In my blogging, in my other research and in investing, I gain some degree of comfort from being criticized by both bulls and bears. Worst of all would be no criticism; it would mean that I am not saying much. Criticism from both sides means that I am probably not blindly taking a partisan view, or talking my own book.

Briefly this evening, I want to point out some of the costs of our current monetary policies. Now, some things are going well, and the Fed might want to take some credit.  But the costs are soft costs, ones that are preferable to systemic financial collapse. That said, there are smarter and dumber ways to do bailouts. When I criticized the Bear Stearns bailout, I tried to point out how there have been better ways of doing bailouts from history, and that the Fed should have known this. I understand that the Fed may have felt rushed at the time, leading to a suboptimal decision, but they should be better read on economic history. Bailouts should be very painful for those bailed out, or else others line up for them.

Well, now that there has been one bailout, why not more? Other shaky areas of the economy could use a bailout… student lenders, homedebtors, home lenders, etc. Are they less worthy than Bear Stearns? Ignore the student lenders, because they pose little systemic risk. If housing prices fall another 20%, the systemic risk issues could be severe. Consider there two quotes from the article:

“There is no way to put the genie back in the bottle,” Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. “What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.”

and

Richmond Fed chief Jeffrey Lacker and policy adviser Marvin Goodfriend wrote in a 1999 paper that central bank lending creates ever-expanding expectations. “The rate of incidence of financial distress that calls for central bank lending should tend to increase over time,” they wrote. That “creates a potentially severe moral-hazard problem.”

We’re on that slippery slope now. Should the Fed bend monetary policy even more to compensate for areas of lending where they have inadequate control? To the extent that you believe in central banking, central banks should deal with the big issues, and leave the little ones alone. Lend at a penalty rate during a crisis; don’t try to make things normal. Where there is systemic risk, stand behind the core but not the fringe; defend debt claims, and wipe out equity claims.

Or, consider the second order effects that our monetary policy creates: the weak dollar and the responses that foreign governments must follow: let their export sector wither, or follow US policy down, and accept more inflation. It will take a long time for the US to lose its reserve currency status, but we are on that path. Here’s to the day when we have to borrow in the currencies of oil exporters, or China. (Please no. )

Or, consider the troubles that the states are in, since they have to run balanced budgets, unlike the Federal government, which can borrow in dollars, and inflate the currency as needed. I follow state tax revenues; it is an excellent coincident read on the economy. Well, sales tax revenues are falling. Also, some states are considering one of the “dumbest ideas ever” — pension bonds (borrowing to fund pension plans, relying on clever investing to beat the rate paid on the bonds). New Jersey lost big on their last attempt at pension bonds. Far better to consistently fund municipal pensions through general revenues. For those that have read me before on municipal pensions, their claim to fame is that they make private sector funding look good.

Finally, to end on a less sad note, is Iceland looking better, or , is it just part of an overall bear market rally?  (What of Argentina?)   My guess is the latter, but maybe they have successfully defended their currency. Then again, we can look at Brazil, which is now investment grade on one side (from S&P). Good news follow good policies, and Brazil has been on the right track — they have become a net creditor, unlike the US. Hey, maybe the Real should be a reserve currency.

I’m an actuary, but not a Pension Actuary. I don’t understand the minutiae of pension law; I only know the basics. Where I have more punch than most pension actuaries is that I understand the investing side of pensions, whereas for most of them, they depend on others to give them assumptions for investment earnings. I’ve written on pension issues off and on for 15 years or so. I remember my first article in 1992, where I suggested that the graying of the Baby Boomers would lead to the termination of most DB plans.

I am here to recommend to you the book Pension Dumping. It is a very good summary of how we got into the mess we in today with respect to Defined Benefit [DB] pension plans. Now, much of the rest of this review will quibble with some aspects of the book, but that does not change my view that for those interested in the topic, and aren’t experts now, they will learn a lot from the book. The author, Fran Hawthorne, has crammed a lot of useful information into 210 pages.

The Balancing Act

One of the things that the book gets right is the difficulty in setting pension regulations and laws. In hindsight, it might have been a good idea to give pensioners a higher priority claim in the bankruptcy pecking order. But if that had been done, many companies might have terminated their plans then and there, because of the higher yields demanded from lenders who would have been subordinated.

She also covers the debate on the “equity premium” versus immunization well. Yes, it is less risky to immunize – i.e., buy bonds to match the payout stream. Trouble is, it costs a lot more in the short run. With equities, you can assume that you will earn a lot more.

She also notes how many companies were deliberately too generous with pension benefits, because they did not have to pay for them all at once. Instead, they could put up a little today, and try to catch up tomorrow.

Things Missed

• · Individuals aren’t good at managing their own money. Even if a participant-directed 401(k) plan is cheaper than a DB plan in terms of plan sponsor outlay, the average person tends to panic at market bottoms and get greedy at market tops. DB plans and trustee-directed DC plans are a much better option for most people. That said, most people prize the illusion of control, and will not choose what is best for them.
• · Technological progress was probably a bigger factor in doing in the steel industry, and other unionized industries, than foreign competition. Nucor and its imitators did more damage to the traditional steel industry than did foreign competition. With commodity products, low price wins, and Nucor lowered the costs of creating steel significantly.
• · In the analysis of what industries could face pension problems next, she did not consider banks and other financial institutions. Most of those DB plans are very well-funded. Why? They understand the compound interest math, and the variability of the markets. But what if the current market stress led to financial firms cutting back on their plan contributions?
• · She gets to municipal pensions at the end, and spends a little time there, but those face bigger funding gaps than most private plans. Also, she could have spent more time on Multiple Employer Trusts, where funding issues are also tough, and plan sponsor failures leave the surviving plan sponsors worse off.
• · She also thinks that if you stretch out the period of time that companies can contribute in order to fund deficits, it will make things better. In the short run, that might be true, but in the intermediate term, companies that are given more flexibility tend to get further behind in funding DB pensions.
• The book could have spent more time on changes in investing within DB pension plans, which are drifting away from equities slowly but surely, in favor of less liquid investments in private equity and hedge funds. How that bet will end is anyone’s guess, but pension investors at least have a long time horizon, and can afford the illiquidity. My question would be whether they can fairly evaluate the skill of the managers.

Summary

This book describes the motives of all of the parties in DB pension issues very well, and why they tend to lead to DB plan terminations. There are possible solutions recommended at the end, but in my judgment they might save some plans that are marginal, but not those that are sick. If you are interested in the topic of pensions, buy the book, and if you buy it through the links above, I get a small commission. (If you buy anything through Amazon after entering from a link on my site, I get a small commission. That’s my tip jar, and it doesn’t raise your costs at all.)

1) A lament for Bill Miller.  Owning Bear Stearns on top of it all is adding insult to injury.  Now, living in Baltimore, I get little bits of gossip, but I won’t go there this evening.  I think Bill Miller’s problems boil down to lack of focus on a margin of safety, which is the main key to being a good value manager.  During the boom periods, he could ignore that and get away with it, but when we are in a bust phase, particularly one that hurts financials.  When financials get hit, all forms of accounting laxity tend to get hit, making the margin of safety more precious.

2) Now perhaps one bright spot here is rising short interest. Short interest is a negative while it is going up, but a positive once it has risen to unsustainable levels.  What is unsustainable is difficult to define, but remember Ben Graham’s dictum, that the market is a voting machine in the short run, and a weighing machine in the long run.  The value of stocks in the long run will reflect the net present value of their free cash flows, not short interest or leverage.

3)  Now, if you want the opposite of Bill Miller in the value space, consider Bob Rodriguez of FPA Capital.  Along with a cadre of other misfit value managers that are willing to invest in unusual long-only portfolios aiming for absolute returns while not falling victim to the long/short hedge fund illusion, he happily soldiers on with a boatload of cash, waiting for attractive opportunities to deploy cash.

4) Retirement.  What a concept amid falling housing and equity prices.  Though we have difficulties at present from the housing overhang, and the unwind of financial leverage, there will be continuing difficulties over the next two decades as assets must be liquidated and taxes raised to support the promises of Medicare, and to a lesser extent, Social Security.  My guess: Medicare gets massively scaled back.

5) I get criticism from both bulls and bears.  I try to be unbiased in my observations, because amid the difficulties, which I have have been writing about for years, there is the possibility that it gets worked out.  When there are problems, major economic actors are not passive; they look for solutions.  That doesn’t mean that they always succeed, but they often do, so it rarely pays to be too bearish.  It also rarely pays to be too bullish, but given the Triumph of the Optimists, that is a harder case to make.

6) Bill Rempel took me to task about a post of mine, and I have a small defense there, and perhaps a larger point.  Almost none of my close friends invest in the market. It doesn’t matter whether we are in boom or bust periods, they just don’t.  These people are by nature highly conservative, and/or, they are not well enough off to be considering investments in equities.  They are not relevant to a post on investing contrarianism, because they are outside the scope of most equity investing.  They are relevant to a discussion of the real economy, and where your wage income might be impacted.

7) To close for the night, then, a note on contrarianism.  When I read journalists, they are typically (but not always) lagging indicators, because they aren’t focused on the topics at hand. They get to the problems late.  But when I think of contrarianism, I don’t look for opinions as much as financial reliance on an idea.  Many opinions are irrelevant, because they don’t reflect positions that have been taken in the markets, the success of which is now being relied upon.  Once there is money on the line, euphoria and regret can do their work in shaping the attitudes of investors, allowing for contrary opinions to be successful against fully invested conventional wisdom.  But without fully invested conventional wisdom, contrarianism has little to fight.

I’ve written about “the lost decade” before at RealMoney.  A lost decade is where  the stock market goes nowhere, or loses money for ten years.  My purpose in doing so was to point out:

• That it is normal for lost decades to occur.  Stock returns are weakly autocorrelated.  Good years tend to be followed by good years, and bad years by bad years.
• Once a generation, you have to get a severe boom and a severe bust.  It is partly driven by monetary policy/financial regulation laxity, followed by tightness.  It is partly driven by the fear/greed cycle, because most people, even professional investors, chase performance.
• This has a chilling effect on retirement planning.  Recall my recent article on longevity risk.  In that article, I tried to point out the similarities for retirement investment planning between Defined Benefit plans, and an individual with his own unique retirement circumstances, typically with defined contribution plans.

I’ll amplify the last point, because the WSJ doesn’t do much with it.  Nothing kills a DB plan’s funding level worse then a protracted flat/falling equity market, and low bond yields (showing not much alternative for reinvestment).  Same for an individual financial plan.  If a DB plan has an assumed earnings yield of 8%, and the stock market earns zero, and bonds earn 5%, with 60/40 stocks/bonds, than plan earns 2% when it needs 8%.  The funding deficits grow rapidly, and corporations finally bite the bullet, and begin making contributions to their DB plan, cutting earnings in the process.

As for individuals, they should start to save more for their retirements after such a long bad market, in order to get their retirement funding back on track.  Oops, wait.  This is America.  We don’t save personally (particularly Baby Boomers), and our governments run deficits (even more on an accrual basis when we look at Medicare, Social Security, and other long-term inadequately funded programs.  Only our corporations save on net.

So, what to do?

• Save more.
•  Don’t materially increase or decrease allocations to stocks.  Things may be rough for a while longer, until excesses in the US financial system and in China are worked out, but positive returns will recur.
• Avoid investing in companies with large pension funding deficits.
• Avoid investments with high embedded leverage, whether individual companies, or ETFs.
• Be wary of investing in esoteric asset classes this late in the performance cycle.  They may do well for a while longer, but their time is running out.  (It could be one year or another decade.)
• Be ready for increasing inflation.  Even with the income giveup, it is probably wise to have bond durations shorter than the benchmark.
• To the extent you can, push back retirement, or plan that you will do it in phases, where you slowly leave the formal labor force.

Of course, you could be a good stock picker, but that’s not a common gift.  The choices are hard when we have a “lost decade.”  There’s no silver bullet; only ways to mitigate the pain.

1) I typically don’t comment on whether we are in a recession or not, because I don’t think that it is relevant. I would rather look at industry performance separate from the performance of the US economy, because the world is more integrated than it used to be. Energy, Basic Materials, and Industrials are hot. Financials are in trouble, excluding life and P&C insurers. Retail and Consumer Discretionary are soft. What is levered to US demand is not doing so well, but what is demanded globally is doing well. Much of the developed world has over-leverage problems. Isn’t that a richer view than trying to analyze whether the US will have two consecutive quarters of negative real GDP growth?

2) So Moody’s is moving Munis to the same scale as corporates? Well, good, but don’t expect yields to change much. The muni market is dominated by buyers that knew that the muni ratings were overly tough, and they priced for it accordingly. The same is true of the structured product markets, where the ratings were too liberal… sophisticated investors knew about the liberality, which is why spreads were wider there than for corporates.

3) Back to the voting machine versus the weighing machine a la Ben Graham. It is much easier to short credit via CDS, than to borrow bonds and sell them. There is a cost, though. The CDS often trade at considerably wider spreads than the cash bonds. It’s not as if the cash bond owners are dumb; they are probably a better reflection of the true expectation of default losses, because they cannot be traded as easily. Once the notional amount of CDS trading versus cash bonds gets up to a certain multiple, the technicals of the CDS trading decouple from the underlying economics of the bond, whether the bond stays current or defaults. In a default, often the need to buy a bond to deliver pushes the price of a defaulted bond above its intrinsic value. Since so many purchased insurance versus the true need for insurance, this is no surprise.. it’s not much different than overcapacity in the insurance industry.

4) If you want a quick summary of the troubles in the residential mortgage market, look no further than the The Lehman Brothers Short Swaption Volatility Index. The panic level for short term options on swaps is above where it was for LTCM, and the credit troubles of 2002. What a take-off in seven months, huh?

5) Found a bunch of neat charts on the mortgage mess over at the WSJ website.

6) I have always disliked the concept of core inflation. Now that food and fuel are the main drivers of inflation, can we quietly bury the concept? As I have pointed out before, it doesn’t do well at predicting the unadjusted CPI. Oh, and here’s a fresh post from Naked Capitalism on the topic of understating inflation. Makes my article at RealMoney on understating inflation look positively tame.

7) The rating agencies play games, but so do the companies that are rated. MBIA doesn’t want to be downgraded by Fitch, so they ask that their rating be withdrawn. Well, tough. Fitch won’t give up that easily. Personally, I like it when the rating agencies fight back.

8 ) Jim Cramer asks if Bank of America will abandon Countrywide, and concludes that they will abandon the bid. Personally, I think it would be wise to abandon the bid, but large companies like Bank of America sometimes don’t move rapidly enough. At this point, it would be cheaper to buy another smaller mortgage company, and then grow it rapidly when the housing market bounces back in 2010.

9) Writing for RealMoney 2004-2006, I wasted a certain amount of space talking about home equity loans, and how they would be another big problem for the banking system. Well, we are there now. No surprise; shouldn’t we have expected second liens to have come under stress, when first liens are so stressed?

10) In crises, hedge funds and mortgage REITs financed by short-term repo financing are unstable. No surprise that we are seeing an uptick in failures.

11) As I have stated before, I am not surprised that there is more talk of abandoning currency pegs to the US dollar. That said, it is a getting dragged kicking and screaming type of phenomenon. Countries get used to pegs, because it makes life easy for policymakers. But when inflation or deflation gets to be odious, eventually they make the move. Much of the world pegged to the US dollar is importing our inflationary monetary policy.

12) Finally, something that leaves me a little sad, people using their 401(k)s to stay current on their mortgages. You can see that they love their homes, as they are giving up an asset that is protected in bankruptcy, to fund an asset that is not protected (in most states). Personally, I would give up the home, and go rent, and save my pension money, but to each his own here.

Monday, at about 10AM, I sold my holdings in Deerfield, Deutsche Bank, and Royal Bank of Scotland.  I did it bloodlessly, realizing that Deerfield is the largest loss I have ever taken.  With the proceeds, I bought two placeholder assets that I will hold until the next reshaping (coming in a month), the Industrial (XLI) and Technology (XLK) Spiders.  By doing that, I cut the majority of the links that I had to the leveraged lending economy, which is collapsing at present.  When I saw that haircuts on repo for prime agency collateral had been raised for the second time, I threw in the towel, because too many things have broken that even I did not expect would break. (Even the haircuts on Treasuries have risen.)

With Deerfield, I made the error that if the collateral was very high quality, it could survive, even at high levels of leverage.  In a true panic, that does not matter.  All that matters is whether your leverage is low enough to allow you to survive the credit bust, and that you can do that over your financing horizon.

Financing horizon?  By that I mean how often your solvency gets measured.  For many mortgage REITs, that is a daily, weekly, or monthly phenomenon.  The longer the period, the better the odds of survival.  Short repo financing is by its nature is a weak financing method in a crisis.  The day you cross the line (margin inadequate) the brokers move to liquidate.  Given that some other managers may have been more aggressive, your excess capital can disappear, as more aggressive mangers miss margin calls, and the pressure of their liquidations, forces your more conservative positions down, and you have to liquidate also.

Now, think of a life insurance company, a long-tailed casualty insurer or a defined benefit pension plan.  If they buy AAA whole loans, or prime mortgage collateral, they can hold that position for 3+ years without worry.  Their liabilities aren’t going anywhere.  They know what they will be able to hold the investment through the panic period.  There are still questions over what the best time to buy is, but with many large companies or plans, the optimal thing to do is to suck in a little bit each day, quietly, when the bonds are cheap.  You won’t get the exact bottom; no one does, but you will do well.  My own example is buying floating rate trust preferreds back in late 2002.  Bought a 2% position over two months for my life insurance client without disturbing the markets.  My client cleared a minimum of 10% on those investment grade bonds within a year as the panic lifted.

Accounting vs. Financing

Now, there’s a lot of talk about fair value accounting standards, and how they are adding to the volatility at present.  They are adding to the volatility, but they have less effect than the way things get financed.  Unless the fair value accounting leads a company to violate a debt covenant, typically it does not have that much effect, because it does not change the pattern of cash flows that the company will generate.  Short term financing, where the portfolio’s “market value” gets measured on a daily basis has a much bigger impact, because as prices fall, liquidation of assets can feed a collapse of prices.  Or consider this article from Going Private, which cites an article from Financial Crookery, which highlights an attempt by Merrill Lynch to avoid having to pay out cash on a putable bond.  In order to do that, they make the bond more valuable, so that it won’t be put.  But this isn’t an accounting issue.  It is a financing issue.  Merrill doesn’t want to part with cash now, so it makes its future financing schedule more difficult.  It is a complex way of selling off a bit of the future in order to bail out the present.

Now, I disagree with The Economist article that spawned those posts as well.  There is a better way.  In place of the four common financial statements (Income Statement, Balance Sheet, Cash Flow Statement, and Shareholders Equity), have six.  The two additional statements would come from having a amortized cost income statement, and a fair value statement, and then, the same for the balance sheet.  It would not be a lot of extra work, because all of that data has to be gathered now already.  It would just create two different ways of looking at a financial entity.  One views it as a buy-and-hold investor (amortized cost), and the other as a trader (fair value).  The interpreter of those statements could decide which is more relevant.

I proposed this to an IASB commissioner 2-3 years ago, and she was horrified at the idea.  Two income statements?  Two balance sheets?  What confusion.  I pointed out to her that every financial statement is designed to answer one question.  Bond investors have to rearrange the data to do their analyses; we could create an EBITDA statement to make life easier for them, but we don’t.  The two statements types define two different ways of looking at a firm.  Each is more valid in different situations.

Now, for utility and industrial firms, these distinctions usually don’t matter much, but they do matter for financial firms.  There could be a seventh statement added there, which life insurance companies calculate for their regulators.  All financial companies should have cash flow testing done over the greater of the life of their assets and liabilities, over a wide number of interest rate and credit scenarios, calculating the present value of distributable earnings, to show where they are vulnerable.  They should publish the assumptions and results, and then let the market stew over them.

Now, for my actuarial friends, this would be the “Actuarial Full Employment Act.” Life Insurers control risk not by looking at short term movements in market prices, but through long-term stress testing.  It is no surprise that the insurers are doing much better than the banks in this environment.

My post yesterday on corporate bond spreads was received well.  I want to amplify one point that I did not make strongly enough.  During market crises, asset values cheapen not only in response to likely losses over the long run, but the possibility that there might be forced sellers due to:

• Reduction of leverage because of asset values declining
• Reduction of leverage because of brokers lending money get skittish
• Reduction of leverage because of rating agency downgrades
• Reduction of leverage because of client withdrawals
• Reduction of leverage because of an increased need for capital from the regulators
• Arbitrage from falling prices in related markets

This can temporarily self-reinforce falling asset prices, until unlevered (or lightly levered) buyers find the returns from the assets to be compelling.  Though my piece yesterday was more fun to write, this makes the argument plain.  Can you carry the asset through hard times?  What about the rest of the asset holders?

The concept of weak hands versus strong hands is a very real issue, and for those with a subscription to RealMoney, I recommend these four classic (Labor of love) articles of mine:

Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders’ Hands, Part 1
Get to Know the Holders’ Hands, Part 2

These articles are core to my thinking, and I spent a lot of time on them.

I’m just trying to clean up old topics, so bear with me:

1) This blog is not ending because of my new job. Finacorp wants me to keep it going, and they may use the posts in PDF form for clients. Also, unlike my prior employer, Finacorp wants me to have a high degree of exposure, because it aids them. You may see me in more venues, which could include TV and radio.

2) In one sense, I had an unusually productive Saturday. I built two models — one for a critique of the PEG ratio, and one for a model of the Treasury yield curve. You will see articles on both of these, and I am really jazzed on both of them. It is not often that I get one impressive result in a day. Today I got two. I’ll give you one practical upshot for now, if you are an institutional bond investor: go long 10-year Treasuries and short 7-year. We are very near the historical wides. If you are like me, and can live with negative carry, dollar duration-weight the trade, so that you are immune to parallel yield curve shifts.

3) I didn’t read Barron’s, Forbes, or The Economist today, but I did read the Financial Analysts Journal. In it there were three articles that are worth a comment. There was an interesting article on fundamental indexation that comes close to my view on the topic. Fundamental indexation, when properly done, is nothing more than enhanced indexing with a value tilt. Will it make you more money than an ordinary index fund? Yes, it will, over a long enough period of time. Will it work every year? No. Is there one optimal way to fundamentally index? No. There is no one cofactor, or set of cofactors that optimally define value, if for no other reason than the accounting rules keep changing.

4) The second article went over the value of immediate annuities as risk reducers to retirees, something I commented on recently. The tweak here is buying annuities that start paying later in retirement, for example at 80 or 85, with the risk that if you die before then, you get nothing. Longevity insurance; a very good concept, but the execution is tough.

5) The third article was on Risk Management for Event-Driven Funds. Here’s my take: risk arb is like being a high yield bond manager. Anytime a deal is announced, you have to do a credit risk analysis:

• How likely is it that this deal will go through?
• How badly could I be hurt if it does not go through?
• Am I getting paid more than a junk bond with equivalent risk?

But the portfolio manager must ask some more questions:

• Are there any common factors in my risk arb book that could bite me? Sectors? Need for debt finance?
• What if deal financing terms go awry all at the same time? How will that affect the worst risks in my book?
• Am I getting paid more than a junk bond with equivalent risk? (Okay, it’s a repeat, but it deserves it.)

Risk arbs have been burned lately, with all of the deals that have been busted because financing is not available on easy terms. It’s tough but this happens. Most easy arbs tend to get overplayed before blowups happen. The lure of easy money brings out the worst in people, even institutional investors.

6) Naked Capitalism had an interesting post on GM. I made the following comment:

I took some criticism at RealMoney.com for writing things like this about GM, though the author here was a much better writer.

The thing is, there are enough levers here that GM can keep the debt ball in the air for some time, as can many of the financial guarantors, so long as they can make their interest payments.

The “Big 3″ lose vitality vs. Toyota and Honda each year — in the long run GM and Ford don’t make it. Perhaps after they go through bankruptcy, and shed liabilities to the PBGC, and issue new equity to the current unsecured bondholders, they can exist as smaller companies that have focus. Maybe Ford could be a division of Magna, and GM a division of Johnson Controls. At least then there would be competent management.

7) Barry Ritholtz had a good post called, 5 Historical Economic Crises and the U.S. The paper he cited went into five recent crises in the developed world, and how the current US situation stacks up against that.  Here was my comment on one of the areas where the US situation did not seem so dire, that of the run-up in government debt:

On the last point about the increase in the debt, what is missed is that a lot of the government debt increase is hidden by the non-marketable Treasury bonds held by the entitlement programs. Add that in, and consider the unfunded promises made at the Federal, State, and municipal levels, and the debt increase on an accrual basis is staggering.

We do face real risks here.  The rest of the world will not finance us in our own currency forever.  Oh, one critical difference between the US and the 5 crises — we are the worlds reserve currency, for now.

8 )  I like Egan-Jones on corporate debt.  They have quantitative models that follow contingent claims theory, and use market based factors to estimate likelihood and severity of default.  They are now trying to do models for asset backed securities.  Very different from what they are currently doing, and their corporate models will be no help.  They will also find difficulties in getting the data, and few market-based signals that inform their corporate models.  I wish them well, but they are entering a new line of business for which they have no existing tools to help them.

9) This article from Naked Capitalism pokes at the rating agencies, and the proposed reforms from the SEC.  My view is this: the financial regulators need a model on credit risk.  They need a common platform for all credit risks.  They need one set of ratings that allow them to set capital levels for the institutions that they regulate, or they need to bar investments that cannot be rated adequately.  The problem is not the rating agencies but the regulators.  How do they properly set capital levels.  They either have to use the rating agencies, or build internal ratings themselves.  Given my experiences with the NAIC SVO, it is much better to use the rating agencies.  They are more competent.

10)  Finally, on Friday, a UBS report stirred the pot regarding non-borrowed reserves.  You can see the H.3 report here. Both Caroline Baum of Bloomberg and Real Time Economics debunked the UBS piece.  But it was simpler than that.  The Fed published its own explanation at the time they put out the H.3 report.  UBS did not include the effect of the new TAF.  Whoops.  Oh well, I make mistakes also.  It’s just better to make mistakes when one doesn’t sound so certain.
Full disclosure: long MGA, HMC

Those that know me well know that I have been following the entitlements issue for over 15 years. I feel that the leadership of the American Academy of Actuaries has blown it royally over this whole period, and before, through and before the Greenspan commission (his worst legacy). We had a chance to warn the nation, and did not do it. We allowed actuaries who could do the math, but didn’t understand the politics, to write in our journals, and talk to Congress, and suggest that everything would be fine.

Well, things are fine now, and they might be fine for the next president, but they won’t be fine by the 2020 election.

I am talking about Medicare/Medicaid. Unless there are significant changes made, there is no way that we can afford the promises that have been made.  The graph from the Wall Street Journal (from this fine article), on the right, depicts spending excluding interest.  Including interest payments makes the graph worse, and more so as time goes on.  In general, Americans don’t like sending more than 20% of GDP to the Federal Government.  By 2020, that will no longer be possible to avoid, unless significant changes are made.

This is the same issue that faces every state in the nation (except Wisconsin) and the Federal Government over their retiree health care programs; they didn’t set aside money for the future payments, but decided to pay-as-it-goes.  Now, what choices are there to remedy the situation?  Not many good ones:

• Raise taxes significantly.
• Raise the age for Medicare eligibility to 75 or so (don’t phase it in).
• Means-test eligibility (lousy incentives there, as it is for Medicaid)
• Eliminate part D now, while there is no imperative to keep it.
• Create a reimbursement system that forces the creation of a two-tier medical system.  For the elderly, it will mean limited help in their waning years.  Treatments for expensive prolonging of life will have to come out of private sources.  Call it the Federal Elderly HMO.

The likely solution will involve all five policy options in some form.  How it works out depends on how much political resistance the elderly Baby Boomers will put up.  Another political hurdle: much as I dislike National Health Care, that is a wild card in this mix.  That could be the de facto way that limits the benefit payments that seniors receive.

I’m not into doom and gloom.  I manage money that is invested in stocks, and I have to look for advantage every day.  But we have put off real reform of entitlements for over 25 years, and we continue to do so.  Which of our six remaining presidential candidates is willing to talk about reforming Medicare?  I haven’t heard any of them go that way; it just loses votes.  But when it is hitting us between the eyes twelve years from now, younger people will be incented to vote in politicians that will curb benefits.

My investment implication is this: don’t rely on Medicare existing in its current form past 2020.  Plan today for the medical care you will need then.  Unless you have a funded private plan behind you, that means saving for the future costs.

When financial matters are opaque, there must be a large discount to prices representing clarity to interest people to buy.  Unfortunately, with 401(k)s and other defined contribution plans, it is sometimes akin to being limited to the “company store.”  I’ve written about these issues before, both here and at RealMoney.  Here’s a good example of one of them:

		David Merkel
		Pension Consultants: Watch Your 401(k) Expense Levels
		9/27/2006 5:36 AM EDT

I want to point you to an article of John Wasik’s of Bloomberg. Having worked in the pension business while an actuary at a mutual life insurer, I had the experience of reviewing the pension services proposals of a number of competitors, and of complementary service providers. Most players were honest, but there were a number of players, while technically not breaking the law, would stretch ethics by finding ways to disguise fees by wending them into the change in unit value of the funds inside a deferred compensation plan. Why embed them in the unit value change? Slice up a fee over hundreds or thousands of participants, and over 365 days a year, and it is remarkable how little people notice it, because most people don’t bother to go and look at plan expenses as disclosed in the Form 5500. Even if everything were disclosed in detail there (some charges don’t get unbundled), an individual doesn’t see that the pro-rata expenses are coming out of his hide. Unless the plan sponsor goes the extra mile to try to minimize costs to participants, there is little that an individual can do.

We had a rule at our firm. We only take fees from one source, and we disclose them. We had a second rule: we only pay commissions once, and they can be disclosed to the ultimate client, or nondisclosed, but not both, but if nondisclosed, the ultimate client must know that.

Oe reason why we did not hire certain investment consultants was the potential for conflict of interest. We eventually hired a consultant to aid us in manager selection that took no fees from the managers, so we could get unbiased advice. There were other consultants that were less than scrupulous in that matter. Without naming names, we terminated our first investment manager consultant because we learned they would not recommend managers to us, unless they were receiving a fee from the manager. That fee would get built into the expenses would into the unit value, or, come out of my firms profit margins, which were for the good of the participating policyholders.

Now that was just my experience, so take that for what it’s worth, perhaps I’m just an investment actuary with a axe to grind. If you want a more general view of the problem, you can review this 2005 study of conflicts of interest done by the SEC. Now, as John Wasik notes, “The commission didn’t take any enforcement action after the report was issued, nor did it name any of the firms surveyed.” The problem is still there, and I’m afraid your only advocate is for you to appeal to your plan sponsor to watch out for the best interests of all participants, which is the duty of trustees under ERISA.

Position: none, but at the mutual life insurer, we had a saying, “We’re out to save the world for 25 basis points on assets, plus shipping and handling.” Beats a lot of other deals out there…

Now, here is another piece from Bloomberg: Fees on 401(k)s Rock Boomers Facing Flawed Disclosure.

The difficulty here is that fees on small plans are sometimes high, and defined contribution plans don’t allow for easy examination of the total fee structures.  How much are the investment managers taking?  The recordkeeper? The custodian/trustee?  The marketer?  It is not always clear.  What can be worse is the manager selection, which are usually random on average (before fees) in terms of any outperformance versus indexes.

Now, in fairness, anytime you have a large number of small accounts, the costs will be high as a percentage of assets.  But there are limits.  Disclosure needs to be improved, but until then, ask your plan sponsor for all of the Form 5500 documents.  There are two classes of expenses.  Explicit: what the fund pays for directly.  Implicit: what gets deducted from investment returns.  Add the two together, because that is the total load.  Insist on as full of an accounting as the plan sponsor will give you.

If you are paying more than 1% of assets per year, then something is wrong, unless the asset classes are esoteric, which should not be the case for DC plans.  Remember, you have to be your own guardian with defined contribution plans.  No one will do it for you.  And, if a few of your colleagues complain at the same time, you will be amazed at how quickly it will be taken seriously, because the administrative staff of the plan sponsor usually doesn’t get that much feedback.