1) After reading a piece on Falkenblog yesterday, I decided to add up all of the profits from Fannie and Freddie over the last 20 years.  Ready for how much they made?  Ta-da!  They lost $114 billion.

When writing at RealMoney, I was always skeptical of the GSEs, and felt that they were too lightly reserved, because eventually they would run into a situation where real estate prices would fall.

2) Bruce Krasting comments on the solvency of the FHA.  I comment:

“I’ve argued that FHA would go negative for some time. Even the FDIC is engaged in a bit of chicanery by fronting future premiums forward to avoid borrowing from the Treasury.

We may avoid a banking crisis — at the cost of a sovereign crisis.”

3) I probably have a longer post coming on the paradox of thrift, that bogus concept that Keynes put forth.  But Paul Kedrosky crystallized it for me when he posted this.  And so I wrote:

The problem with the “paradox of thrift” is that it assumes there is only one way to save. Same for the “paradox of toil.” It assumes that all work is interchangeable and uniform.

The aggregation of all saving and all labor is necessary to make these models work mathematically, but isn’t valid in real life.

Yes, if everyone tries to do the same thing, stupid things happen, like bubbles from overinvesting. If there only a fixed possible number of tasks, and people work longer hours, it takes fewer people to do them.

But there are many opportunities, including ones that we don’t presently know about. Businesses that no one could imagine before the crisis can spring out of hard times.

This paper oversimplifies the economy. If the economy were that simple, he would be right. But the economy is not that simple.

4) I don’t know if the Volcker Rule will be eliminated or not, but I do know that the same ends could be achieved through changes in the risk-based capital formulas.  What I wrote:

The same ends of the Volcker Rule can be accomplished through adjusting the risk-based capital formulas — Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

For another off-the-wall idea: ban interstate banking, and let the states rule all depositary institutions. Results: No more too big to fail, and you get back “scaredy cat” regulators who don’t let banks deal in anything they don’t understand, which isn’t much.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing — that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

But Life and P&C insurers survive the process because of RBC, and “scaredy cat” state regulators. What a great system, which prior to the crisis, was criticized as behind the times.

PS — if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.

5) Is the stock market overvalued?  Probably, but consider this article here.  I wrote:

truth, P/Es are best related to corporate yields, not deposit rates or government bonds. And, you have to flip them to be E/Ps. Current E/P on the S&P 500 is 5.4%. A dividend yield of 2.05% is 38% which is close to the long run average.

The longest corporate series that I have is the Moody’s Baa series — because of the growth inherent in stocks, for bonds to be the better deal versus stocks, Baa bonds need a 3.9% premium over the earnings yield, or a yield of 9.3% in the present environment.

So, I’ll take it back, because the present Baa yield 6.45% augurs in favor of stocks versus bonds. Not crazy about bonds in this environment — few categories offer good risk-adjusted yields. Now, maybe both are overvalued vs. commodities, but that one I don’t know.

6) Perhaps the phrase “Greek Banking System” will be a cuss word someday.  Fitch recently gave them a downgrade, and I wrote:

Rating agencies exist to be scapegoats. When they are proactive (yes there have been eras where they have been proactive) the bond buyers scream — “Ratings are supposed to be good over a full market cycle!” When they are reactive, which is most of the time, they get accused of being coincident indicators.

They can’t win, which is why institutional investors ignore the ratings, aside from the capital charges that they force, and instead, read what the rating agency analysts write. The true opinion is in the writing, not the rating.

7)  Barry comments on how Goldman Sachs bags clients.  Truth, almost all investment banks bag clients, selling complex products that they understand better than their clients do.  My comment:

I always advise retail investors not to buy structured notes — Wall Street offers an above-average yield, and has the buyer sell short some expensive option. You lose more in capital losses than you gain in interest on average.

This isn’t any different. It just that bigger players that should have known better are getting hosed.

There is no better defense than “buyer beware,” and “Don’t buy what someone else wants to sell you. Buy what you want to buy.”

Unless we want radical revisions to contract law, you are your own best defender.

8 ) One story with more sizzle than substance is put-backs, at least as far as it affects homeowners.  It was featured by Barron’s and picked up in a piece by Barry.  Investors that purchase a mortgage or any o=ther sort of loan have a limited window of time to give the mortgage back to those that they bought it from for full value.  My comment:

This seems to be useful for investors, but not for homeowners. Reps and Warranties claims can be enforced by investors that bought loans through securitizations. It does not help homeowners.

9) Jeff Matthews wrote a piece that was a little critical of splitting the “B” shares and Buffett’s logic on the Burlington Northern acquisition.  My comment:

I don’t always agree with Warren Buffett, but I do agree here. Index investors are passive investors. Individually, they are dumb. As a group they are smart, because they lower their investment costs.

Warren is also correct on Burlington Northern — it should be like his utilities, and throw off a growing inflation-protected return over time, allowing him to earn a spread over his cost of funds (negative) that his insurance enterprises generate.

He is still a bright man after all these years.

PS — I am a Calvinist Christian; the question asked regarding Jesus is not relevant to the short-term running of Berky, but is relevant to an Christian investor who cares about the ethics of the organization. Also, it is relevant to the long-term well-being of Mr. Buffett. The rest of us will have to face the results of that question one day as well.

10) The Developments blog at the WSJ hides in the shadow of better known blogs, but often puts up some really good pieces.  They recently did a piece on whether it is better to buy a home now or wait a while.  My comment:

This post was prompted by Barry’s article Credit Rating Firms: Worthless in a Bull market, Damaging in a Bear Markets.

When I was a bond manager, we had a rule for our analysts — ignore the rating, but read the write-up.  The analysts at the rating agencies would give their true opinion in the write-up.  The buy side analysts usually found themselves in agreement with what was written, and would tell us what they thought the rating really should be.

After that, the portfolio managers were encouraged to ignore the rating, except to calculate the yield haircut for the incremental capital employed.  Those doing structured products developed their own models for benchmarking the risks of deals, ignoring the ratings, but reading the reports, because there was often really good information on the weak points of deals, including things not mentioned in the prospectus.

As managers, we knew we could always find seemingly cheap bonds for a given rating, but they were “cheap for a reason.”  We would avoid them.  Who would buy them?  Collateralized Debt Obligations [CDOs].  In CDOs were run by mechanical rules that relied on the ratings of the debts, among other things.

As such, they tended to fail.  After seeing the debacle 1999-2002 in CDOs, most insurers swore off CDOs — aside from AIG.  They were structurally weak securities with lousy collateral.

-==-=–=-==-=–=-=

The rating agencies have a hard task.  In the old days, they said that ratings were good for a full credit cycle.  Bond managers wanted stable ratings, and didn’t want to be bothered with ratings that were higher in the boom, and lower in the bust.

In 2001, after Enron, the rating agencies took several actions to be more proactive about ratings.  Result: a lot of ratings moved down rapidly, led to a collective screech from bond managers.  Result 2: the rating agencies stopped being proactive.

Barry is mostly right that in a bull market, ratings are worthless, and in a bear market, you don’t need them.  But they do have uses:

1)  Many bonds have no one analyzing them — particularly small deals.  A rating helps create a buyer base.

2)  The bread-and-butter corporate ratings are usually pretty accurate.

3) They summarize a lot of useful data in a small space.

4) What the analysts write is usually pretty good.  They are reasonably good at ranking credits within a given class against one another.

The corruption occurred higher up in the firms, because they mis-set the ratings for categories as a whole.  CDOs too high, subprime CDOs way too high, Munis too low, CPDOs ridiculous etc.  Part of the problem is inadequate thinking and risk aversion about new asset classes, because they don’t have loss data for assets that have been bought to securitize.

I’ve written too much, but I will give you one more key lesson of the period 1990-2008 regarding ratings, and this applies to sovereign issues today: Ratings that must be maintained in order to avoid a given result are dangerous, and good bond managers avoid investing in such bonds.

Examples:

1)  Insurers that made their Guaranteed Investment Contracts [GICs] putable on ratings downgrades.  (Fixed rate failure early 90s [Mutual Benefit], floating rate late 90s.  [General American / ARM Financial])

2) Enron-like structures that would force issuance of preferred stock on a downgrade (and some other triggers)

3) Reinsurance treaties callable on a downgrade.

4) Swap counterparty agreements requiring more capital on a downgrade.

5) Step-up bonds, where more interest is paid after a downgrade — not worth it…

It is perverse to want more out of a company when they are downgraded — often it leads to a collapse.  As a bondholder, it does not pay to stand near cliffs where a downgrade can change the creditworthiness of a company.

Sovereign governments are the same way.  You can’t make them pay; the only big penalty is getting shut out of the bond market — which means that in the future, their budget would have to be balanced on a cash basis.  So, I offer one simple insight on sovereign risk — I suspect that sovereigns default when the interest payments are more than structural budget deficit.  At that point, it would pay for a government to default.  Of course, this would have to be a situation where the structural budget deficit is high, and there is little hope of bringing it down politically.

Now one could just print their way out of the situation, and hand fresh currency to creditors — but at a cost of high interest rates and inflation, which could crush economic activity in real terms.  Partially inflating to do it, and borrowing to make interest payments would face a similar hurdle, because the borrowing would likely be at higher rates due to inflation.

But States of the US, municipalities whose States don’t allow them to file for Chapter 9, members of the EU, and other Semi-Sovereign credits that don’t have access to a printing press have it tougher, but I think the same test applies.  If the structural budget deficit is high, but less than interest payments, the odds of a default rise considerably, because if they cease paying the interest, the budget is balanced.  Being shut out of the bond market does not matter at that point.

Now, there are still costs to defaulting.  Rare would it be for a government to stop being profligate after a default.  They would need the bond market back at some point, and then the negotiation over past debts would begin.  There would also be seizures of assets abroad.  There might even be economic sanctions.  If the defaulting nation is big enough, it could cause some bank failures, leading to a broader set of crises.  At some level of crisis, war is not impossible, improbable as that may be.

-=-==–==–=-=-=-=-=-=-=-=-=-=-=-=-=-=-=

Coming back full circle, I am reminded that corporate credits don’t typically default because they can’t refinance, they typically default because they can’t make the interest payment.  My opinion is that it is the same for sovereign debts, except that is more sturm und drang around it because of currency, political, and solvency of financial institutions issues.

So, what would be a good next step?  Create a table of Sovereign and Semi-sovereign debtors, estimate their structural budget deficits and their interest payments.  My question: has anyone done this already?  Is there a good place to look where the data is summarized?  Let me know any ideas in the comments, and thanks.

Debt levels in an economy matter.  They matter a lot.  An economy that is financed primarily by debt can be like a chain of dominoes.  If one fixed claim fails, and it is large enough, many other fixed claims that rely on the first claim could fail as well, triggering a chain of failures.  This is a reason why a fiat-money credit-based economy must limit leverage particularly in financial institutions.

Why financial institutions?  They borrow and lend.  They also lend to other financial institutions.  A  big move in the value of some assets can make many banks insolvent, and perhaps banks that lent to other banks.  The banks should have equity bases more than sufficient to absorb losses at a 99% probability level.  That means that leverage should be a lot lower than it is now.

Economies are more stable when they limit fixed claims and encourage financing via equity rather than debt.  Imagine what the economy would be like if interest was not deductible from taxable income, but dividends were deductible.

• People would save money to buy homes, and would put more money down when they borrowed.
• Corporations would lower their debt-to-equity ratios, and would pay more dividends.
• Fewer people and corporations would go broke.

Pretty good, but in the short run, the economy would probably grow slower.  The debt bonanza from 1984-2006 pushed our economy to grow faster than it should have, where people and firms took more chances by borrowing more, and making the overall economy less resilient.  Debt-based economies lose resilience.

What was worse, the Federal Reserve in the Greenspan and Bernanke years facilitated the debt increases because the Fed never took away the stimulus fast enough, and offered stimulus too rapidly.  This led to a culture of unbridled debt and risk-taking.  If only:

• Greenspan had been silent when the crash hit in October 1987.
• Greenspan had not given into political pressure in late 1990, where he set up a process of cutting interest rates too much.
• Greenspan had not cut rates in 1995.
• Greenspan had not cut rates during the LTCM crisis.
• Greenspan would have cut far less 2000-2002.
• Instead of tightening 1/4% at a time 2004-6 , they would have raised the rate far more rapidly, completing the rise in one year.
• Bernanke would not have let the fed funds rate go to zero, but would have limited fed funds to never go lower than 1% below the ten-year Treasury yield.  We never need more than that to stimulate, but some patience is necessary.

What’s that you say?  The economy would have grown more slowly?  Right, and the economy should have grown more slowly, rather than gunning the engine through the overaccumulation of debt.  As it is, the economy will grow more slowly for some time a la Japan, until we delever the economy enough that it can once again grow without stimulus.

The economy is at a fork in the road.  Do we:

• Leave rates low and leave quantitative easing in until price inflation unfolds?
• Let rates rise gradually and drain quantitative easing slowly?
• Raise rates significantly and drain quantitative easing rapidly?

The third view is off the table.  No one wants to see any failure.  Bad decisions of the past must be grown out of, even if it takes a long time of subpar growth to do that.

When Eastern Europe left the Soviet orbit, the countries that did the best were the ones that freed their economies most rapidly.  Well, not in the short-run.  Letting companies fail is always a drag in the short run, but in the longer-run it leads to faster growth, because bad investments fail, and are replaced by better investments.

The same is true with monetary policy.  The US grew faster during periods where failures were reconciled and liquidated, rather than attempting to smooth the economic cycle — leading to fewer failures in the short run, much but bigger failures when the amount of debt became too large.

Before the crisis, when I was writing at RealMoney.com, I usually encouraged taking the less risky macroeconomic route, suggesting policies that would not increase debt levels.  The trouble was, that all of those ideas were losers in the short-run, and so they were not followed.  In the long run we are all dead, leaving the failures of short-run policies to our kids.

Personally, I would raise the Fed funds rate to 2% immediately, and let it shadow the 10-year rate less 1% thereafter.  But no one likes jolts, except when the Fed is loosening.  After that, I would rather the Fed allow inflation to raise collateral values and end the home and commercial mortgage crises.  But no, what we are likely to get is a Japan-style muddle-in-the-middle where they struggle with a slow raising of rates, and a slow end to quantitative easing, with a premature giving in when the economy has a negative burp before the removal of policy accommodation is complete.  I expect us to move in the direction of Japan.

What may change the story are sovereign defaults as government debt levels get too high.  In the short run, that may favor the dollar — it won’t fail rapidly.  But perhaps the euro might fail.  Even the yen might.  The era we are in is like the mid-1800s, when nations were constrained by their debt levels.

From the recent book “This Time is Different,” we know that countries with high debt levels grow more slowly, and defaul more frequently.  Ignore anyone who tells you that debt levels don’t matter.

Before I begin, I want to tell all of my friends in Japan that I have a great love for their country.  I have not traveled much, but if I were to travel abroad, Japan would be my first choice.  Plus, I have many friends in Kobe, Japan.

Japan is at the leading edge of the demographic wave where many developed countries have a shrinking population.  But beyond that, Japan has high government budget deficits and a very high government debt.  Consider this graph from Bill Gross’ latest missive:

Japan is in the awkward spot of having high government debt, though much is internally funded, and is still running high government budget deficits.

What a mess.  I happened across a blog I had never seen before today, and it gave a simple formula for when government debts would tend to become unsustainable.  It was analyzing Greece, but I looked at it and said to myself: “What about Japan?”

The main upshot of the equation in the article about Greece is that you don’t want the rate your government finances at to get above the rate of GDP growth.  If so, your debt will increase as a fraction of GDP, even if your deficits drop to zero.

So, what about Japan?  Can we say two lost decades?

Oooch! 0.2%/yr average growth of nominal GDP?!  That stinks.  But here is what is worse.  The Japanese government  finances itself at an average  rate of 0.6%.  The debt is walking backward on them unless GDP growth improves.  No wonder S&P has put Japan on negative outlook.

Japanese interest rates could rise.  Like the US. Japan has an average debt maturity around 5.5 years.  Unlike the US, 23% of its debt reprices every year, which makes them more vulnerable to a run on their creditworthiness.

Here are three more links on the Pimco piece, before I move on:

• An eye-catching quote…
• “UK gilts resting on a bed of nitroglycerine”
• Gross on Gilts: ‘On a Bed of Nitroglycerine’

We can think of central banks as equivalent to a margin desk inside an investment bank in the present situation.  Though I can’t find the data on the web, what I remember from the scandal at Salomon Brothers that led Buffett to take control, there was a brief loss of confidence that led the investment banks margin desk to raise the internal borrowing rate by 3-4% or so. Within a day or so, the trades expected to be less profitable of Salomon were liquidated, and Salomon had more than enough liquidity to meet demands.

But this is the opposite situation: what if the margin desk were to drop the internal lending rate to near zero?  Risk control would be hard to do.  Lines of business and people get used to used to cheap financing fast.  If it were just one firm that had the cheap finance, say, they sold a huge batch of structured notes to some unaware parties, it would be one thing, because after the easy money was used up, the margin rate would revert to normal, and so would business activities.

But let’s expand the paradigm, and think of the Central Bank as a margin desk for the nation as a whole.  Pre-2008, before the Fed moved to less orthodox money market policies, this would have been a more difficult claim to make, but the claim could still be made.

Pre-2008, the Fed controlled only the short end of the yield curve, which, with time, is a pretty powerful tool for making the economy rise and fall.  Short, high-quality interest rates move virtually in tandem with the Fed funds rate, but during good times, with the Fed funds rate falling, economic players seek to clip interest spreads off of longer and lower quality fixed claims, causing their interest rates to fall as well, with an uncertain timing, but it eventually happens.

And when Fed funds are rising, the opposite happens — funding rates for those clipping interest spreads rise, and the expectation of further rises gets built in, leading some to exit their trades into longer and riskier debts, which makes those yields rise as well, with uncertain timing, but eventually it happens.

I like to say that every tightening cycle ends with a crisis.  Let’s see it from an old RealMoney CC post:

		David Merkel
		Gradualism
		1/31/2006 1:38 PM EST

One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

Or, these two posts, which you can look at if you want… one suggested that housing was the next bubble (in 2004), and the other critiqued Bernanke’s reasoning on monetary policy.  (Aaron Task has an interesting rejoinder to the latter of these.)

Things are a little different now, because the Fed is not limited to the Fed funds rate any more.  They have a wider array of tools, and the Treasury is in the act as well through the TLG program.  The Fed owns over $1.5 Trillion of longer dated debts, mostly residential MBS.  The Fed as the margin desk has itself become involved in clipping interest spreads, using its cheap short-term funding to buy longer dated paper, directly forcing long rates down.  The Fed may innovate in other ways as well, offering/receiving term financing as well as overnight financing via Fed funds.

But, here’s the rub.  If the Fed brings the margin rate down to near zero and leaves it there, while actively creating expectations that it will stay there “for a considerable period,” and does so in a lesser way for long-dated paper as well, it can manufacture lower interests rates seemingly everywhere for a time.  It’s amazing how fast bond managers can shift from fear to yield lust.  (I leave aside the effects of foreign players for now.)

But as I pointed out in my visit to the US Treasury, you can change the financing rate, but the underlying cash flows don’t change.  The margin desk drops the financing rate, and prior good trades look better, marginal trades look doable, but there are investments that are still losers at a discount rate of zero.  No way to help those.

So what happens when the next crisis arises?  It could be commercial real estate, inflation, a war, a sovereign default (e.g., Greece, Japan, UK, Italy), another wave of corporate defaults, or, a very weak economy, with banks that are willing to clip spreads, but not take any significant financing risks.

Back to Japan.  Two lost decades.  Debt walking backwards on them.  All of the Keynesian remedies they applied.  Government spending and deficits ultrahigh.  Interest rates ultralow.  Start with a government with little debt; end with a government that is the most indebted among developed nations.

This developed world in Bill Gross’s “ring of fire” is pursuing the same strategies that Japan did over the last two decades.  They should expect the same results, until sovereign defaults begin.  Then the game will change — mercantilists like China will see their strategies blow up, and the nations that default will see their living standards decline.

This has gotten too long, but one thing that I will try over the next few days is estimate Nominal GDP growth rates for nations in the “ring of fire,” and their Government’s financing rates.  If I find anything interesting, I will let you know.

Final note: Ben Franklin at the Constitutional convention in 1787 commented that the half-sun on Washington’s chair was a rising sun, not a setting sun.  Though my title plays on a name for Japan, all nations in this predicament may find that their sun is setting as well.  Unwillingness to take short run pain in trading leads to failure in trading — even so, it is the same for nations.

The first thing I do when a PR flack sends me a book is throw away their summary.  Unlike other reviewers, I read the books.  The publisher sent me this book, but I did not ask for it.

All that said, I thought Wealth, War & Wisdom was a great book, and I spent more time on it than I normally do for books of equivalent length.  Why?  It covered areas of history that I was not as aware of.

This book is really two books in one.  It is a book that covers the history of WWII in an eclectic and cursory way.  After that, it asks the harder question of how one can assure the preservation of wealth in a volatile world.  In a lesser way, I have talked about that recently.

Regarding the history of WWII, I came away with a greater appreciation of:

• The troubles Britain faced.
• The cruelty that the people in the nations overrun by Hitler and the Soviets faced.
• The compromises many nations made to have an easier time in the War.
• The courage that it took to oppose aggression in the face of initially bad odds.

One commonality between Germany and Japan was a lack of resources, and rather than produce and trade to get them, they chose conquest.

But the greater problem is how one preserves wealth over all contingencies.  The problem is almost insuperable.  Even as some wealthy people today are buying farmland, that was one strategy to preserve wealth in WWII.  Homely farms that were reasonably productive, but not ostentatious, were ideal to preserve wealth and lives.  Away from that, investing abroad was wise for the rich.  Also, commodities and TIPS, which did not exist then might preserve some wealth.  Gold and other precious items, if small could also preserve wealth, or at least life.

For those who live in the US today, we live in a special time and place.  We are free from the losses that come from aggression on our home soil.  We largely agree with one another, much as politicians may disagree on that point.  Americans are exceptional in so many ways, though not all of them are good.

Preserving wealth means owning productive land locally, and having flight capital abroad.  Away from that, Biggs counsels owning stocks because good times happen more often than they should.

I liked this book, more than many, and if you want to buy it, you can find it here: Wealth, War and Wisdom.

Full disclosure:  Publishers send me books.  I review some of them.  I try to review the best of them, but I promise the publishers nothing.  If you click on a link that leads you to Amazon through my website, and you buy something, I get a small commission.  My view is that you should buy what you want.  Don’t reward me for something that you don’t like.  Rather, enter Amazon through my website and buy what you want; it will cost you nothing more.

1) Inflate the size of my balance sheet by 2.5x over last year, all through borrowing at really low rates.

2) Increase my interest spreads by ~50% over last year.

means:

3) I only increased my profits by ~50% over last year??!    I would have thought that profits would have more than tripled.

Such is life for the Fed.  The crisis was a time that led me to write pieces like The Liquidity Monopoly, where the Fed, FDIC, and Treasury played favorites in the economy, and starved the portions of the economy not dominated by large firms, particularly with banks and autos.

My main point is that the Fed should have earned a lot more.  Where did it all go?  It will be interesting to see a detailed rendering of the Fed’s finances when this is done.  Did they realize losses on some of the assets that they bought?

My friend Peter Eavis of the Wall Street Journal agrees.  Or, read Felix, and then read the exchange between my two friends Alea and Kid Dynamite.  Alea knows more, but I like KD’s spirit.

The Fed has become more like the banks that it regulates.  They are taking on credit risk, duration risk, convexity risk, etc.  And being a government institution, they don’t have good incentives for knowing how to price risk.

So, when I see the Fed’s seniorage profits up only 50%, I am not impressed.  The Fed doesn’t mark to market, so we really don’t know the true performance.  Also, remember that seniorage profits are a hidden tax on savers, would earn a higher yield if the government provided less financing.

Part of why we end up in an economic funk is that we finance dud assets at favorable rates, so capital does not get redeployed to better uses.  Aside from that, cheap leverage creates a yield frenzy over healthy assets, so that they can become over-levered as well.  Examples are numerous:

• The corporate bond market continues to be on fire.
• Investors  including PIMCO, are flocking to European corporates, though generally only the stronger countries, not Greece, Italy, Ireland, Portugal or Spain.  (Note: PIMCO will exit the trade at a better time than most imitators.)
• Average people are willing to fund all of this as well, accepting low rates of return for the duration and credit risks that they take on.  If the Fed wanted people to bid up bond prices to unsustainable levels, they have succeeded.
• Finally, I suppose if one pours enough jet fuel on a soggy, rotten log, I suppose one could get it to burn.  If the prices of non-GSE mortgage debt are rising rapidly, to me, that means speculation is getting out of hand.  Financial leverage is even coming back to these markets.  As with junk bonds, the markets are subject to two risks — that the cheap financing disappears, or that the likelihood of defaults becomes more obvious.

To me it is no great achievement that the financial markets are doing well while the real economy is in the tank (Unemployment, Production).  That is the nature of what happens when credit is force-fed into an economy, even leaving aside the problems of cronyism.  There should be no optimism over the large profits realized by the Fed; it may defray our taxes, but on net, the policies have not helped create a healthier real economy.

1) Yield-seeking — it is alive and well.  Check out this article on pay-in-kind bonds.  With PIKs, one can be concerned with the return on the money, and the return of the money at the same time.  The history of returns on PIK bonds are such that you are usually better off putting the money under a mattress.

2) More yield-seeking — spreads on mortgage bonds over Treasuries are at a 17-year low, and as I measure it, and all-time low.  Investors have gone maniac for GSE insured mortgage bonds.

3) I am as close to neutral on PIMCO as anyone I know.  I have written articles explaining how they make money, which is different from the public pronouncements of Gross and McCulley.  The current missive of Gross impresses me as fair, recognizing the limits of the Federal Government and the Fed.  PIMCO is taking less risk, selling US and UK debt, and buying German debt.  This is conservative; they are giving up yield.

4) Bruce Krasting notes that the Social Security system paid out more in 2009 than it took in.  That event was not supposed to happen until 2016 or so.  Aside from that, he notes the negative COLA adjustment.  As for me, I look at this and say, “Whether it comes slower or faster, it will come.  Medicare and Social Security will destroy the Federal budget eventually, or will be scaled back to where those that were taxed complain about it.

5) If you want to consider a technical reason for rates being so low, consider all of the mutual fund buyers.  They have favored bonds.  This is a contrary sign for interest rates — they are headed higher.

6) Bernanke blames bank regulation so that he can absolve monetary policy.  Typical.  Blame what you control less, to absolve what you control directly.  A better and brighter economist (in my opinion), John Taylor disagrees.  He views the mid-decade low rate policies as contributing to the lending frenzy.  Don’t get me wrong.  Bank regulation was lousy, but monetary policy was lousier, helping to create the boom that now gives us the bust that normalizes things.

7) How amazing was the junk bond market?  Better, how amazing was the distressed debt market?  Oh my, though junk bonds paced equities, distressed debt did far better.  Such is the case when a turn happens; this one was forced by the US Government.

If you want to understand how finance reform gets blocked, read this article.  Better than most, it explains the intricacies of why the Democrats have a hard time passing the legislation that the radicals would like.

9) I am not a Buffett-lover or hater.  When I read his opposition to Kraft raising its bid, I said to myself, “Of course.  Don’t overpay.  Most deals are best avoided.”  Which is true — M&A is in general a value destroyer.

10) Personal bankruptcies are rising in the US.  It is a messy time.

11) Let the Chicago School of Economics die.  I have already argued for their demise.

12) The CMBS market is experiencing delinquencies that have not been seen before.  This is just another example of the difficulties many commercial mortgage loans are in.

13) Strip malls have high vacancy rates.

14) I appreciate Tyler Cowen’s article, suggesting that things are pretty good.  We should be glad that other places in the world did well, even if we did not do so well.

1) There is a new blog that I recommend: Macroeconomic Resilience.  I have commented there recently, and I think that he understands the complexity of markets in ways that most Ph. D. economists don’t.  Here is a recent post, and my comment.

http://www.macroresilience.com/2010/01/01/moral-hazard-a-wide-definition/comment-page-1/#comment-6

One job ago, at a hedge fund that was bearish on financials, we would talk about this all the time.  Regulators could have stopped the crisis in the early 2000s had they simply enforced lending standards.  The banks would have screamed and ROEs would have gone into the single digits, but the crisis could have been prevented.

But, regulators are to a degree subject to politicians.  Politicians, in the absence of any moral compass aside from re-election, are mainly beholden to those that fund their campaigns, when the electorate is without education, or a moral compass as well.  Thus, regulations were neutered.

After that, how many businessmen would watch out for the companies they served, instead of what would maximize their pay?  There were some bankers that did so and got shown the door.  There were other banks owned privately, were conservative, and missed the crisis.  It could be done, but the management team or owners had to deliberately sacrifice the short run in favor of missing an uncertain crisis.

Chuck Prince said something to the effect of “When the music is playing, you gotta get up and dance.” to justify doing business in the face of bad credit metrics.  Well, yes, in a place where no one cares for the long-run health of the firms, or of society as a whole.

Someone has to care for the long run.  Better it be free individuals rather than the government.  But if free individuals will not do it, eventually the government will.

2) I have been a fan of Michael Pettis for many years, from his publication of his book, The Volatility Machine.  Here is a comment that I posted at his blog, which I highly recommend:

http://mpettis.com/2010/01/china-new-year-and-one-more-vote-for-gdp-adjusted-bonds/

Michael, I ordinarily agree with you on almost everything economic, but I can’t agree on the trills. I believe in asset-liability matching, even at the government level. Try to match term risk and liquidity risk to what is being funded.

I have argued that the debt structure of the US government has been getting too short, and recommended that the US Treasury lengthen its funding policies — I even said that to the Treasury officials that I met with in November.

http://alephblog.com/2008/11/25/issuing-debt-for-as-long-as-our-republic-will-last/
http://alephblog.com/2009/11/04/my-visit-to-the-us-treasury-part-2/ (2 of 7)

But trills have exceedingly long duration — the remind me of some structured settlements that I have had to model, but these are perpetuities — even longer for the coupon to grow. Duration looks like it would be north of 40 — it depends on the assumptions used.

A perpetuity growing at GDP rates saddles our posterity with debts that they cannot bear. Cheap debt up front — really costly on the back end.

http://alephblog.com/2009/12/27/not-so-cheap-trills/

But, thanks ever so much for your blogging. I learn so much from you. Keep it up.

3)  Insurance for those dropping out of school?  Sounds really dumb:

http://blogs.wsj.com/economics/2009/12/31/would-insurance-for-college-failure-keep-more-students-enrolled/

This sounds like a product that only dumb insurers would write. Never write insurance where the insured has better knowledge and more control than the insurance company.

4) Many are crying over auction rate preferred securities.  But most of the assets that were harmed were owned by corporations, who had investment professionals that chose auction rate preferred securities because they yielded significantly more than money market funds, but with seemingly little risk, and the system worked for around 20 years.

They took above average risks, and now they expect to be bailed out?  I have read through many ARPS prospectuses.  For those that read them, the risks were clearly disclosed.  I do not have a lot of sympathy for those that did not do their job.

5) From the “bitter taste” zone, we learn that foreign investors in US debt lost the most versus investing in the debt of other developed nations in 2009.  Should that surprise us when demands for loans accelerated dramatically in 2009?  I don’t think so, and most reasonable analysts would agree.

As I roll through the day, i often make comments on the blogs and websites of others.  I suppose I could gang them up, and post them here only.  I don’t do that.  Other sites deserve good comments.  Today, though, I reprint them here, with a little more commentary.

1) First, I want to thank a commenter at my own blog, Ryan, who brought this article to my attention.  I’ve written about all of the issues he has, but he has integrated them better.  It is a long read at 74 pages, but in my opinion, if you have 90 minutes to burn, worth it.  I will be commenting on the ideas of this article in the future.

2) My commentary on Dr. Shiller’s idea on Trills drew positive attention, but the best part was being quoted at The Economist’s blog.

3) Tom Petruno at the LA Times Money & Company blog is underappreciated.  He writes well.  But when he wrote Fannie and Freddie shares soar, but for no good reason.  I wrote the following:

7) Then we have Evan Newmark, who is a real piece of work, and I mean that mostly positively.  His article:  My comment:

I have often thought that international macroeconomics boils down to looking at all of the big nations that have some degree of economic flexibility, and are willing to make non-economic decisions for political purposes.  They drive the excesses in the global economy through their actions.

It is not as if their actions have no cost, but that the cost is realized later.  They get to impose their will for a time, but eventually their non-economic actions catch up with them, impoverishing them, and set the stage for the next set of actors to abuse their power.

Tonight, I want to talk about China.  Bloomberg has a great piece up about Andy Xie, former Morgan Stanley economist who posits that China will head into inflation because of their monetary and fiscal policies.  If true, it is my opinion that a bursting of a China Bubble will decrease demand across the world.  The world depends on a China with increasing demands for all kinds of raw goods.

My view is that China is stretching itself too far economically.  The powers that be chose too fast of a growth path, and inflationary consequences will come, and spread to assets in China, as well as Western nations.

In the long run, there is no free lunch.  No country can permanently force the rest of the world to do their bidding, whether that is buying up debt, or buying goods or services.  Eventually the terms of trade change, and either value is delivered, or trade collapses after a default.

Be aware.  The global economy could shift down dramatically if China has to slow down its economy because if inflation.