of around 0.25%
  • The affiliated banks, not finding as many opportunities as they would like to lend privately on a risk-adjusted basis, leave more money than they have to at the Fed, again earning about 0.25%.

What a cheap funding base.? They can buy almost any asset and make money, so long as equity/credit risk is limited, and so long as the yield curve doesn’t hit new records for steepness.? Given that the Fed does not have to mark most of its positions to market, and does not have to worry about margin calls in the conventional sense of the term, they make money year after year, and hand most of the profits over to the US Treasury, which keeps accounts for the Fed’s main owner, the US Congress.

Life is tough when you have to serve multiple conflicting interests.

  • They demand that you create conditions for full employment, something beyond your control.
  • They ask that you restrain inflation, which is possible.
  • They ask that you lend, because the banks affiliated with you are not lending, and an increase in lending is always a good thing, right?

So, like Keynes, the fools that think that a lower rate of interest is always better urge that the Federal Reserve should expand its balance sheet and buy up more Treasuries, Agencies and Agency MBS, forcing rates lower.? What good can come from forcing high-quality long rates lower?

My answer is, not much.? Existing debts if non-callable, will be worth more.? If debtors are solvent, and can refinance, they? can lower their debt service costs, though that is a minority of borrowers.? Beyond that, it will lead the favored debtors to borrow more — Treasury, Fannie, Freddie, etc.? We need more borrowing, right?

But a greater effect can be the speculative frenzy engendered by dropping the rate that savers earn to such a low level, leading them to invest more aggressively to meet their income targets.? As with any other sort of speculation, the game is over when people rely on the occurence of capital gains.

I think quantitative easing is a mistake; I also think it does not help matters much.? It transfers resources from creditors to debtors in a funky way.? That is not the right way to go if you want a country to grow.? (Which, contrary to the received wisdom, would mean that raising short term rates would be better for the US and Japanese economies than engaging in quantitative easing.? There would be short-term pain, but there will be pain regardless of how this policy is conducted.)

If the Fed makes a bow in the direction of quantitative easing on Tuesday, such as reinvesting the proceeds of MBS in more MBS, the markets will rally, but I would fade it, because it will have no long-term beneficial? impact on the economy.

There is no free lunch.? Any action that seems to cost nothing on the part of the Fed or the Federal Government will have no long-term effect on the economy.? Quantitative easing is one of those comforting fairy tales that is a fraud, whether intentionally so, or not.

Book Review: Fault Lines

Book Review: Fault Lines

Posted on by David Merkel

Raghuram Rajan made a name for himself at the Jackson Hole conference in 2005, which was a kind of send-off for the victorious Alan Greenspan.? Alas, but the paper he brought was not appreciated at the time, as it pointed to imbalances in the financial system.

He was ahead of the curve.? Thus his book on the economic crisis deserves our attention. More than most, he sees the problems in a global way, across nations and across asset classes.

His view is that for a variety of reasons, income inequality grew in the US, and in order to paper over that, the government encouraged a credit-oriented society to allow people to stretch for prosperity, hoping that the debts would not catch up with them.

It was a fool’s bargain.? Debt deceives average people.? They overestimate their ability to repay, and end up defaulting at high frequencies.

Like me, he is critical of the Fed’s monetary policy during the ’00s as being too easy.? The “Great Moderation” was a result of over-stimulus, not of sound policy.

Similarly, he faults banking regulation for being too easy, leading to private profits with public risk.

This is a well-written book from a man who was ahead of the curve.? I recommend it.

Quibbles

Where I differ with Dr. Rajan is how easy it would be to fix income inequality in the US.? He suggests a number of policies, many of which sound good, but have the Federal Government intervene in matters that they can’t handle effectively.? Persistent unemployment is a problem, but should that be handled by the Federal Government.? Far better in my opinion that it be handled informally and locally, by family and friends, that there would be more urgency, and more willingness to compromise in finding work.

Retraining is a good thing, but also not something the Federal Government does well.? One of the beauties of the US is that we have community colleges, which can retrain people at modest costs.

He also levels a decent amount of the blame at Fannie and Freddie and the Community Reinvestment Act, for making too many lousy loans.? He is correct in direction, but not likely in degree.? Yes, they were problems, but not the leading problems.

But these are mere quibbles on an otherwise excellent book.? If you want to buy the book, you can buy it here:? Fault Lines: How Hidden Fractures Still Threaten the World Economy

Who would benefit from this book

Anyone who wants a comprehensive view of the crisis would benefit from this book.? It does a fairly complete job, and is not long at ~230 pages.

Full disclosure: The publisher sent me a copy, because I met the author at a conference, and asked to receive a review copy.

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.

We Might Be Dead In The Long-Run, But What Do We Leave Our Children?

We Might Be Dead In The Long-Run, But What Do We Leave Our Children?

Posted on by David Merkel

One of the problems with Neoclassical economics is that it assumes that the economic system tends toward stability.? In all of my years of doing quantitative analyses of equity and debt markets, as well as the economy as a whole, my models have shown me that there is a tendency toward mean-reversion, but it is a very weak tendency that is swamped by shocks to the system in the short run.? The further we are away from the mean, the stronger the tendency toward mean-reversion.

But, as I have often said, the beauty of Capitalism is its ability to handle instability.? There is creative destruction as some economic concepts are no longer as useful as they once were — e.g. fixed-line telephones, newspapers, buggy-whips, everyone should own a home, residential real estate is an easy road to riches, etc.

It is dangerous to try to stabilize that instability, to create a great moderation of volatility, to keep marginal concepts from failing, whether through fiscal means (tax incentives and subsidies), or monetary policy (lower the policy rate or some banks will fail).

It’s good to see bad economic concepts fail, along with those who finance them, particularly when a society is not so dependent on debt finance that the failures will not cause a cascade of more failures.? Failures allow resources to be redeployed to more productive uses, and keeps capital focused on the best opportunities.? Unemployment stays cyclical.

But when failures are quickly bailed out through overly easy monetary policy, as well as a fiscal policy that favors debt over equity, debt grows like crazy, because there is little to restrain it.? Why should the politicians care?? Easy money means prosperity today.? Bureaucrats don’t argue with the politicians; that is suicide.

Debt issuers crave stability.? Credit spreads fall when conditions are stable, until enough marginal borrowers take on debts that they can’t afford, and the bust phase of the credit cycle kicks in.? If the central bank eases too soon, as was true for the Greenspan/Bernanke era, then the bust doesn’t get to do its job.? Marginal concepts survive.? The marginal efficiency of capital falls.? Asset prices stay inflated.

This process can continue until the central bank’s policy drives the economy into a liquidity trap, because they can’t drop rates lower than zero.? (Though I wonder, couldn’t the Fed go negative, and require the banks to pay them interest on reserve balances?? Perverse, I know, but what isn’t perverse today?)? The central bank can further lower rates, a subsidy to bad decisions, by buying long debt, and maybe credit-sensitive debt (not yet, but wait and see).

That’s where we are today.? Now there are two competing theories for why we are in this mess.

  1. Aggregate demand has failed, so the government needs to step in and spend to keep growth going in the short-run.
  2. Our economy is too levered.? We need to adopt policies that reduce indebtedness, and also expect that these policies will cause some pain in the intermediate-term, but that it will give us a healthier economy in the long run, that is, for our children, even if we are dead.

My view is that neoclassical economists are wrong.? Aggregate demand has failed for four reasons:

  1. Overleveraged consumers will not readily buy.
  2. Citizens of overleveraged governments will not readily spend, for fear of what may come later from the taxman, or from fear of future unemployment.
  3. Aggregate demand is mean-reverting.? It overshot because of the buildup of debt, and is now in the process of returning to more sustainable levels.? The same is true of private debt levels, which are being reduced to levels that will allow consumers to buy more freely once again.
  4. When the financial system is in trouble, people get skittish.

The thing is, we are not in a liquidity trap, as much as we are in a broken financial system.? Ordinarily, savings in a bank lead to investment.? The bank lends the savings.? When the banks are impaired, or forced to put up more capital against their operations, as financial reform properly will do, lending is light.

If we give it enough time, willingness to lend will recover, without government help.? That implies that debt levels mean-revert across the economy down to levels where people aren’t concerned about their own debt, or the debts of the government.? We are in a process now where the private economy is properly trying to reduce debt levels, and the government is interfering through monetary policy, deficits, and tax credits for borrowing, in order to support the economy of the 1990s, where we needed more houses and cars, and all who created/serviced them.

Thus I will tell you that the current set of policies is not only useless, but unproductive.? Don’t keep interest rates artificially low.? It punishes savers.? Savings are what lead to sustainable investment.? Don’t stimulate the economy via fiscal policy; it never rewards the economy of the future, only that of the past.

Here are my solutions:

  • Make interest non-deductible, and dividends tax-deductible.? Phase this in over five years.? Yes, the prices of houses would fall, and many other asset prices.? Venture capital would get whacked.? But the system that would emerge by 2020 would be delevered, more profitable, and much more stable.? It would grow more rapidly as well.
  • Issue coupons to taxpayers? that can be applied to repay debt.? That would delever the economy rapidly, aside from the government.? (A weakness of the idea.)
  • Bar the Fed from running overaggressive policies.? Fed funds can never be more than 1.5% below the 10-year rate, or 0.5% above the 10-year rate.? Constrain the madness of unelected bureaucrats that see no problem in weakening the credit of the economy.? Also, eliminate section 13:3, so that the Fed can’t do bailouts.? Let Congress, who we elect, sign off on every bailout, so that we can kick them out thereafter.
  • Worst case scenario: Inflate the currency, such that it passes into goods prices.? That will lower the value of old debts, making them not as much of a burden to the economy.? But try the other three strategies first.

I write this not because I get any kick out of austerity, but because I think the present set of solutions will not only not work in the long-run, but make things worse.? There will be no recovery without some pain.? People always want something for nothing, and that never works in the long run.? If we want to have two or three lost decades, like Japan, well, keep following the status quo.? But if we want to get this over with, follow my solutions, and stop interfering with the economy.

As it is, there are limits to borrowing for any government in real terms, and the present set of policies will test those limits.? Perhaps Greece or Japan will be the canary in the coal mine for the US, but will we learn the lesson early enough to avoid default or a severe inflation?

Fishing at a Paradox. No Toil, No Thrift, No Fish, No Paradox.

Fishing at a Paradox. No Toil, No Thrift, No Fish, No Paradox.

Posted on by David Merkel

Aggregation of economic variables is required for macroeconomic modeling.? One of the largest problems with macroeconomics is whether that aggregation makes sense, or conceals a more dynamic and diverse economy.

The paradox of thrift as proposed by Keynes assumes that all saving is similar.? People invest excess monies in some simple depositary instrument that earns interest.? As people panic over bad economic activity, they save more, driving interest rates lower.? But wait.? What if they don’t place their money in depositary instruments?? What if they pay down debt, whether secured or unsecured?? In that case, banks will find themselves more willing to lend, as the surplus/assets ratio rises.? The liquidity crunch at the banks will lessen.? Or, people may save in a different way, by:

  • Buying gold, commodities, or non-perishable consumables
  • Enhancing their homes, cars, etc., making them cheaper to operate, or giving them longer lifespans
  • Investing in foreign debt instruments

Saving can take many forms, some of which may look like consumption or investment.? The main idea is to direct your excess assets to the place that will give you the best long term benefit.

Even corporations will want to save during a tough environment.? Building up cash balances gives flexibility for the future, and gives options to buy assets cheaply if competitors crater.? Some firms even borrow long-term to have cash on hand.? It’s a negative arb, but it gives the firm flexibility.? But even firms may have alternative ways to save:

  • Investing in labor-saving or waste reducing technology.
  • Stockpiling needed nonperishable commodities, or locking in long-term supply agreements, at attractive prices.
  • Retiring stock or debt through buybacks at attractive prices.

Saving need not be in money markets or banks.? There are many ways to save, and there are always alternative uses for money.? Each economic actor has to find the most fitting savings method for his needs.

Now, recently I ran across a paper called The Paradox of Toil.? The abstract:

This paper proposes a new paradox: the paradox of toil. Suppose everyone wakes up one day and decides they want to work more. What happens to aggregate employment? This paper shows that, under certain conditions, aggregate employment falls; that is, there is less work in the aggregate because everyone wants to work more. The conditions for the paradox to apply are that the short-term nominal interest rate is zero and there are deflationary pressures and output contraction, much as during the Great Depression in the United States and, perhaps, the 2008 financial crisis in large parts of the world. The paradox of toil is tightly connected to the Keynesian idea of the paradox of thrift. Both are examples of a fallacy of composition.

This paper does the same simplifications that Keynes did to produce his paradox of thrift.? There is only one type of labor.? Well, certainly if everyone does the same thing, there are diminishing marginal returns to scale.? Big deal.

But labor is different.? We have the ability to choose different firms to work at.? Not all work is equal, and there are often better and worse opportunities available for labor.? Recessions occur partially because capital and labor are misallocated.? Look for the firms that are showing promise in the recession, and angle to work for them.

But beyond that, workers have one more option: work for yourself; start your own firm.? Find a problem that irritates many, and solve it.? Create a product or service that meets the needs of many.? In a deflationary environment that might mean finding a cheaper way to do things.? But it could be creating a new product that meets needs that people or businesses did not know they wanted.? Go for a Blue Ocean Strategy.

The best businesses are often created in recessions.? Flip the paradox of toil, and work many hours for yourself and your ideals.

Summary

I don’t believe in the paradox of thrift or the paradox of toil.? They are bogus results of oversimplified models that do not reflect reality.? As an investor and an economic historian, I know of many times where massive amounts of money were allocated to a single asset class or a single sector of the market.? If everyone follows a mania strategy, whether due to greed or panic, I can guarantee that there will be a bad result.

  • The dot-coms of the late ’90s
  • The one decision stocks of the ’60s.
  • Gold in the ’70s.
  • Railroads in the late 1800s.
  • Buying stocks in the 1920s.
  • Selling stocks in the 1930s.
  • Selling bonds in the early ’80s.
  • The mercantilist era — exporting cheaply to get gold, then getting less in return when liquidating the gold.

I could go on to various manias in earlier eras, less well-known manias, or individual stocks, but that wouldn’t help make my case any more than I have already.? The main point is the same.? Anytime everyone does the same thing, it is foolish.? It would be stupid for everyone to save using T-bills, or sell their excess labor to agricultural day labor.

I trust intelligent people to seek their best advantage in the markets.? That does not mean that foolish people will not get hosed.? That’s the nature of being foolish.? But bright people see recessions as a time to reorient and look ahead, to see what the new economy will want, and ignore what the old economy wanted.

So, I don’t see any value in:

  • Stimulus programs that don’t produce economic value.? If it only pays a wage, that is destructive.? For stimulus to be effective it must produce infrastructure that lowers the costs of the economy.? Think of all the useless projects built in Japan.
  • Paying extended unemployment benefits.? Additional consumption today, plus debt tomorrow is a recipe for economic lethargy.
  • Running large deficits.? If the money is not being spent on something that will produce future growth, it is a loss.
  • Bailouts of large financial institutions.? We have too many of those.
  • Housing tax credits.? We have too many houses.
  • Bailing out auto companies.? Too many autos are made in our world today.
  • Bailing out the GSEs.? They are deadweight losses.? Let them die, and let the senior bondholders feel the pain.? Let the junior bondholders be wiped out.
  • Monetary policy that steals from savers, thus depriving the private capital markets of a supply of private capital for productive investments, rather than the government absorbing most of the capital at low rates, and wasting the money on less productive projects.

Don’t listen to the fools that insist that we must run huge deficits and run a loose monetary policy.? A “big bang” would be preferable to the “Chinese water torture” that we are now undergoing.? Far better to take a short dose of sharp pain, where asset prices fall, some more banks fail, and bad debts are purged from the system, than to endure another lost decade, where the ability to employ capital productively is difficult.

As it is, we are pursuing the Japan solution to our overleverage.? They have had two lost decades, and are starting on their third lost decade.? Is that what we want?

Economics is Hard; the Bad Assumptions of Economists Makes it Harder

Economics is Hard; the Bad Assumptions of Economists Makes it Harder

Posted on by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

An Opportunity in Comerica Warrants

An Opportunity in Comerica Warrants

Posted on by David Merkel

This will be a bit of an unusual post for me.? How often do I suggest option trades?? Almost never.? But because of auctioning of TARP warrants, there are a decent number of very long dated options trading on some bank stocks, and many of them are cheap.? I’m here to talk about the cheapest one this evening, Comerica.

Comerica warrants [CMA/WS] closed at $14.50 today, a price that makes the computer say, “does not compute.”

CMA neg vol

The Comerica warrants are trading so cheaply that they discount negative volatility.? At zero volatility, the warrants would trade 5% higher:

CMA zero vol

And at a fair-ish volatility level, 17% higher.

CMA 20 vol

Now there are two ways to extract value here.? Buy the warrant and sell short 2/3rds of a share of the common stock, which is empirically delta-neutral.

CMA delta neutral common

As the delta of the positions change, adjust your hedge in the common stock to reflect it.? The other way is not to short the common stock, but to short long dated options.? The most liquid long dated options are the 40s expiring in 2012.? The hedge would be to sell options on 170 shares of stock against every 100 warrants owned.

CMA delta neutral optionsOver ten months the transaction makes a profit with CMA stock between 30 and 53.? That is one wide band, and there is still room for adjusting hedges in ways that could improve matters.

Now, I am open to feedback from readers/bloggers who trade options.? What’s wrong with this idea?? Free money is rare in the markets, but this warrant really seems like a mispriced security.

Full disclosure: no positions

PS — note that you may not get favorable margining being long the warrant and short the option.

11 Notes

11 Notes

Posted on by David Merkel

Internet issues are resolved, so here’s a post of things that built up while things were down.

1) You know that I have mixed feelings about the Fed.? They have done a poor job with bank regulation, monetary policy, and managing systemic risk.? The trouble is, if you?re going to have a fiat currency, monetary policy is credit policy, and so your central bank should broadly control credit if you are going to do that at all.? (If not, then set up a currency board, or back your currency with silver/gold.)

So when I hear that the Fed is winning in reconciliation of the finance bill, I think it is good in some ways ? yes, they should oversee small banks, but bad because the Fed should not have bailout authority, or at least they should not be able to hide what they do when monetary policy is unorthodox.? It is one thing to delay oversight of ordinary dealings, but rotten to hide debasement of the currency through special dealings with favored entities.

But I see little value in the size of the Fed.? They have too many people doing too little.? Monetary policy and bank supervision?? Fine if they do it well.? But the institution as a whole could be radically slimmed.? Congress should take closer control of the Fed, slim it down, and focus it on the missions that it should attend to.

2) I am not impressed with Donald Kohn.? He has a farewell interview with the Wall Street Journal, and not once does he mention the buildup of debt in our economy, partially fostered by easy monetary policy from the Fed, as a problem.? Blind guy, and even worse, he still doesn?t get that bubbles are typically able to be seen in advance, or, that the Eurozone isn?t structurally flawed.

Thought experiment time.? What if we tossed out all the Fed governors, and replaced them with a bunch of notable value investors?? Value investors suffer from the problem that we see problems early, and adjust portfolios too soon.? That could be of benefit to monetary policy, because value investors often see when things are becoming overdone, well in advance of it becoming too big to handle.? This would be a big improvement on the current system.

3) I get email from congressional staffs asking for advice on issues, or asking me to write about them.? Recently I was asked what I would ask the nominees for the Federal Reserve Board.? This is what I said:

  • We find ourselves in this crisis because the Fed ran an asymmetric monetary policy for years: loosen aggressively when the least crisis comes up, and tighten slowly until there are small squeaks of pain.? This led short interest rates progressively lower, until we found ourselves in the liquidity trap that we are now experiencing.? How are you going to get us out of this liquidity trap?
  • How are you going to provide decent opportunities to savers so that capital formation can begin again?
  • What have you done in your life that qualifies you for this level of responsibility?
  • To the economists: neoclassical economics did us no favors with respect to this crisis.? Only a few Austrian economists predicted it, along with a few practical economists in the business world.? We need a new paradigm for monetary policy.? Are you capable of providing it?
  • To the non-economist:?You will be working primarily with neoclassical economists, with their theories uncontaminated by?data.? How will you avoid being sucked in by their groupthink?

4) When I went to hear Raghuram Rajan and Carmen Reinhart at the Cato Institute, I was very impressed with what both of them had to say.? Rajan was the skunk at the farewell party for Alan Greenspan back in 2005 at Jackson Hole, when he was the only one to fully suggest that imbalances were building up due to debts being incurred in the financial sector.? Few aside from The Economist noted what he said.? More noted Donald Kohn?s dismissive response, which was not erudite, in my opinion.

Both noted that the current financial reform bill would do little to fix the real underlying problems, with which I agree.? It constrains in many areas that don?t need it, and does not constrain areas that were significant to the crisis ? e.g., the GSEs and the Fed.? Imagine a simple proposal that would immediately force flexibility onto the economy: dividends are deductible, but interest payments (and preferred dividends) are not.? An easy way to lower leverage, and encourage flexible finance.

Also, they noted the possibility that the US Government would engage in financial repression, which would force people to invest in government securities on unfavorable terms.? Ugly stuff.

And as an aside, we met in the F. A. Hayek Auditorium.

5) Can Hayek be cool?? Perhaps, give the recent rap video.? I am not surprised that few neoclassical economists give Hayek any credit; he cuts against most of what they stand for, so why should they commit treason?

As for Glenn Beck, I get tired very quickly of the facile answers that appeal to the anger of the masses.? There are real problems, and we need to deal with them, but oversimplifying the problems will not get us to the solutions; it will only create a new set of problems.? I have no favor toward the Tea Party; they don?t stand for anything coherent.? I am not an Austrian economist, much as I like some of their ideas.? My ideas have been derived from my observation of how financial systems work over the last 25 years.

6) Following Austrian economics would be a huge improvement over what we usually do, though there is a problem.? Once you hit the bust, nothing works.? The Austrian view will be a ?big bang? and clean it up fast, but it will be a lot of sharp pain.? The virtue of Austrian Economics is that it would restrain the boom, and thus make it less likely that one faces the pains of the bust.? But there are no easy solutions in the bust.

Focus on the boom, not the bust.? Solve the boom, and the bust does not come.

7) It is common that many debt classes that have few defaults get an aura about the qualitative factors that forestall default.? Well, what of municipal finance?? Under stress, is it possible that the cultural factors that made default less likely might wither, and defaults cascade in likelihood?? Yes, I think that is possible, and I think that is why Buffett is lightening the boat on munis.

8 ) Solve the revolving door problem for the SEC?? Pay them more.? I get it, but are we really willing to pay market-based salaries for expertise?? I doubt it.? The government tends to be chintzy; penny wise and pound foolish.

But if you hired real experts, would the government be willing to set them free and let them corner real frauds?? That is the question.

9) Fannie and Freddie common stocks are on their way to zero.? Their NYSE delisting is just one more step in the road to total dissolution.? The simplest solution is to fold them into GNMA, and slim down the massive operations that don?t do much for the mortgage market.

10) The unequal signal problem exists with the banks that took TARP money.? We hear a lot about those that repay, but little about those that do not pay.? Well, here is an article about those who did not pay.

11) Evan Newmark is occasionally annoying, but often perceptive.? Should President Obama do what he does not want to do?? It couldn?t hurt; his allies on the far left are already disaffected. The question is whether he can be as dispassionate as Bill Clinton, and pursue a centrist course.? I don?t think he is capable of that, because he is too smart, and smart people, unless they moderate their idealism, don?t compromise well.

That?s all for now.

Morning Financials Update

Morning Financials Update

Posted on by David Merkel

Big Movers

Top 20 Financial Stock Movers
Company [ticker] News Price Move
Washington Mutual Inc [WAMUQ] Valuation-insensitive buyers on high volume and no news.

13%
Pacific Capital Bancorp NA [PCBC] Strong buying at the open leads the stock up on no news.

6%
Ashford Hospitality Trust Inc [AHT] No news materially driving the stock price

6%
First BanCorp/Puerto Rico [FBP] No news materially driving the stock price

4%
Radian Group Inc [RDN] No news materially driving the stock price

4%
EastGroup Properties Inc [EGP] Jim Cramer likes it for the yield.? Mentioned on Mad Money.

3%
Advance America Cash Advance C [AEA] No news materially driving the stock price

3%
LoopNet Inc [LOOP] No news materially driving the stock price

3%
Heartland Financial USA Inc [HTLF] No news materially driving the stock price

3%
China Real Estate Information? [CRIC] No news materially driving the stock price

3%
Move Inc [MOVE] Banxquote.com sues them for antitrust reasons.

2%
First Bancorp/Troy NC [FBNC] No news materially driving the stock price

2%
United America Indemnity Ltd [INDM] No news materially driving the stock price

2%
Enstar Group Ltd [ESGR] No news materially driving the stock price

-3%
New York Community Bancorp Inc [NYB] No news materially driving the stock price

-3%
Stewart Information Services C [STC] No news materially driving the stock price

-3%
Waddell & Reed Financial Inc [WDR] No news materially driving the stock price

-3%
Artio Global Investors Inc [ART] Dilution.? Issuing shares to buy back units from principals.

-4%
First American Financial Corp [FAF] Index investors sell off FAF as CLGX remains in the S&P 400.

-4%
Assured Guaranty Ltd [AGO] Determined sellers on light volume and no news.

-4%

Thoughts:

Group Price Movements for this Morning

Real Estate Mgmnt/Servic

1.2%

 Reinsurance

0.0%

 REITS-Health Care

-0.3%
Commercial Serv-Finance

1.1%

 Diversified Banking Inst

0.0%

 REITS-Storage

-0.3%
Finance-Consumer Loans

1.0%

 Multi-line Insurance

0.0%

 Commer Banks-Western US

-0.3%
Insurance Brokers

0.7%

 Exchanges

0.0%

 S&L/Thrifts-Central US

-0.4%
Life/Health Insurance

0.7%

 Property/Casualty Ins

0.0%

 Commer Banks-Central US

-0.5%
Other

0.5%

 Fiduciary Banks

-0.1%

 Invest Mgmnt/Advis Serv

-0.5%
Retail-Pawn Shops

0.4%

 REITS-Hotels

-0.1%

 REITS-Diversified

-0.5%
Real Estate Oper/Develop

0.4%

 Commer Banks-Eastern US

-0.1%

 REITS-Single Tenant

-0.5%
Finance-Invest Bnkr/Brkr

0.4%

 Grand Total

-0.1%

 Finance-Credit Card

-0.5%
REITS-Mortgage

0.4%

 REITS-Office Property

-0.1%

 S&L/Thrifts-Eastern US

-0.7%
REITS-Regional Malls

0.1%

 REITS-Forestry

-0.1%

 Finance-Auto Loans

-0.7%
Commer Banks Non-US

0.1%

 REITS-Warehouse/Industr

-0.1%

 Super-Regional Banks-US

-1.0%
REITS-Apartments

0.1%

 REITS-Shopping Centers

-0.2%

 Financial Guarantee Ins

-1.1%
S&L/Thrifts-Western US

0.1%

 Commer Banks-Southern US

-0.2%

 GSEs

-2.3%

I look at these companies for big news events that have occurred since the last close.? Often there isn?t any, but big changes here can be an indication that someone knows something, or there is trading noise.? After that, it is up to the analyst to dig.? Often, the dog that does not bark is the clue, as stocks move up or down on no news, as well as unexplained large spikes in volume, CDS spreads, and implied volatility of options.

Note: If I use the phrase ?better seller,? it does not mean ?sell.?? If I use the phrase ?better buyer,? it does not mean ?buy.?? ?Better seller? and ?better buyer? are bond portfolio manager terms that simply mean that if I were forced to take action on a security, what would I do as a trader in the short run, given the current news.

Disclosure: long ALL NWLI SAFT RGA AIZ PRE CB

Place Political Limits on Overly Compliant Central Banks

Place Political Limits on Overly Compliant Central Banks

Posted on by David Merkel

In theory I agree that Central Banks should be free from political influence.? In practice, I don’t.? Why?? Central Banks regularly cave into political influence.? They are quick to loosen, and slow to tighten.? They are happy to let asset bubbles develop, because that is not what they are employed to handle.

The truth is, the arguments of Ben Bernanke are a joke (here too).? When Central Banks felt no pressure, they happily went along with what the politicians wanted.? No one wanted a strict central bank.? Thus for all of the Greenspan/Bernanke era, asking to be free from political control is just a show.? They want to agree with the politicians, who want easy credit.? They don’t want rules that would lead to a better economy in the long run, where their political friends get harmed.

Here’s a simple rule, that if put into place, would reduce volatility considerably: if the 3-month T-bill yield is more than 2% lower than the 10-year T-note yield, tighten.? If the 3-month T-bill yield is more than 1% higher than the 10-year T-note yield, loosen.? When in doubt, set Fed funds rate such that the gap between the 10-year and 3-month T-bill to 0.5%.? It’s that simple.? We don’t need grotesque yield curve shapes to guide the economy; we do need to limit? the amount of excess liquidity in loosening, lest we get asset bubbles.

This would all be easier to handle if the Fed had been clean during the boom.? They were anything but clean, loosening too soon, tightening too late, and being lax in regulating underwriting.? (Note: what miscreants has the Fed fired due to incompetence?? If they fired no one, then the incompetence goes to the top, and the entire Board of Governors should be cashiered.? And if they are not cashiered, let us move on to the politicians who hide behind the Fed and eliminate them.? Perhaps we should adopt a rule of our own: if incumbent, then vote him down.)

The Federal Reserve has not shown that it is worthy of retaining the freedom that it thinks it has.? Please let them show me instances where they did something bold, and received political criticism.? No, they have not done so.? They are slaves to the existing system, and will not speak truth to power.? They cravenly demand freedom, while they love their bondage to the political establishment.

My view is this: scrap the Fed.? Since we are not ready for a commodity standard as a nation, put into place a new Fed.? Fire all of the economists.? Let the new Fed adopt my neo-Wicksellian rules, which are a lot more flexible than Friedman’s baseless dogma, and more market-based.? Here are the rules again:

  • If the 3-month T-bill yield is more than 2% lower than the 10-year T-note yield, tighten Fed funds.
  • If the 3-month T-bill yield is more than 1% higher than the 10-year T-note yield, loosen Fed funds.
  • When in doubt, set Fed funds rate such that the gap between the 10-year and 3-month T-bill to 0.5%.

The Fed does not need a big staff to pull all of this off.? They could get by with a core staff of a few hundred, and however many are needed to do bank underwriting supervision.? Also, the Fed should disclaim responsibility for the economy, and simply focus on price stability.? No more bailouts.? If a bailout should be done, let Congress pass it, that they might be praised or judged for their wisdom once every two years.

The Fed led us into this mess.? That they ask to lead us out is a rude joke.? Please, let us get a totally new cast of characters at the Fed, or eliminate it and replace it with a commodity standard or a currency board.? This Keynesian stuff is killing us slowly, and leading to an eventual US sovereign crisis, which will lead most of the world into a deep recession, if not a depression.

Two Experiments

Two Experiments

Posted on by David Merkel
fed's balance sheet
fed's balance sheet

The image above is borrowed from this blog post at The Wall Street Journal.? Here’s my main point: the Fed is not succeeding in reducing the size of their balance sheet.? They are happily letting it grow, buying more mortgage backed securities, more than are paying off or defaulting.?? The Fed’s balance sheet is now at a record size.

I have argued in the past that the Fed is not likely to remove stimulus prematurely.? We have the bad providence that Ben Bernanke is Fed Chairman, and has the wrong view of the Great Depression, and also the wrong view of monetary policy.? He will leave rates low for too long, and buy long duration assets for the Fed, and be reluctant to sell them.

In absence of a commodity standard (which would be a very good thing), monetary policy should act to preempt high growth in debt.? If debt across the economy is growing at more than twice GDP growth rates that is a time to raise rates, and make it hard to borrow.? I realize at a time like now, this makes no sense, but had we adopted it in the 70s or 80s we would not have the present crisis.

In a fiat money/credit world, evil as it is, monetary policy is credit policy.? The issues become clear at the bust, but the prescriptions work best before the boom starts.

The Fed always delays trouble in the modern era.? Slow to tighten, quick to loosen.? No wonder that we built up a mountain of debt, because the Fed would always ride to the rescue of crises, but never let the pain settle in that would liquidate poor investments.

We need fewer banks, fewer homebuilders, and fewer auto companies.? But guess what we bailed out?? We bailed out the very things that were the least productive in our economy, and taxed those more productive to do so.? Monstrously dumb.

So when the market corrects because there has been no effective change in economic policy that would allow for elimination of bad debts, and shrinkage of bloated industries, we should not be surprised.? Government stimulus can only do so much.? The markets incorporate the stimulus, and they move on.? Those stimulated gain, and taxpayers/moneyholders lose, but the markets move on.

In the two-dimensional Fed where they offer credit to banks, and buy long assets as well, the Fed can’t be considered to be tight when the Fed funds rate is under 1/4%, and they are still sucking in long duration paper.? The Fed is engaged in an operation to support asset prices, which may fail when goods prices begin to show some life, regardless of whether the CPI agrees or not.

Monetary policy needs an anchor like gold, and people need to stop looking to the government for prosperity; the government can do little to achieve prosperity, aside from laying down a consistent set of rules.? Prosperity is in the hands of the culture, and productive cultures that take on little debt will tend to be prosperous.

And Now For Something Slightly Different

While I’m on the topic of monetary policy, what if the money markets are beginning to run ahead of the Fed?? Look at this:

Money markets rising?
Money markets rising?

There are 3 components to the Treasury-Eurodollar [TED] spread:

  1. The orange line is the LIBOR slope: 3 month US Dollar [USD] LIBOR minus overnight USD LIBOR.? LIBOR is a rate that banks will supposedly lend to each other at unsecured for short amounts of time.? As the LIBOR slope gets higher, banks are less willing to lend to each other.
  2. The yellow line is the Overnight LIBOR gap: it is overnight USD LIBOR minus the Fed funds target.? This measures how much banks need overnight money through sources outside of Fed Funds.
  3. The green line is called the Fed spread: it is the Fed funds target minus 3 month T-bills.? It measures how tight Fed policy is versus the ability of the US government to fund itself on the short end.

Now the current move is small, so far.? Banks are showing slightly more need for funding versus Fed funds, and since the crisis in the Eurozone intensified, the costs of borrowing longer in the Eurodollar market have risen.? But there isn’t the grab for safety, when T-bills go to zero, at least, not yet.? And contrast the last year with the last five years:

money markets panic
money markets panic

Panics aren’t pretty. They also start small.? I’m not saying that this must turn into a money markets panic, but only that it is possible.? There is a budding distrust in the Eurodollar lending markets, and that could spill into the short term lending markets in the US, though the effect should be less than in the Eurozone, where distrust is building across national borders.? Many banks implicitly say, “Better to have assurance regarding getting our money back if we need it, than be at the mercy of another nation’s laws.? Who knows if this grand experiment of the EU and the Euro will really last?”

Two Experiments

The Euro is an experiment, but so is unbacked paper money.? Both are undergoing a lot of stress at present; it will be interesting to see if either survives.

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