My piece on bank reform will have to delay until Monday evening.  I am still working on it.  Tonight’s piece is on entitlements and pensions globally and locally.

I asked recently if anyone had data on other countries of the world to analyze where other countries were in terms of debt plus unfunded liabilities as a percentage of GDP.  I got a few good suggestions, but then I stumbled across this article in the New York Times that provided the graph to the left.

The article is about Greece, but the graph covers all of Europe and the US.  I am not sure where the author got the 5x GDP estimate for the US, but I have e-mailed him.  My own estimate was 4x GDP.

Either way the US and the EU are more comparable than different by this measure.  They are both in the 4-5x GDP zone.  But the EU contains some real basket cases such as Poland, Greece, Slovakia, Slovenia, and Latvia.  Oddly, Spain looks good on this measure, and Ireland and Italy are better than the EU average.

Now, recognize that these figures are from 2004, so they could be worse by now — they are unlikely to be better.  Here is the original article from Jagadeesh Gokhale, the fellow who calculated the European figures at the Cato Institute.  Quoting from his paper:

No EU government has made the necessary investment. As an alternative, the next-best option is for these countries immediately to gradually but significantly increase saving and investment. In particular, the average EU country could fund its projected budget shortfall through the middle of this century if it put aside 8.3 percent of its GDP each and every year. Despite this adjustment, a budget shortfall is likely to emerge after 2050, requiring additional fiscal reforms.

What will happen if EU countries do not set aside these funds? Unless they reform their health and social welfare programs, they will have tomeet these unfunded obligations by increasing tax burdens as the larger benefit obligations come due. Although spending averages 40 percent of GDP today:

• By 2020, the average EU country will need to raise the tax rate to 55 percent of national income to pay promised benefits.
• By 2035, a tax rate of 57 percent will be required.
• By 2050, the average EU country will need more than 60 percent of its GDP to fulfill its obligations.

Later, he continues:

In comparison, the United States’ shortfall for Social Security and Medicare alone has been somewhat smaller than the EU average, at 6.5 percent of future GDP. But as a result of the expansion of the Medicare program to cover prescription drugs, the U.S. fiscal imbalance is now 8.2 percent of future GDP. Putting this in perspective, to close its fiscal imbalance:

• The United States would need to save and invest an amount equal to 8.2 percent of its GDP beginning now and continuing every year forever to pay expected future benefits without future tax increases.
• This could be accomplished by more than doubling the current 15.3 percent payroll tax on employers and employees, immediately and forever.
• Alternatively, the federal government could immediately stop spending nearly four out of every five dollars on programs other than Social Security and Medicare — eliminating most discretionary spending on such programs as education, national defense, environmental protection and welfare — forever.

Each year that the United States does not take action to reduce the projected shortfall, it grows by more than $1.5 trillion, after adjusting for inflation.

If you are a wonk on these matters, I recommend that you read the paper.  But the article from the New York Times motivated the issue in other ways.  A hairdresser in Greece retires at age 50?  In the US, aside from the military, the only people I know of that retire with a full pension at age 50 are oil wildcatters, and those that similarly punishing hard work.  Also, it is backward for women to retire earlier than men; they live a lot longer.

There is no way that we are going to get governments to run 8% of GDP surpluses per year to deal with these crises.  I hate to say this, but if some of the profligate European governments want to deal with this situation, they will need to change their constitutions or laws that guarantee pension payments at a certain level and age, and extend the age and drop the benefits.  Political suicide, I know.  But do you care if the Eurozone fails?  Do you care if your nation fails?  I’m not saying that one group has to bear pain while another does not, but aside from those that work at physically demanding jobs, there is no reason why everyone can’t work until age 75.  Yes, 75, leaving aside disability.  Retirement should be the last 10 years of life on average, not the last 20, much less 35.

When someone stops working, the rest must pick up the slack.  Is there any way for a culture to work where those who work must support 2+ people excluding themselves?  Many Western governments are staring at cultural failure, and can’t see the forest for the trees.  They see the short run funding difficulty, but do not see the long-term problem that is lurking to begin to bite in the next decade.  The sad thing is — it’s too late.  Aside from cutting benefits, or raising benefit ages, there is no way out.

The Divided States

The Barron’s cover article dealt with high state and municipal pensions.  Though I wrote a piece on this recently, talking about the Pew report study, among other things, this article makes the valid point that the state and municipal discount rates on pension liabilities are likely too high, averaging 8% or so.  The nominal GDP growth rate of the economy of the whole is probably the best estimate of where discount rates should be — what shall we say? 4-5%/year?  In this low rate environment, earning 8% forever is ludicrous.  But at 4-5%/year we are talking about a deficit of ~$3 trillion, not $1 trillion.

As the article points out, workers in the public sector earn more on average than those in the private sector.  The need to have high pensions to attract workers is no longer valid.

Also, the states and municipalities are taking above average risks to try to earn their target rate, even though doing so is highly unlikely.  As it says in the article:

Finance professors Robert Novy-Marx at the University of Chicago and Joshua Rauh of Northwestern University asserted in a recent paper that the funding gap for state pension plans alone might exceed $3 trillion, in part because state funds are using an unrealistic long-term annual investment return of 8% to compute the present value of future payments to retirees, as is permitted in government standards for pension-fund accounting.

This establishes a “false equivalence” between pension liabilities and the likely investment outcomes of state investment portfolios, which are increasingly taking on more risk by beefing up their exposure to stocks, private-equity deals, hedge funds and real estate. Using a much lower expected return — say, one at least partially based on the riskless rate of return on government securities — would both properly and dramatically boost the present value of the pensions’ liabilities while decreasing their likely ability to meet them. The academic pair, using modern portfolio theory, claim that state funds, as currently configured, have only a one-in-20 chance of meeting their obligations 15 years out.

As I said above with countries, so it might be with states.  Some states will have to repeal statutory or constitutional guarantees on pensions in order to survive.  I don’t like saying this, but I don’t think there is any choice eventually.  Do you want your state or municipality to survive or not?  Even Chapter 9 and/or ERISA should be amended to allow for adjustment of pension obligations in municipal bankruptcy.  States also should be able to use Chapter 9, or, a new Chapter of the Bankruptcy code for States.

That is why bond investors are getting skittish over General Obligation bonds, and moving to Revenue bonds, if the revenues are stable enough, and protected for bondholders.  They don’t trust the states and municipalities.

Now, this comes after years of underfunding the pension funds.  Few truly were farsighted, and set aside the assets, rather than having more current spending, or deceasing taxes.

Where does this leave us?  In no good place.  Is there a solution?  Yes, but only that of shared pain.  We have to decide whether we take structured pain now, through benefit cuts and higher taxes, or, take unstructured pain when the riots arrive, time to be determined.  Cultural failure is a real possibility; civilization is more veneer than solid when everyone argues for their self interest, and few argue for the good of the whole.

Roughly three months later than originally scheduled, the fiscal year 2009 Financial Report of the United States Government came out.  I had predicted a few times (latest here) that the final total of debts and unfunded liabilities would be about 4x GDP.  Well, I was close:

As I commented in my piece The Biggest, Baddest Bubble of Them All:

This doesn’t take into account the value of land and certain less tangible assets that the U.S. Government has. It also does not take into account the considerable operating and capital lease liabilities, deferred maintenance, or liabilities for the GSEs, and other lending guarantee programs of the federal government.

That comment was originally written in October 2003.  As I commented at RealMoney a number of times, I felt that it was possible that the GSEs would fail — they held so little in reserve against mortgage losses.  Back then, the figure wasn’t $57 billion, it was $25 billion for fiscal year 2002, which would be 2.4x GDP.

The US Government has made a lot of promises to pay.  I have no idea how big the annual obligations for capital and operating leases are, but it would be cheaper for the Government  to borrow and buy their buildings, rather than hiding the debts through Credit Tenant Leases.  I also can’t quantify the full range of guarantees they have made, including implicit ones to bail out GSEs, big financials, allies, etc.

A reader wrote me asking: Would you please write a post on what will happen if the US goes bankrupt? This government spending continues to get worse and I am wondering what if anything I, a retired person, can do to get in front of this.

Okay, here goes.  Remember that the US Government has choices.  It can raise taxes, inflate, or default.  I don’t think default, even if it is only an external default, is the most likely option.  Also, the promises for Social Security and Medicare are not guaranteed — they can be reduced or canceled by Congress and the President.  Changing Social Security and Medicare would be political suicide, but suicide is an option.

An aside, why have I not mentioned cutting discretionary spending (or defense or entitlements)?  Because they aren’t that large a portion of the budget.  Defense and entitlements are large, but who could get a consensus on cutting those?  Our culture has a “more is better” mentality, even though spending money on “defense” has probably not made us more secure.

In order of highest likelihood, here is how I see the options:

1. Borrow more
2. Raise taxes
3. Inflation
4. Cut discretionary spending
5. Cut defense spending
6. External default
7. Total default
8. Cut entitlement spending
9. Internal default

Much as I would like to see the US Government reduced in size to only core functions, my views are not the consensus.  They will try to raise taxes, and failing that, inflate the currency.

To the one who asked the question, I am not a tax expert, so consult one to limit your taxes.  On inflation, you probably know the drill: Money market funds, TIPS, commodities, and equities with hard assets or pricing power.

The US government talks about cutting discretionary spending, but rarely does so.  Defense is worse; it always expands.  For the US to cut defense spending would be a mindshift requiring closing overseas bases, and a quiet surrender of the idea that the world is ours to guard/rule.  We think we are neutral, when we are genuinely self-interested.

External default would not be enough to solve the problems the US faces, and, it would enrage the rest of the world.  We would find our assets abroad seized by foreign governments.  Say goodbye to goodwill and globalization.

I don’t know what to say about total default, aside from depression everywhere, with many financial institutions failing in the US and abroad.  If the global reserve currency fails, well, those that rely on it will fail.

I don’t view cutting entitlement spending or an internal default only as likely.  They are political suicide for whoever does it.

My sense is when the ability to raise taxes fails, inflation will be the solution.  If/when the political outcry becomes too great against inflation, then the lesser remedies will be considered.

The pain has to go somewhere — we’ve been really good at ignoring the problem, delaying the payment, etc., but it has only had the effect of building up the eventual pain that will have to be taken.  Our leaders are seemingly opting for a Japan-style solution — stagnation for two-plus decades with debt shifted from private to public entities.  We have better much better demographics, but Japan has had better saving in the past — more of their explicit debts are internally funded compared to the US.

The trouble with offering advice in a situation like this is that the right answer depends on what our officials do.  The best or worst investment could be long Treasury zero coupon bonds.  Or it could be gold.  Remember, many thought the Great Depression would end with inflation, but it didn’t, at least not to the degree that many feared.  Me?  I am invested in a mix of well financed businesses that generate a lot of cash and would be difficult to do without, and some money market funds, where I suffer the punishment of a saver, while retaining flexibility.

There are no easy answers here.

When does a sovereign or semi-sovereign government default?  I have seen three answers:

1) When debt is greater than future seniorage revenue (central bank profits) plus future debt repayments.  (Kind of a tautology, but what is implied is that if future debt repayments are onerous, a government would default.)

2) When the interest rate a government pays is greater than the likely growth rate of revenues. (I.e., if you are paying more than your revenue growth rate, the indebtedness will continue to grow without bounds…)

3) When the structural deficit is high, and total interest paid exceeds the size of the structural deficit.  (In that case, default would bring the budget into balance, at the cost of being shut out of the bond market.  But, given the situation, in the short run, being shut out of the bond market isn’t a problem.  There would be problems if the day comes when they need to borrow again; negotiations would begin over paying old debts.)

I will propose a fourth idea: governments can lay claim to a percentage of the GDP of their country/state/municipality.  How large that can be will vary by culture.  Beyond a certain point, attempts to take more than the natural limit for that culture will not result in higher revenues, because people will hide income, and/or leave the country/area.  When debts and unfunded obligations exceed the present value of maximum GDP extraction by the government, default is likely, the only question is when it will happen – when does cash flow prove insufficient?  Perhaps the earlier three rules can help with that.

Tough Time to be a Municipality

Revenue is declining for almost all states and municipalities.  Given the need to run balanced budgets (on a cash basis), and not having a central bank to fall back on, the problems are much deeper for States and Municipalities than for the Federal Government.  This report from the Rockefeller Institute shows how widespread the loss of revenues is.

But what should larger governments do for smaller governments in this crisis?  Oddly, the best answer is nothing, and even some of the Europeans recognize this.  Smaller governments need to grasp that they have to solve their own problems, and not rely on the Federal government to help – it has enough problems of its own.

So, if I had any great advice for strapped municipalities in California, or any other place in the US, one of the first things I would recommend is that you assume you aren’t going to get any help.  Those that could help you are in worse shape.  Such does the Pew Institute indicate.  Few states have their pension and retiree healthcare benefits funded.  They won’t have excess funds to aid municipalities, and my even compound the problem by reducing revenues shared with municipalities in order to stem their own budget shortfalls.

The Federal Government Won’t Be Much Help Either

The politics of the US are dysfunctional enough with opaque congressional earmarking benefiting local and special interests.  It will be yet more dysfunctional if states and municipalities ask the US Government for aid.  Besides, the US Government has issues of its own.  Tonight, it will release the 2009 Financial Report of the United States Government, somewhat behind schedule.  With all of the chaos, who could blame them for being late?  My suspicion is that when one adds up the explicit debts of the US Government and its unfunded obligations, it will add up to a figure near four times GDP.  If the US dollar were not the global reserve currency, we would have long ago slipped into chaos.

What would it take to make the US’s debt to GDP ratio stop rising permanently?  We would need to run surpluses of around 8% of GDP, if I understand the charts on page 5 right.  Absent some major shift in governing philosophy, that’s not even close to being on the table.

As I wrote in my seven part article, My Visit to the US Treasury, Part 5: After the meeting, I said to one Treasury staffer, “One of the quiet casualties of this crisis is that you lost your last bit of slack from the entitlement systems.”

“What do you mean?”

“Just this, prior to the crisis, Social Security and Medicare would produce cash flow surpluses for the Government until 2018.  Now the estimates are 2016, and my guess is more like 2014.  The existing higher deficit takes us out to the point where the entitlement systems go into permanent negative cash flow.  This means that the US budget is in a structural deficit for as far as the eye can see, fifty years or more, absent changes to entitlements.”

He looked at me and commented that it would be the job of a later administration.  No way to handle that now.  To me, the answer reminded me of what I say to myself when I go on a scary ride at Six Flags with my kids.  There is nothing we can do to change matters.  The only thing to adjust is attitude.  So, ignore the fact that you are afraid of heights, and enjoy the torture, okay?

Now, with interest rates so low on the short end, there is one further risk: that the Fed would keep rates low simply to keep  the US Government’s financing costs down.  As the Kansas City Fed’s President Hoenig said recently,

“Depending on your assumptions about the economy, that federal debt will grow at an unsustainable level starting immediately, or in a very few years,” Hoenig said. “We do have significant private debt, so that’s in place, so what worries me about that [is] that puts pressure on the Fed to keep interest rates artificially low as you try to deal with that debt.”

The US Government is in a tough spot financially, and if inflation rises (which is not impossible, consider stagflation in the 70s), its ability to continue to finance itself cheaply will erode.  On the bright side, the US is still viewed as a safe haven, so if there are troubles in Europe or Japan, the US will benefit from additional liquidity in the short run.

Back to the States

For another summary of how tough things are at the states, consider this piece from the Center on Budget and Policy Priorities.  Because many state budgets assume a better economy than they actually got, and some were quite optimistic, the average state has a 6.6% gap to fill as a percentage of its 2010 budget.  The gap projected for 2011 is 17% of the 2010 budget.  Not pretty, and if you want to look at it from a bottom-up perspective, this article offers a lot of links to the various emerging troubles.

One further wrinkle in the matter is Vallejo, California, which is in Chapter 9 now.  In the past, muni bond investors and insurers felt assured that in defaults by cities and counties that they would eventually be paid back in full.  With Vallejo, that may not happen; bondholders may have to take a haircut.  If that happens, and it establishes a precedent for Chapter 9 cases, yields will rise for cities and counties that can file for Chapter 9, in order to reflect the increased risk of loss.  Higher future borrowing costs will further burden city and county budgets.  There is no free lunch in the muni bond market.  (For more good articles by Joe Mysak of Bloomberg, look here.)

Conclusion – Why do I Write This?

This is a pretty gloomy assessment, but it is consistent with the deleveraging process that is rippling through the US economy.  All sorts of hidden leverage have been revealed including:

• Reliance on optimistic economic assumptions in budgets.
• Reliance on a robust housing sector.
• Reliance on financial guarantee insurers.
• Reliance on increasing leverage at banks, and sloppy underwriting of loans.
• Reliance on Fannie and Freddie to absorb poorly underwritten mortgages.
• Reliance on large pension and retiree healthcare promises to keep wages low, and not funding those promises to keep taxes low.
• Reliance on high stock returns to pay for pensions.
• Reliance on increasing debt levels in households.
• Low bond yields make it difficult to invest for pensions.

And there may be other things we have relied on that may fail.  Banking crises often lead to financial crises, as is pointed out in the excellent book, This Time is Different.

• The US government can always borrow more.
• The Treasury and Federal Reserve can stimulate the economy out of any crisis.

My main message is that this is a serious situation almost everywhere in the US.  We have borrowed ourselves into a corner.  I write this so that all parties can understand the dynamics going on, so that when muni defaults happen, and the normal dynamics in the bond market shift, you won’t be surprised at the results.  Also, now you have links to a wide number of reports indicating how serious the problems are with Federal and State debts and unfunded liabilities, so that you can do your own digging on the topic.

Good cultures balance short and long-term goals.  Focusing too much on the long-term can lead to overinvestment, and problems like Japan still faces.  Focusing on the short-run can lead governments and companies to focus on manipulating budget and earnings numbers to fulfill their own selfish ends.

At present, we have no surplus of long-termism, but a surfeit of short-termism.    Many economic players have decided that it is in their interest to play for time  — make things look good in the short run, and maybe a magical fix will appear for long run problems.

It seems that the EU thinks that if they can make Greece behave, that all will be right.  Well, tell that to those that protest in Greece.  Let each EU nation rather take a step back and ask, “What is cheaper in the long-run, bailing out Greece, or bailing out my banks with Greece exposure?”  The latter is probably cheaper, but not certainly so.  Given the lack of unanimity, the situation would lean toward bailing out domestic banks, because bailing out Greece requires the cooperation of separate nations, many of which have electorates that strongly oppose a bailout of Greece.

But, that could mean a virtual dissolution of the Eurozone.  Not necessarily.  You could end up with a lot of nations in default, and shut out of the bond markets (the PIIGS), while the rest do seemingly fine, as they quietly bail out their banks.

In that situation, the Euro would still exist, and might continue to be the currency of nations that are in default.  They just could not borrow any more at any rate in Euros, and perhaps not in any currency.

But the Eurozone itself would be in tatters, at least from a marketing standpoint.  What is good about being in the Eurozone?  Free trade?  Well Britain has that, even though they are a basket case, at least they control their own destiny, sort of.  The veneer that being in the Eurozone means that you are a high quality borrower is shattered.  Credit spreads over the German Euro benchmark will be high indeed for nations that have been undisciplined in their finances.

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People and governments like stasis.  No change.  Why?  It makes policy simple.  If something is in trouble, give it aid.  But — what if the trouble is an indication that people don’t want what is being produced by the one that is in trouble?  Capitalism is wonderful because it is dynamic. It can quickly adjust to changing conditions, unlike socialist bureaucrats.  Rather than volatility being a negative, with capitalism it is a positive.  It shows that the economy needs to change, that losses on prior bad investments should be recognized.  Failure to see things like this lessens the flexibility of the economy, and makes the eventual adjustments much larger than they would have to be if we did not interfere in the economy.

Now, this applies all over the world.  China is creating some of the biggest white elephants in history, so it seems.  Like Japan in the late 80s, they are building up useless industrial capacity.  Naive Keynesianism says that it does not matter what one spends money on, what matters is that the money gets spent, and quickly.

We may as well throw bricks at every window we see with that logic, knowing that GDP will record that glassman’s wages, but will not record the loss from a broken window.

Alas, we have too much automotive capacity, so we support automotive firms in the US.  We have too many bankers and too much capacity to build homes, so we support that as well.  Far better that we let firms fail, and let the assets be released to better uses.  Why waste your life or capital in an industry where there is not enough demand?

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In one sense, my claim of cultural failure boils down to not being willing to recognize losses.  In another sense, it is using the political process to invalidate economics.  Why should the government bail out company A and not company B?

The present political climate in the US could be summarized as a question of fairness.  Why should some benefit from bailouts, and not others?  There should be some answer here that doesn’t sound lame.  Lame answer: we were protecting the whole economy by protecting banks.  Better answer: we goofed in protecting the banks.  We should have let them fail, and bailed out depositors.  Don’t bail out anyone; let housing prices drop until ordinary people can afford them.  But if you must bail out, go down to the lowest level, and bail out those with mortgages, which will benefit not only them, but everyone above them.

This leaves aside moral hazard — all bailouts are a mistake.  Far better to let all fail, and let the system reset.  Run a hard culture where failure is punished.  That will cause people to avoid failure with greater assiduousness.

I will have more on this in the likely final segment for this topic.

I have been thinking about the the forces distorting the global economy.  In the long run, the distortions don’t matter, because economies are bigger than governments, and eventually economies prevail over governments.  Here are my dozen problems in the global economy.

1) China’s mercantilism — loans and currency.  The biggest distortionary force in the world now is China.  They encourage banks to loan to enterprises in order to force growth.  They keep their currency undervalued to favor exports over imports.  What was phrased to me as a grad student in development economics as a good thing is now malevolent.  The only bright side is that when it blows, it might take the Chinese Communist Party with it.

2) US Deficits, European Deficits — In one sense, this reminds me of the era of the Rothschilds; governments relied on borrowing because other methods of taxation raised little.  Well, this era is different.  Taxes are high, but not high enough for governments that are trying to create the unachievable “permanent prosperity.” In the process they substitute public for private leverage, and in the process add to the leverage of their societies as a whole.

3) The Eurozone is a mess — Greece, Portugal, Spain, etc.  I admit that I got it partially wrong, because I have always thought that political union is necessary in order to have a fiat currency.  I expected inflation to be the problem, and the real problem is deflation.  Will there be bailouts?  Will the troubled nations leave?  Will the untroubled nations leave that are the likely targets for bailout money?

4) Many entities that are affiliated with lending in the US Government, e.g., FDIC, GSEs, FHA are broke.  The government just doesn’t say that, because they can still make payments.

5) The US Government feels it has to “do something” — so it creates more lending programs that further socialize lending, leading to more dumb loans.

6) Residential real estate is still in the tank.  Residential delinquencies are at all-time highs.  Strategic default is rising.  The shadow inventory of homes that will come onto the market is large.  I’m not saying that prices will fall for housing; I am saying that it will be tough to get them to rise.

7) Commercial real estate — there is too much debt supporting commercial real estate, and too little equity.  There will be losses here; the only question is how deep the losses will go.

8 ) I have often thought that analyzing the strength of the states is a better measure for US economic strength, than relying on the statistics of the Federal Government.  The state economies are weak at present.  Part of that comes from the general macroeconomy, and part from the need to fund underfunded benefit plans.  Life is tough when you can’t print your own money.

9) The US, UK, and Japan are force feeding liquidity into their economies.  Thus the low short-term interest rates.  Also note the Federal Reserve owning MBS in bulk, bloating their balance sheet.

10) Yield greed.  The low short term interest rates touched off a competition to bid for risky debt.  The only question is when it will reverse.  Current yield levels do not fairly price likely default losses.

11) Most Western democracies are going into extreme deficits, because they can’t choose between economic stimulus and deficit reduction.  Political deadlock is common, because no one is willing to deliver any real pain to the populace, lest they not be re-elected.

12) Demographics is one of the biggest  pressures, but it is hidden.  Many of the European nations and Japan face shrinking populations.  China will be there also, in a decade.  Nations that shrink are less capable of carrying their debt loads.  In that sense, the US is in good shape, because we don’t discourage immigration.

I once wrote a post on university endowment investing that I thought was one of my better ones, but drew little attention.  It helped to inform another piece I wrote that was better received, The Forever Fund.  Okay, two more if you are a glutton for this kind of stuff: Liquidity Management is the First Priority of Risk Management, and The First Priority of Risk Control. (Note: university endowments had a lousy year ending in June of 2009.  Things may be looking better now, but with interest rates so low, university endowments are even more reliant on outperformance of equities and other risky assets.)

The key idea is this: understand what you are trying to fund before you begin investing.  When will the money be needed?  How much?  How realistic is the implied rate of return?  What if everyone with needs like yours tried to do this?  Would it work then?  Is the demand for investments that are optimal for entities with your liability structure greater than the available investments to be had?  Do you have some sustainable competitive advantage that few others have?

When I look at ideas like pension plans employing leverage (also here), I think they don’t know what they are doing.  Anybody remember how New Jersey decided to sell pension bonds and lever up their pension investments in risky assets?

• How the Garden State Dug a Hole
• Strapped Governments Revive Pension Bonds
• Christie Crosses N.J. Party Line Amid $34 Billion Pension Gap

That last article is timely, published today.  What began as borrowing $2.7 billion to plug a gap became a $34 billion gap.  Risky assets, particularly equities, did not perform.  Not only did they not earn enough to earn the actuarial rate needed to fund the defined benefit plan, they also had to pay interest on the pension bonds.

Trying to fill a funding gap via a more aggressive strategy is usually foolish.  If that were the best strategy, you should have been employing it already.

But consider the leverage angle more closely.  A defined benefit plan is by its nature a plan to pay out a stream of benefits over time to beneficiaries.   Typically they invest some of their assets in bonds that are shorter than the length of the stream of benefits they will have to pay.  Those bonds typically don’t earn enough to cover the actuarial funding rate, so they invest the rest in risky assets that they think that blended with the return on the bonds, will earn the actuarial funding rate or better.

There are at least three problems here:

• It would be ideal to invest entirely in super-safe debt instruments that match the expected liability cash flows, but that would require too much in taxes from the citizenry.
• But the moment that you move to funding some of the assets into stocks you open up two risks: 1) funding risk — what if the risky assets don’t perform to the degree needed? and, 2) Interest rate risk — the moment you are not matched there are risks if interest rates move against you.  This is usually a risk if rates move down.  It is rare for a defined benefit plan to buy enough long debt such that the value of bonds rises as much or more than the present value of the liabilities rise when interest rates fall.
• Pension bonds, or any sort of investments with internal leverage have the potential to increase funding risk, and they increase interest rate risk as well.  Pension bonds add another fixed claim to the existing semi-fixed claim of the benefit stream.

Are we the double-down society as far as investing goes?  It sure seems like it, and if many entities do this as a group the failure of the idea will be spectacular.  Risk premiums are not high now; take a look at Jeremy Grantham’s forecasts on page 4 of this PDF (which has many other useful bits that you can learn from).  Borrowing money to invest when risk premiums are small is playing the exact same game as we were doing with CDOs from 2005 to 2007.  If the spreads are thin, pile on more leverage!  That will get us to our earnings target.

It’s sad to see this phenomenon reappearing.  Don’t we ever learn?

I have long been a fan of immediate annuities, particularly those that are inflation indexed, as retirement products for seniors.  Yet, they do not get bought by retirees.  Why?  Well, insurance products are sold, not bought, typically, and when the agent sells an immediate annuity, that is his last sale on that money.  They would rather sell a less suitable product that offers them another sale down the road.  And, people like having flexibility with and control over their investments, even if that leads to less money for them in the long run.  Annuitizing a portion of one’s lump sum lowers risk, and takes the place of investing in bonds in the asset allocation.

Most people like the reliability of their pensions, and Social Security, should it be paid, but do not seek the same thing when investing their private money.  One would think they would invest that money for growth if they had a strong stream of income elsewhere, but often that money is conservatively invested as well.

People get fooled by yield, and in an environment like this, more so.  People try to make their investments do more through targeting higher yields, while ignoring the possibility of capital losses.

Most people can budget, if pressed to do so.  Few can manage a lump sum of capital, and know what to invest it in, and how much to take from it per year.  Few have the discipline to buy an immediate annuity or limit their withdrawals to 4% of assets per year.

But where there is chaos and confusion, some in our government will seek to create a “solution.”  The ill-defined solution that sounds a bit like a Stable Value Fund is what is getting called “R Bonds.”  Here’s the idea: for those with 401(k)  or IRA balances, if they should retire, and not decide what to do with the money, the assets would get automatically get placed into a Retirement Bond, and for two years, the retiree would receive income.  They can opt out before that happens.  If after two years they still don’t decide, the income continues.  There is nothing mandatory about this program, should it come into existence; people who are asleep about their finances may find themselves trapped in it, at least for a time. [Note: there are scandalmongers alleging out-and-out theft being planned by the US Government.  From what I can see that is not true for anyone that keeps his wits about him.  All the proposals allow people to "opt out."]

But let me go further.  Scrap the idea of “R bonds.”  Issue a limited number of Trills for retirees to use, or create a special variant of TIPS that pays until someone dies.  These are easy solutions that do not require a lot of changes to the legal codes, or changes in investment behavior.

Now, there is not just one proposal out there.  Let me give the two most comprehensive:

• Increasing Annuitization in 401(k) Plans with Automatic Trial Income
• Guaranteed Retirement Accounts Toward retirement income security — less desirable.  People should not be coerced into investments for retirement.  People should have a right to choose or not choose.

With interest rates so low on the short end, I don’t see how the returns could be that great from “R Bonds.”   I would play for higher returns given the risk of inflation.  Today that would mean safe stuff that yields little, while waiting for a correction in the fixed income markets, and high quality common stocks with some yield.  And, annuitization at present?  I would wait for higher rates.

Other posts on the topic worthy of your consideration:

• Americans Oppose Proposals to Limit 401(k)s, ICI Says
• Administration explores ‘R bond’ as option for retirement accounts
• Rating the Idea of R Bonds
• Retiree Annuities May Be Promoted by Obama Aides
• Obama Administration Wants to Annuitize 401k’s and IRA’s – Mandatory “R Bonds”

Now, all that said, there is a reason to be politically aware here.  Governments have in the past forced people to convert assets that were more valuable for those that were less valuable.  And, we have the example of Argentina doing it in the present with pension assets, and also when their currency blew up — most debtors faced a forced conversion to less valuable bonds.  With the pension nationalization, it was done in the name of protecting people’s pensions, but ended up benefiting the finances of the Argentine Government.

So, be aware.  R Bonds, as currently proposed, are a bad idea.  But there are worse ideas not yet proposed that might be proposed in the guise of protecting your future.  Let us work to make sure they never get implemented.

Before I start, I would like to toss out the idea of an Aleph Blog Lunch to be hosted sometime in January 2010 @ 1PM, somewhere between DC and Baltimore.  Everyone pays for their own lunch, but I would bring along the review copies of many of the books that I have reviewed for attendees to take home, first come, first served.  Maybe Eddy at Crossing Wall Street would like to join in, or Accrued Interest. If you are an active economic/financial blogger in the DC/Baltimore Area, who knows, maybe we could have a panel discussion, or something else.   Just tossing out the idea, but if you think you would like to come, send me an e-mail.

Onto the comments.  I try to keep up with comments and e-mails, but I am forever falling behind.  Here is a sampling of comments that I wanted to give responses on.  Sorry if I did not pick yours.

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

Blog comments are in italics, my comments are in regular type.

http://alephblog.com/2009/12/16/notes-on-fed-policy-and-financial-regulation/#comments

Spot on David. I often think about the path of the exits strategy the fed may take. In order, how may it look? What comes first what comes last? Clearly this world is addicted to guarantees on everything, zirp, and fed QE policy which is building a very dangerous US dollar carry trade.

Back to the original point, I would think the order of exit may look something like:

1. First they will slowly remove emergency credit facilities, starting with those of least interest, which were aggressively used to curb the debt deflationary crisis on our banking system. The added liquidity kept our system afloat and avoided systemic collapse that would have brought a much more painful shock to the global financial system. Lehman Brothers was a mini-atom bomb test that showed the fed and gov’t would could happen – seeing that result all but solidified the ‘too big to fail’ mantra.

2. Second, they will be forced to raise rates – that’s right folks, 0% – 0.25% fed funds rates is getting closer and closer to being a hindsight policy. However, I still think rates stay low until early 2010 or unemployment proves to be stabilizing. As rates rise, watch gold for a move up on perceived future inflationary pressures.

3. Third, they can sell securities to primary dealers via POMO at the NY Fed, thereby draining liquidity from excess reserves. I think this will be a solid part of their exit strategy down the road – perhaps later in 2010 or early 2011. As of now, some $760Bln is being hoarded in excess reserves by depository institutions. That number will likely come way down once this process starts. The question is, will banks rush to lend money that was hoarded rather then be drained of freshly minted dollars from the debt monetization experiment. For now, this money is being hoarded to absorb future loan losses, cushion capital ratios and take advantage of the fed’s paid interest on excess reserves – the banks choose to hoard rather then aggressively lend to a deteriorating quality of consumer/business amid a rising unemployment environment. This is a good move by the banks as the political cries for more lending grow louder. The last thing we need is for banks to willy-nilly lend to struggling borrowers that will only prolong the pain by later on.

4. And finally, as a final and more aggressive measure, we could see capital or reserve requirements tightened on banks to hold back aggressive lending that may cause inflationary pressures and money velocity to surge. Right now, banks must retain 10% of deposits as reserves and maintain capital ratios set by regulators. Either can be tweaked to curb lending and prevent $700bln+ from entering the economy and being multiplied by our fractional reserve system.

I think we are starting to see #1 now, in some form, and will start to see the rest around the middle of 2010 and into 2011. The last item might not come until end of 2011 or even 2012 when economy is proven to be on right track and unemployment is clearly declining as companies rehire.

Thoughts????

UD, I think you have the Fed’s Order of Battle right.  The questions will come from:

1) how much of the quantitative easing can be withdrawn without negatively affecting banks, or mortgage yields.

2) How much they can raise Fed Funds without something blowing up.  Bank profits have become very reliant on low short term funding.  I wonder who else relies on short-term finance to hold speculative positions today?

3) Finance reform to me would include bank capital reform, including changes to reflect securitization and derivatives, both of which should require capital at least as great as doing the equivalent transaction through non-derivative instruments.

http://alephblog.com/2009/12/15/book-reviews-of-two-very-different-books/#comments

David,
A few years back you mentioned to me in an e-mail that Fabozzi was a good source for understanding bonds (thank you for that advice by the way, he is a very accessible author for what can be very complex material.)  In the review of Domash’s book you mention that he does not do a good job with financials. I was wondering, is there an author who is as accessible and clear as Fabozzi, when it comes to financials, who you would recommend.

Regards,
TDL

TDL, no, I have not run across a good book for analyzing financial stocks.  Most of the specialist shops like KBW, Sandler O’Neill and Hovde have their own proprietary ways of analyzing financials.  I have summarized the main ideas in this article here.

http://alephblog.com/2007/04/28/why-financial-stocks-are-harder-to-analyze/

http://alephblog.com/2009/12/05/the-return-of-my-money-not-the-return-on-my-money/#comments

Sorry to be a bit late to this post, but I really like this thread (bond investing with particular regard to sovereign risk). One thing I’m trying to figure out is the set of tools an individual investor needs to invest in bonds globally. In comparison to the US equities market, for which there are countless platforms, data feeds, blogs, etc., I am having trouble finding good sources of analysis, pricing, and access to product for international bonds, so here is my vote for a primer on selecting, pricing, and purchasing international bonds.

K1, there aren’t many choices to the average investor, which I why I have a post in the works on foreign and global bond funds.  There aren’t a lot of good choices that are cheap.  It is expensive to diversify out of the US dollar and maintain significant liquidity.

A couple of suggested topics that I think you could do a job with:  1) Quantitative view of how to evaluate closed end funds trading at a discount to NAV with a given NAV and discount history, fee/cost structure, and dividend history;   2) How to evaluate the fundamentals of the return of capital distributions from MLPs – e.g. what fraction of them is true dividend and what fraction is true return of capital and how should one arrive at a reasonable profile of the future to put a DCF value on it?

Josh, I think I can do #1, but I don’t understand enough about #2.  I’m adding #1 to my list.

http://alephblog.com/2009/12/05/book-review-the-ten-roads-to-riches/#comments

I see that Fisher’s list reveals his blind spot–how about being born the child of wealthy parents. . .

BWDIK, Fisher is talking about “roads” to riches.  None of us can get on that “road” unless a wealthy person decided to adopt one of us.  And, that is his road #3, attach yourself to a wealthy person and do his bidding.

I am not a Ken Fisher fan, but I am a David merkel fan—so what was the advice he gave you in 2000?

Jay, what he told me was to throw away all of my models, including the CFA Syllabus, and strike out on my own, analyzing companies in ways that other people do not.  Find my competitive advantage and pursue it.

That led me to analyzing industries first, buying quality companies in industries in a cyclical slump, and the rest of my eight rules.

http://alephblog.com/2009/11/28/the-right-reform-for-the-fed/#comments

“The Fed has been anything but independent.  An independent Fed would have said that they have to preserve the value of the dollar, and refused to do any bailouts.”

This seems completely wrong to me.  First, the Fed’s mandate is not to preserve the value of the dollar, but to “”to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  I don’t see that bailouts are antithetical to those goals. Second, I don’t see how the Fed’s actions in 2008-2009 have particularly hurt the value of the dollar, at least not in terms of purchasing power.  Perhaps they will in the future, but it is a bit early to assert that, I think.

Matt, even in their mandates for full employment and stable prices, the Fed should have no mandate to do bailouts, and sacrifice the credit of the nation for special interests.  No one should have special privileges, whether the seeming effect of purchasing power has diminished or not.  It is monetary and credit inflation, even if it does not result in price inflation.

¨Make the Fed tighten policy when Debt/GDP goes above 200%.  We’re over 350% on that ratio now.  We need to save to bring down debt.¨

David, I fully agree (as with your other points).
However, I do not see it happening.

I´d appreciate your, and other readers´, take on this.

Carol, you are right.  I don’t see a limitation on Debt to GDP happening.

As to nations rolling over each other’s debts for 10 more years, I find that unlikely.  There will be a reason at some point to game the system on the part of those that are worst off on a cash flow basis to default.

The rollover problem for the US Treasury will get pretty severe by the mid-2010s.

http://alephblog.com/2009/11/13/the-forever-fund/#comments

Any chance of you doing portfolio updates going forward? I’d be curious to see if you still like investment grade fixed incomes, given the rally.

Matt, I would be underweighting investment grade and high yield credit at present.

As for railroads, I own Canadian National – unlike US railroads, it goes coast to coast, and slowly they are picking up more business in the US as well.

Long CNI

http://alephblog.com/2009/11/10/my-visit-to-the-us-treasury-part-7-final/#comments

Did none of the bloggers raise the question of the GSEs? I can understand Treasury not wishing to tip their hands as to their future, but I would have expected their status to be a hot topic among the bloggers.

I also don’t buy the idea that the sufferings of the middle class were inevitable. Over the past 15 or so years the financial sector has grown due to the vast amount of money that it has been able to extract. Where would we be if all of those bright hard working people and capital spending had gone to the real economy? I’m not suggesting a command economy, but senior policymakers decided to let leverage and risk run to dangerous levels. Your comment seem to indicate that this was simply the landscape of the world, but it seems more to be the product of a deliberate policy from the Federal government.

Chris, no, nothing on the GSEs.  There was a lot to talk about, and little time.

I believe there have been policy errors made by our government – one the biggest being favoring debt finance over equity finance, but most bad policies of our government stem from a short-sighted culture that elects those that govern us.  That same short-sightedness has helped make us less competitive as a nation versus the rest of the world.  We rob the future to fund the present.

http://alephblog.com/2009/11/07/my-visit-to-the-us-treasury-part-6/#comments

it’s not clear from your writing whether the treasury officials talked to you about the GSEs or whether your comments (in the paragraph beginning with “When I look at the bailouts,”) are your own. could you clarify?

q, That is my view of how the Treasury seems to be using the GSEs, based on what they are doing, not what they have said.

http://alephblog.com/2009/10/31/book-review-nerds-on-wall-street/

“There are a lot of losses to be taken by those who think they have discovered a statistical regularity in the financial markets.”
David, take a look at equilcurrency.com.

Jesse, I looked at it, it seems rather fanciful.

http://alephblog.com/2009/10/27/book-review-the-predictioneers-game/#comments

David,
Just wondering if there’s an omission in this line:

“The last will pay for the book on its own. I have used the technique twice before, and it works. That said, that I have used it twice before means it is not unique to the author.”

Did you mean to write “that I have used it doesn’t mean it is not unique….”

In the event it is, I’ll look it up in the book, which I intend to buy anyway.
Otherwise, may I request a post that details, a la your used car post,your approach to buying new cars?

Saloner, no omission.  I said what I meant.  I’ll try to put together a post on new car purchases.

http://alephblog.com/2009/10/22/book-review-the-bogleheads-guide-to-retirement-planning/

thanks for the book review. it sounds like something that i could use to get the conversation started with my wife as she is generally smart but has little tolerance for this sort of thing.

> unhedged foreign bonds are a core part of asset allocation

i agree in principle — it would be really helpful though to have a roadmap for this. how can i know what is what?

I second that request for help in accessing unhedged foreign bonds – Maybe a post topic?

JK, q, I’ll try to get a post out on this.

http://alephblog.com/2009/10/20/toward-a-new-theory-of-the-cost-of-equity-capital-part-2/#comments

to the point above, basically just an IRR right?

JRH, I don’t think it is the IRR.  The IRR is a measure of the return off of the assets, not a rate for the discount of the asset cash flows.

When I was an undergraduate (after already having been in business for a long time), I realized that M-M was erroneous, because of all the things they CP’d (ceteris paribus) away. For my own consumption, I went a long way to demonstrating that quantitatively, but children, work and family intervened, and who was I to argue with Nobel winners.

But time, experience and events convince me that I was right then and you are right now. As you’ve noted the market does not price risk well. In large part this is due to a fundamental misunderstanding of value. The professional appraisal community has a far better handle on this, exemplified by drawing the formal distinction between “fair market value as a going concern”, “investment value”, “fair market value in a orderly liquidation”, “fair market value in a forced liquidation” and so on. One corollary to the foregoing is one of those lessons that stick from sit-down education, that “Book Value” is not a standard of value but rather a mathematical identity.

Without going into a long involved academic tome, the cost of capital (and from which results the mathematical determination of value per the income approach) has a shape more approaching that of a an asymmetric parabola (if one graphs return on the y axis and equity debt weight on the x.).

If I was coming up with a new theorem, risk would be an independent variable. So for example:

WAAC = wgt avg cost of equity + wgt avg cost of debt + risk premium

You’ll note the difference that in standard WAAC formulation risk is a component of the both the equity and debt variable – and practically impossible to consistently and logically quantify. Yes, one can look to Ibbottson for historical risk premia, or leave one to the individual decision making of lenders, butt it complicates and obscures the analysis.

In the formulation above, cost of equity and cost of debt are very straightforward and can be drawn from readily available market metrics. But what does risk look like? Again if you plot risk as a % cost of capital on the y axis and on the x axis the increasing debt weight, on a absolute basis risk is lowest @ 100% equity. From there is upwards slopes. However, risk however is not linear, but rather follows a power law.

The reason risk follows a power law is that while equity is prepared to lose 100%, debt is not. Also, debt weight increases IRR to equity (in the real world) contrary to MM. Again, debt is never priced well, because issuers don’t understand orderly and forced liquidation, whereby in “orderly”, e.g. say Chapter 11,recoveries may be 80 cents on the dollar, and forced, e.g., Chapter 7, 10 cents on the dollar. One really doesn’t begin to understand the foregoing until you’ve been through it more than a few times.

So in the real world, as debt increases, equity is far more easily “playing with house money.” A recent poster child for this phenomena is the Simmons Mattress story. In the most recent go round equity was pulling cash out (playing with house money) and the bankers were either (depending on one’s POV) incredibly stupid for letting equity do so, or incredibly smart, because they got their fees and left someone else holding the bag. I’m seen some commentators say that ‘Oh it was OK because rates were so low, the debt service (the I component only) was manageable.’ Poppycock; sometime it’s the dollar value and sometimes it’s the percentage weight and sometimes it is both.

But you’ve already said that: “company specific risk is significant and varies a great deal.” I would also add that – or amplify – that in any appraisal assignment the first thing that must be set is the appraisal date. Everything drives off that and what is ‘known or knowable’ at the time.

Gaffer, thanks for your comments.  I appreciate the time and efforts you put into them.  This is an area where finance theory needs to change.

http://alephblog.com/2009/10/10/pension-apprehension/

I have a DB plan with Safeway Stores-UFCW, which I’ve been collecting for a few years. I’m cooked?

Craig, not necessarily.  Ask for the form 5500, and see how underfunded the firm is.  Safeway is a solid firm, in my opinion.

Long SWY

http://alephblog.com/2009/09/29/recent-portfolio-actions/#comments

David, I am curious about your rebalancing threshold. Do you calculate this 20% threshold using a formula like this:

= Target Size / Current Size – 1

I have a small portfolio of twenty securities. A full position size in the portfolio is 8% (position size would be 1 for an 8% holding). The position size targets are based generally on .25 increments (so a position target of .25 is 2% of the portfolio and there are 12.5 slots “available”). I used that formula above for a while, but I found that it was biased towards smaller positions.

Instead I began using this formula:

= (Target – Current Size) / .25

So a .50 sized holding and a full sized holding may have both been 2% below the target (using the first formula), but using the second formula, they would be 8% and 16% below the target respectively. I found this showed me the true deviation from the portfolio target size and put my holdings on an equal footing for rebalancing.

I was curious how you calculated your threshold, or if it was less of an issue because you tended to have full sized positions. For me, I tend to start small and build positions over time. There are certain positions I hold that I know will stay in the .25-.50 range because they either carry more risk, they are funds/ETFs, or they are paired with a similar holding that together give me the weight I want in a particular sector.

Brian, you have my calculations right.  I originally backed into the figure because concentrated funds run with between 16-40 names.  Since I concentrate in industries, I have to run with more names for diversification.  I don’t scale, typically, though occasionally I have double weights, and rarely, triple weights.  The 20% band was borrowed from three asset managers that I admire.  After some thought, I did some work calculating the threshold in my Kelly criterion piece.

A fuller explanation of the rebalancing process is here in my smarter seller pieces.

http://alephblog.com/2009/09/04/tickers-for-the-latest-portfolio-reshaping/

Have you seen DEG instead of SWY?
Extremely able operator. Some currency diversification as well. I’d like to know your thougts.

MLS, I don’t have a strong idea about DEG – I know that back earlier in the decade, they had their share of execution issues.  It does look cheaper than SWY, though.

Long SWY

http://alephblog.com/2009/06/11/problems-with-constant-compound-interest-2/

I like your post and want to comment on a couple of items.  You point to the peak of the 1980’s inflation rates and the associated interest rates.

The reason that the yield spread exploded is well known.  Here is a snippet from Irving Fisher.  http://capitalvandalism.blogspot.com/2009/01/deflationary-spirals.html

CapVandal – Great comment.  A lot to learn from here.  I hope you come back to blogging; you have some good things to say.  Fear and greed drive correlated human behavior.

I like investing internationally, because of the diversification it offers, both in stocks and bonds.  Or, think of it as a hedge.  Will the American Experiment continue to prosper?  We have come a long way from the Founding Fathers, and more than half of it is not good.

But there are some place in our world that I will not invest in.  I have two requirements.

• Contract law must be close to that in the US, or better.
• Accounting practices must be close to the quality of the US, or better.

Sounds simple, but foreign tales are beguiling.  There is an exclusiveness about them, and a sense of greater knowledge for the one who has bothered to learn a trifle.  My acid test is watching over a long period and seeing how they treat foreign shareholders.  That is a good measure of the morality of management.  If they cheat foreign shareholders, they will eventually cheat domestic shareholders as well.

So, what don’t I invest in?

• Russia
• China
• Most of the Middle East.
• Venezuela
• And other places that do not protect foreign shareholders on a level that is at least close to that of citizens.

The idea is to avoid situations where your rights as a shareholder might be ignored.  It does not matter how cheap an asset is; if the ability of the asset to be liquidated is low, so should the valuation of the asset be low.  Don’t buy pigs in pokes.

This has application today with Dubai.  The Dubai government is telling creditors that it will not stand behind Dubai World, and nor will the UAE, but Abu Dhabi will stand behind UAE banks.  This is tough on foreign creditors because foreign creditor rights in Dubai have not been tested until now.  Even domestic rights are unclear.

A Note on Debt Risks

Much Islamic debt, because of the prohibition on interest, acts like an extremely volatile hybrid bond during times of stress.  This incident will prove instructive on how these bonds keep or lose value in a reorganization.  What happens here will probably have an impact on how much money will be willing to flow into these vehicles in the future.  Personally, I never found them compelling, and probably won’t in the future.  There is something compelling about straight senior unsecured debt that pays interest.  I think the guarantees involved, together with straightforward reorganization processes, create a fair game where it is easier to decide whether lending or borrowing makes sense.

Complexity in bonds is usually a loser for the lender — whether complexity of the borrower’s finances, complexity of holding company structures, complexity of the governing laws, or even enforcing a complex contract where the lender duped the less-knowledgeable borrower.

What applies to corporate debt — long term buy and hold investors do okay with investment grade debt, but less well with junk debt, and worse the junkier it gets.  Layer on top of that the difficulty of being able to psychologically buy and hold during a crisis.  Even if you personally have the fortitude to do so, there may be others that influence you that don’t.  (E.g., the rating agencies come along near the trough of the crisis, and tell the CEO that they will downgrade you if you don’t sell bonds with the risk du jour.  Or, your clients look at their statements, and see the unrealized losses and beg you to sell — it doesn’t matter, the screaming is always the loudest at the bottom (in hindsight).

A Final Note on Sovereign Risks

Sovereign and quasi-sovereign risks like Dubai World may play a larger role in overall credit risk as the broader crisis plays out.  When I was younger, I thought the great risk of the Euro was that it would be too weak.  Bite my tongue.  The risk is that it could be too strong, and marginal European countries (Greece, Iceland, Ireland, Spain, Portugal, and many Eastern European countries) that have too much Euro-denominated debt relative to their ability to tax and pay will find themselves pinched — and they can’t inflate their way out.

When I first came to bond investing (early 90s), sovereign risks were viewed  skeptically, excluding the large Western nations — bond managers had been taught by the greyheads who had seen sovereign defaults, and the difficult of recovering money in default, still had a bias against sovereign and quasi-sovereign risks.  That bias is largely gone today, after a period of few sovereign losses.  Yes, Mexico, Russia and Argentina have given their share of heartburn, but the significant growth in the emerging markets has made bondholders forgiving.  Add in the long term structural deficits of the US and Japan, and it makes for a really interesting investment picture.

Be aware.  If you hold sovereign debts, look at the ability of the government to tax and pay over the long haul.  On quasi-sovereigns, analyze the explicit guarantees, if any, and the governing law — as you can see with Dubai World, in a crisis, only the guarantees matter, and only to the degree that they are enforceable under law.  With Dubai World, it will be judged in Dubai courts by a judge appointed by the ruling family of the emirate, which owns the equity of Dubai World.  Not a strong bargaining position in my opinion.  The only thing worse than relying on the kindness of strangers, is relying on the kindness of adversaries.

A Final Aside

I knew about how dodgy the investments were that Dubai and its corporations were undertaking, so I was always a skeptic, though I never wrote about Dubai, because it is so far afield for me.  What I did not know was the near slavery of foreign workers tricked to go to Dubai, and then forced to work with little to no rights.  Read the story, it is not pretty, but reinforces a belief of mine that governments and corporations willing to cheat one group of people, will cheat other groups of people as well.  Character is important in any credit decision, and the government of Dubai does not have good character in my book.

One other blogger took his nameplate with him — I’m not sure who; the rest left theirs.  But this is what was in front of each one of us as we sat down to discuss matters at the US Treasury.  Treasury officials had similar nameplates.  It dictated where we would sit as well.  From the front of the room on the left, for bloggers it was Financial Armageddon, (Megan McArdle — not there), Accrued Interest, and Across the Curve.  On the right, Naked Capitalism, Kid Dynamite, Interfluidity, Me, and Marginal Revolution.  Aside from putting the two bloggers with the most traffic at the front, there did not seem to be any rhyme or reason to the seating.

The Treasury officials presenting generally sat in front, a few sat to the side and behind us.  It made for an interesting dynamic during the portion of the meeting where some bloggers disagreed over whether derivatives should be exchange traded or not.  The folks from the Treasury grinned.  See?  These aren’t easy questions to answer!  For me, with a middle view (bring interest rate swaps to exchanges first and see how they work, then try other instruments that are less liquid), I found the exchange to be a waste of precious time, but it was revealing of the attitudes of those in the Treasury.  I knew what the bloggers thought already.

The Biggest Financial Problem

I’ve written a number of pieces on why debt matters. (Or, where is the breaking point?)  I am in the process of reviewing This Time is Different: Eight Centuries of Financial Folly — a book that deals with the reality of sovereign defaults over the last 800 years.

Surprise! Over-indebted countries do default on their debt more often than less-indebted countries.  During the current crisis, we have two mechanisms running to blunt the troubles.  The government is running a large deficit, and the central bank is sucking in longer-dated bonds to lower interest rates.  I talked about why lower interest rates are not necessarily a blessing yesterday.  Today’s thoughts are on deficits.

After the meeting, I said to one Treasury staffer, “One of the quiet casualties of this crisis is that you lost your last bit of slack from the entitlement systems.”

“What do you mean?”

“Just this, prior to the crisis, Social Security and Medicare would produce cash flow surpluses for the Government until 2018.  Now the estimates are 2016, and my guess is more like 2014.  The existing higher deficit takes us out to the point where the entitlement systems go into permanent negative cash flow.  This means that the US budget is in a structural deficit for as far as the eye can see, fifty years or more, absent changes to entitlements.”

He looked at me and commented that it would be the job of a later administration.  No way to handle that now.  To me, the answer reminded me of what I say to myself when I go on a scary ride at Six Flags with my kids.  There is nothing we can do to change matters.  The only thing to adjust is attitude.  So, ignore the fact that you are afraid of heights, and enjoy the torture, okay?

Would that I could do that with the present situation.  The long term problems are too numerous, and the present crisis saps attention from what is arguably a larger problem.  Medicare, Social Security, unfunded Federal pensions and retiree healthcare, underfunded state pensions and unfunded retiree healthcare, and underfunded corporate pensions (flowing to the PBGC) are the crisis of the future.  We are talking underfunding and debts equivalent to 4x GDP in total.

The deficits may be helping out areas of our economy for which there is already too much capacity — autos, banks, housing, but isn’t aiding the parts of the economy that don’t have excess capacity.  The one advantage to Americans is that a decent amount of the debt is absorbed by the neomercantilists, who will get paid  back in cheaper dollars (if at all) than the goods that they provided originally.

This all feels like the Japan scenario.  Low interest rates, low growth if any in non-protected sectors, soggy debt-laden protected sectors, excess capacity in areas not salable to the rest of the world, high government debt, and a demographic crisis.  Also speculation using cheap leverage for carry trades.

I’ll try to tie this up in another post or two.  Sorry if this is verbose.