Comments

• So they extend the period of accommodation by a little more than a year.  Sends financial markets flying, and especially TIPS prices, but will have little impact on the economy.  (Do they want the yield on 30 year TIPS to go negative?  Looks that way.)
• GDP growth is not improving much if at all, and the unemployment rate improvement comes more from discouraged workers.  Inflation has moderated, but whether it will stay that way is another question.
• In my opinion, I don’t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy finances itself.
• Also, the reinvestment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government, even with the recently announced refinancing changes.
• 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.
• The Fed is out of good policy tools, so it will use bad policy tools instead, and for longer than before.

Questions for Dr. Bernanke:

• Why do think extending the period of accommodation by a little more than a year will have any significant effect on the economy, aside from stock and bond prices?
• Is it possible that you don’t really know what would have worked to solve the Great Depression, and you are just committing an entirely new error that will result in a larger problem for us later?
• Discouraged workers are a large factor in the falling unemployment rate. Why do you think the economy is doing so well at present?
• Why do you think that holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy finances itself?
• Why will reinvestment in Agency MBS help the economy significantly?  Doesn’t that only help solvent borrowers on the low end of housing, who don’t really need the help?
• Couldn’t increased unemployment be structural, after all, there is a lot more competition from labor in emerging markets?
• Isn’t stagflation a possibility here?  I mean, no one expected it in the ‘70s either.
• Could we end up with another debt bubble from keeping short rates so low?
• If the Fed ever does shrink its balance sheet, what effect will it have on the banks?

Risk premiums should never be capitalized, they should only be taken into income as earned.

This may end up being another odd post of mine.  I’m going to start writing about bank regulation, but I will end up talking about monetary policy.

There are many people who hate the rating agencies. They hate them because they are a convenient target, and most people don’t understand what they do. Rating agencies provide opinions. Nothing more, nothing less.

Many people would like to get rid of the rating agencies. But it’s not that easy. Regulators outsource their credit rating function to the rating agencies because they don’t want to do that work.

There is a way to eliminate the rating agencies, and I have written about that before. But the idea is so radical, that the banks would rather have the rating agencies exist, than use my idea.

So what’s my idea? Simple. If you were setting up a portfolio, what would you assume would be the minimum that you could earn on the portfolio? My minimum would be buying Treasury bonds and earning interest on them.

So if I am looking at a portfolio of risky assets, I would split each asset into two. I would mirror the cash flow pattern of each asset, and construct an equivalent Treasury portfolio to mimic the cash flows. All of the cash flows above that amount from the risky asset are the risky cash flows. The amount of capital that banks hold as reserve against losses should be proportionate to the present value of risky cash flows.

Unlike my last piece on this, I am not saying that the whole present value of risky cash flows should be held as capital against losses. But the regulators should use this, if we are not using rating agencies, as a proxy for credit risk in bank asset portfolios.

Why is this a good measure of credit risk inside banks? The market for lending is fairly efficient. Debts that have more risk have higher interest rates.

This measure of risk benefits from the concept of simplicity. It can be applied everywhere. And, there is good theoretical justification for it. Any return that is upon the government bonds is subject to question.

But suppose we decided to use this as a major portion of our formula for regulating bank capital. What would happen to monetary policy?

Well, if the Fed tries to do something similar to “operation twist” it would require banks to hold more capital against their positions, because the safe interest rate falls, it causes the risky portion of each loan to rise. As such, any sort of “operation twist” would fail, because the rise in capital levels, would blunt any advantage from over Treasury interest rates.

From my vantage point, it would be a real plus to have monetary policy neutered in that way. The Fed, should it deserve to exist, should be concerned with the banking system and its solvency. It should not be concerned with the overall level of interest rates. If lowering interest rates lowers the judgment of solvency, then that would restrain the Fed from being too aggressive in lowering rates. And that would be good. The Fed has generally not succeeded with monetary policy. They have been too loose in the past, leading to the problems of the present.

And, as I have said before, we should not have unelected bureaucrats driving our economy, rather, we should have Congress do it because we can vote them out.

That’s all for now. Thanks for reading me. I appreciate all of my readers.

I’ve long admired ECRI for their timely and accurate forecasts, and their willingness to stick by their models when things don’t seem to be immediately going their way.  I have also appreciated their lack of willingness to divulge their model elements; my thoughts were, “Hey, it’s probably a simple model that no one has ever thought of.  Would I reveal the model if I were in their shoes.  No.”

But I’m not in their shoes, and I know one of the ECRI pair, so I asked for some insight into the models, which he coldly refused.  Okay, fair enough, I’m not a paying subscriber, but we had had good conversations in the past, so I thought I might have some relational capital, but no.

Tonight, I bring you my kludge that should be close to the ECRI Weekly leading index.  I am not saying that I reverse-engineered it because in econometrics there may be many fits with equal probability that explain the dependent variable well.  But here we go.

Yesterday, I read a post at the Bonddad Blog that said it had all of the variables for ECRI’s Weekly Leading Index.  I decided to gather the data, or reasonable proxies of it, and I ended up using the following variables to estimate the ECRI WLI:

1. M2 YOY % increase, SA
2. AAA yields from Moody’s
3. BAA yields from Moody’s
4. S&P 500 price YOY % increase
5. Initial Jobless Claims SA
6. Real Estate Loans from all Commercial Banks, SA YOY % increase
7. PPI for Industrial Commodities

I realized the the independent variables had to go up and down because the WLI does as well.  I normalized the variables against their long run averages, which would have no impact on the fit if the regression, but would enable sorting out the size effects.  Anyway here are the results:

That’s a really high R-squared (normalized F), with highly significant t-coefficients.  What is more, the coefficients sum to materially one in this regression that constrains the intercept to zero.

So, we have a good guess at what drives the ECRI WLI: two items, Corporate interest rates and industrial commodity prices.  The other items are significant, but less material.   BAA bond yields could be expressed as spreads against AAA yields, but the mathematical results would be the same.

So how does my model fit against the ECRI WLI:

If anything, my estimated model is more sensitive than ECRI’s model.  I could have a new business here, except that I have given the model away for free.

Comments are welcome.

The world is a maze of debt.  Debts layered on debts.

The Earth and its productivity is roughly the same or better than prior years.  What is the problem with the economy then?

The problem is this: there are entities that made bad loans in the past that expect to be paid back in full.  They assumed the future would be far better than it turned out to be.  There is no way that the loans will be paid back in full.  The solution is paying back at a discount, whether through compromise or insolvency.

Wait. Many of the lenders are leveraged as well, and can’t take significant losses.  Paying back at a discount will bankrupt a number of banks, which will in turn bollix the economy.

So, we have to go slow?  Does this bring us back to the problem of how one eats an elephant?  “One bite at a time.”  That is the method of Japan, leaving an over-indebted government, and reasonably indebted private sector.  But it took two decades.

Whether it is in the Euro-zone, China, or America, it would be better to let entities fail, and deal with the mess.  Yes, GDP will drop a lot, but it will rocket out of the troubles 2-3 years out, the way that Eastern Europe did post-Warsaw Pact.

Ending  the economic malaise means ending the debt overhang.  Where is the government, or set of governments willing to attack this and reduce debts economy-wide?  I know it is a tough prescription, but economies don’t work well when they are overindebted.

(Note: Nominal = Real + Inflation)

This article is meant to tie up some loose ends, and suggest the outline of what might be a clever way to do asset allocation.  Who knows?  At the end, there might be a surprise.

I’ve done two articles recently on the effects of inflation expectations and real interest rates on two asset classes in the short run — gold and stocks.  Tonight, I want to extend that two directions, to bonds and cash, and whether the effects aren’t different in the long run.

First, bonds in the short run.  Interest rates rise, bond prices fall.  Interest rates fall, bond prices rise.  Doesn’t matter whether that comes from real rates rising, or inflation.  That’s pretty simple, because most bonds are mostly interest-rate driven.

Second, cash in the short run.  Leaving aside financial repression, for the most part cash assets return in line with inflation.  Cash is simple… so what happens in the short run is also what happens in the long run.

Okay, now let’s lengthen the time horizon.  In the long run, gold keeps pace with inflation, nothing more, nothing less.  Bond returns rise if interest rates rise over the long term because of higher reinvestment rates for cash flow, and again, it doesn’t matter whether that comes from inflation or real rates.  Opposite if interest rates fall.

Think of 1979-82: by the time bond yields were nearing their peak levels, bond managers were making money in nominal terms with rates rising because the income from the coupons was so high, and it set up the tremendous rally in bonds that would last for ~30 years or so.

In that same era, stock multiples collapsed.  But eventually stock prices stopped going down even with competition from bond yields, because the earnings yields were so large that book values roared ahead, supporting prices.  That also set up the tremendous rally in stocks that would last for 18 years, until it finally overshot, giving us the present lost decade-plus.

But high rates, whether from inflation or real rates, presage high future bond and equity returns.

One nonlinearity here: in the intermediate-term, rises in real rates kill stocks, but rises in inflation nick stocks.  Why?  Inflation may improve nominal revenues at the same time that it raises the cost of capital, but rises in real rates indicate capital scarcity, raising the cost of capital with no increase in revenues.

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Harry Browne proposed a “permanent portfolio” back in 1981, composed of equal portions of cash, bonds, gold, and stocks.  Reading about the idea in Barron’s in the late 1980s, I did not think much of the idea.  I think differently now.  After my last few articles on related issues, mentioned above, I realize that each of the four asset classes react differently to macroeconomic stimuli in the short run, with a lot of overshooting.  A mean-reverting strategy has a lot of power in this context, and it is double-barreled, in that it lowers volatility and raises returns.

My clients will receive the full details on this as an asset allocation strategy, but my readers have enough from this that if you want to do a little work you can figure this all out yourselves.

All that said, I am surprised at how well the strategy works.  Too easy, and easy strategies rarely work.

Eddy Elfenbein wrote a good post recently on the stock market versus inflation expectations.  When I read it, I said to myself, “Wait, is the relationship between nominal and real rates really 1:1, or is it more complex?”  Though it is not certain, the regressions that I ran indicated that 1:1 was not falsified by the data.  The regression:

Inflation expectations determined the much of the value of the S&P 500 for the last nine years.

And you can see the relationship here as well:

The short answer is “yes, inflation expectations have driven stock valuations for the last nine years.”

I’ve been spending time on issues like this for a variety of reasons, and I’ll try to explain them in the near term, but that’s all for now.

There is little to no fanfare for the release of this report, (why do they release at such a distracted time of year, where people will ignore it?) which strips away a lot of the malarkey that the US Government delivers by providing data on an accrual basis, rather than on a cash basis, which is what the politicians argue about.  As a result, the politicians take actions that hurt the future in order to benefit the present.  If we viewed the national budget the way this report does, we would have had very different policies over the last 25 years.

As it is the report gives credit to Obamacare for lowering the costs of Medicare, as if a stroke of the law could reduce the medical needs of the elderly.  If it does decrease actual demands on Medicare, unlikely but good.  If not, we need to revise estimates up, as the alternative scenario on page 134 does. (PDF pg 156)  And perhaps more than that.

Here are the figures for the last three years:

The big shift was the passage of Obamacare, which was funded by a large cut to Medicare Parts A & B.  It’s not as if that law repealed the health care needs of the elderly, but only the rates at which doctors would be paid.  If the ultimate amounts to be paid by the government don’t shift, because we adjust the law & payments to meet undiminished need later, the 2011 Adjusted figures would be low by around $5 trillion.

The 2010 Adjusted figures attempt to strip out the distortions created by Obamacare.  The 2011 figures leave in the adjments from Obamacare, but reflect the Illustrative Alternative Scenario on page 133:

The Medicare Board of Trustees, in their annual report to Congress, references an alternative scenario to
illustrate the potential understatement of costs under current law. This alternative scenario assumes that the
productivity adjustments are gradually phased out over the 16 years starting in 2020 and that the physician fee
reductions are overridden. These examples were developed by management for illustrative purposes only; the
calculations have not been audited; and the examples do not attempt to portray likely or recommended future
outcomes. Thus, the illustrations are useful only as general indicators of the substantial impacts that could result from future legislation affecting the productivity adjustments and physician payments under Medicare and of the broad range of uncertainty associated with such impacts. The table below contains a comparison of the Medicare 75-year present values of income and expenditures under current law with those under the alternative scenario illustration.

Another factor in holding down the 2011 deficit was that measured inflation was low, there were no cost of living adjustments [COLAs], when assumptions expected 2.5% or so.  To the extent that COLAs remain low in future years, there will be further positive adjustments.

In closing, here are two graphs that display the net liabilities  of the US Government and the ratio of that to GDP:

next graph

To pay down liabilities like these would require the permanent allocation of an additional 8% of GDP.  Where would we find the will to do that?  I suspect as a result that we will see real decreases in Medicare benefits — things that won’t be eligible for payment.  Hospice care will be indicated at higher frequency when healing an old person would be costly.

So just be aware that something has to change, either taxes have to rise, or Medicare benefit levels have to fall.

When there is financial failure, it comes as a result of illiquidity.  Now, truly, these parties are insolvent, because they took the risk of not being able to pay cash when it was due.  Illiquidity and insolvency are really the same thing, though many obfuscate.

If you can’t pay cash, it doesn’t matter what your assets are worth in “normal” times.  Banks should have planned in advance to make sure liquidity was always adequate, rather than doing the usual borrow short, lend long, that they usually do.

But after reading through the Fed ‘s proposal on bank solvency, I conclude that they may not get the picture.  They spend time on liquidity and other issues.  With liquidity, it is uncertain how they will view repo markets.  To me, those should be view as short-term finance of long dated assets.

During times of crisis, repo markets seize up, with rising repo haircuts.  Maybe I’ve read the Fed’s proposal wrong, but it seems that it neglects repo funding, which had a large effect on the recent crisis.

If banks had to be able to size their activity to survive a rise in repo haircuts equal to half of the highest that we have seen, it would probably be enough to make the issue go away, because the haircuts would be less likely to rise as a result of that restraint.

Now, I appreciate the perspective of this article from Dealbreaker on the topic.  All of the assets of the bank support all of the liabilities. In one sense, there are no assets that are tagged “equity” and others tagged “liability.”

P&C Insurance works a little different.  In that, premium reserves are invested in high quality short-term debt.  Claim reserves are invested in high quality debt similar to the period that claims are expected to be paid out over.  The remainder (the equity) can be invested in risk assets in order to earn a decent return for shareholders.  The idea is this: match liabilities with high quality assets of the same length, and take risk with the remainder of assets, realizing that they might might needed for liquidity in the worst case scenarios.

But really, banks should not be viewed differently.  They should invest like P&C or life insurers.  Invest in high quality assets equal to the terms of their liabilities — deposits (estimate stickiness), savings accounts (same), CDs (the term is known).  After that, take risks with the remaining assets in ways that reflect their comparative advantage, realizing that they might might needed for liquidity in the worst case scenarios.  Illiquid investments (e.g. private equity)  should not be allowed for a majority of of those investments.

If banks don’t engage in asset/liability mismatches aka maturity transformation, most of the risks of bank runs will go away.  And that is what I propose.  Note that if that happens, average people will have to pay some fee each year to have a checking account.  Banks would be liquidity utilities.

This fits under my rubric that the insurance industry is much better regulated than the banking industry.  Were it in my power to do so, I would turn banking regulation over to the states, and leave to the Fed control of monetary policy only.  You would soon see intolerant banking regulation, much like we see in insurance, and defaults would decline.

What could be better?

What I write here will not be rigorous.  We’ve heard about “peak oil.”  We’ve heard about other resources, and how production will decline over time.

But what of credit? It isn’t that hard to create, but it is hard to create well, particularly when debt levels are high, as in this environment.

It’s not just the US, debtor-friendly as it has been for most of its existence.  Most of the rest of the world has debt problems.

China has indebted municipalities and banks, and debts to many projects from Party members that will not pay off.  The EU is  overly indebted everywhere, not just the PIIGS, and finds its overall borrowing rates rising as lenders wonder what a Euro will be worth if the Eurozone dies.

In the US, government debt rises more than corporate and consumer debt falls.  We’ll pay the government debt off later.  Don’t worry.

The simple solution to every problem is to say the it is a liquidity problem, not a solvency problem.  How do does one solve a liquidity problem?  Get a loan.  If the assets are really worth more than the liabilities, there should be some unencumbered assets that you can secure a loan with, and pay off the liquidity squeeze.  But absent that, it’s insolvency, regardless of what notional price one places on the assets.

But what if the problem is really a solvency problem?  Will a loan help cure that? No.  You can’t solve a debt problem with debt.

There are generally few liquidity problems relative to solvency problems.  As an example, most corporate bonds don’t default on principal payments, but on interest payments.  For individuals, balloon payments on loans might be relatively more of a problem, but since most people finance their homes, etc., on relatively thin ratios of income to debt service, interruptions of income lead to insolvency more often than balloon payments.

Consider for a moment that every liability is the asset of someone else, but not vice-versa, because some assets are owned free and clear.  Now pretend that we take everything in the world (the same could be applied to a nation), and put it on a single balance sheet, but we don’t net out the liabilities that would cancel out.

Which system would be more stable?  One where the liabilities are roughly equal to the net worth, or one where they are roughly five times the net worth?  The former, of course.  Now, not all liabilities are the same — long-dated claims like pensions only claim a little bit of the assets of the world at a time, whereas a large number of short-dated liabilities would make the system less stable, or perhaps lead to inflation.  Many dollars chasing few goods, or assets, or both.

I’m not sure exactly where the boundary line is for “peak credit.”  It would depend on the structure of the liabilities in question.  But once the fuzzy limits get exceeded:

• Growth can slow.  (Think of the book, “It’s Different This Time.”)
• Debt deflation may arrive. (Extend, Compromise, Default)
• Inflation may arrive for assets, goods, or both, depending on the propensity to save versus consume.
• And, if the debt gets high enough, and immediate enough, any entity may hit the “tipping point” where the market concludes that it is no longer possible for the entity to pay off its debts.  Short-term rates skyrocket, and the prices on long debt discount expected recovery levels.  For countries with their own currency, it may involve a lot of inflation, though a negotiation with creditors might be simpler.

In general, if we were starting over again, there are a lot of things that we should have done differently:

• Dividends would be deductible, and not interest.
• This would apply to all personal and corporate interest, including mortgages.
• We would eliminate the GSEs, and all government lending programs.
• We would run balanced budgets as a nation, and live with the modest volatility that induces.  We would not engage in fiscal stimulus.
• We would eliminate or constrain the Fed, such that it could never let the difference between ten and two year Treasury yields exceed 1.5%, or be less than -0.5%.  We would let recessions do their work of eliminating bad investments, because if you don’t, you end up with the debt deflation we are facing now.
• Or, go back to a gold standard, after analyzing what the proper value for the dollar would be, so as to avoid inflation or deflation.
• We would constrain banks to match assets and liabilities, and not engage in maturity transformation.

Banks would be a lot less profitable under such an arrangement, but it would prevent debt bubbles.  Besides, the banks would make up for it by charging for deposit/checking accounts.

Summary

We may be near “peak credit” at present, and that is true of much of the world.  Better we should have had a smaller financial sector, and avoided the financialization of the economy.  As it is, we face many years of slower growth ahead as we bleed debt out of the economy, or a number of years of inflation ahead, as we inflate away debts.  I suspect the former, but I can’t ignore the latter.

Comments

• The more I read the Fed statements, the more I think that they are paid to be Pollyannas.  The rose-colored glasses are glued to their faces.  There is never any criticism of their actions; blame always goes elsewhere.  They are similar to modern teenagers that lack talent, but have incredible self-esteem.
• GDP growth is not improving much if at all, and the unemployment rate improvement comes more from discouraged workers.  Inflation has not moderated significantly, either.
• They point to the risks coming from global financial markets.  The Fed is the lead regulator in the US of banks and SIFIs; if trouble abroad leads to trouble here, they have no one to blame but themselves.
• In my opinion, I don’t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located.
• Also, the reinvestment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government, even with the recently announced refinancing changes.
• 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.
• The Fed is out of good policy tools, so it will use bad policy tools instead.

Questions for Dr. Bernanke:

• Discouraged workers are a large factor in the falling unemployment rate. Why do you think the economy is doing so well at present?
• Why do you think that holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located?
• Why will reinvestment in Agency MBS help the economy significantly?  Doesn’t that only help solvent borrowers on the low end of housing, who don’t really need the help?
• Couldn’t increased unemployment be structural, after all, there is a lot more competition from labor in emerging markets?
• Isn’t stagflation a possibility here?  I mean, no one expected it in the ‘70s either.
• Could we end up with another debt bubble from keeping short rates so low?
• If the Fed ever does shrink its balance sheet, what effect will it have on the banks?
• Is it possible that you don’t really know what would have worked to solve the Great Depression, and you are just committing an entirely new error that will result in a larger problem for us later?