Recently I got an e-mail from my friend Kid Dynamite.  He asked me an interesting question about pensions and long-duration bonds:

“back to the concept of century bonds.  I’m not sure if you read my recent pension post (http://fridayinvegas.blogspot.com/2010/09/problem-with-pensions.html) , but I’m having trouble with the concept of pensions investing in 100 year bonds at 6% while using an 8% portfolio return assumption. Does not compute…(and you can even pretend that pensions have 100 year obligations)

I just don’t get the concept of locking in long duration returns below your long term bogey. That just means that you have to do even better on the balance of your portfolio…which is nice to pretend about, but in reality, if you can do better on the balance, why bother with the 6% fixed income??”

It’s a great question and one that deserves more thought.  To do that, we have to separate the accounting from the economics.

When I was a young actuary, I was preparing to take the old Society of Actuaries test eight, which was the Investments exam.  An older British actuary made a comment in one of the study notes that I had to think about several times before I understood it: “Risk premiums must be taken as earned, and never capitalized.”

Sadly, the pension profession never got the memo on that idea.  The setting of investment assumptions accepts as a rule that risk margins will be earned without fail.  Therefore, when looking at a portfolio of common stocks in a pension trust, the actuary will assume that the equity premium will be earned over the long haul and build that into his discount rate assumptions and earned rate assumptions.  The same is true of bonds in the pension trust.  They may haircut the yield for potential default losses, but they will assume that much of the spread over Treasuries will be earned without fail and thus they capitalize the excess returns.

Let’s pretend that the 6% century bond that Kid Dynamite told me about is risk free.  Also, let’s pretend that the pension actually needs bonds as long as a century bond.  Defined benefit pension plans, if trying to match cash flows, need bonds longer than 30 years, but probably don’t need bonds longer than 75 years.  That said, given the lack of bonds that are longer than 30 years, a century bond will still prove useful in trying to immunize the tail cash flows of the defined benefit pension plan.

What that 6% century bond tells us is that the investment return assumption on an economic basis is too high.  And, given that the yields on safe debt shorter than a century is much less than 6%, it probably means that the investment earnings assumption rate is way too high at 8%, and should definitely be lower than 6%.

I know that’s not what GAAP accounting requires.  GAAP accounting allows you to choose whatever investment earnings rate you can justify using statistics.  That’s not the way GAAP accounting should work though.  GAAP accounting should work with discount rates derived from low risk fixed income securities, and use those to develop the investment earnings assumption.

If you earn more than the risk free investment earnings assumption, good.  Those excess earnings will reduce the pension plan deficit or increase its surplus.

Okay, then suppose we reset the investment earnings assumption at 4%, because that’s closer to where it should be economically.  My, what large pension deficits we see.  But now, all of a sudden, that 6% century bond looks pretty good, because it brings the cash flows of the plan into better balance, and earns a decent return in excess of the earnings assumption.

So, the problem isn’t with the century bond, it’s with the earnings assumption.  Now why does that earnings assumption exist?

• The US government wanted to encourage the creation of defined benefit pension plans, and so informally encouraged loose standards with respect to the earnings assumption.
• For years, it worked well, while we had bull markets going on, and interest rates were high, which decreased the value of the pension liabilities.
• The IRS took actions to prevent defined benefit plans from building up large surpluses, because it decreased their tax take.  Had companies been allowed to build up large surpluses, we wouldn’t be in the mess that we’re in today.
• There is the lazy acceptance of long-term historical figures in setting earnings assumptions, instead of building them from the ground up using a low risk yield curve, and conservative assumptions on how much risky assets can earn over the low risk yield curve.

So in an environment like this, where interest rates are low, and surpluses could not be built up in the past, pension funds are hurting.  The truth is, they are worse off than their stated deficits imply.  For economic and political reasons, the likely outcome resembles the riddle of how one eats an elephant: one bite at a time.

So we will see investment earnings assumptions and discount rates fall slowly, far too slowly to be the economic truth, but slowly recognizing funding gaps as corporations eat the loss one bite at a time, as they can afford to.

The investing implication is this: for any stock you own that sponsors the defined benefit pension plan, take a look at the earnings assumption and raise the value of the liabilities.  Also recognize that earnings will be lower than expected if the deficit is large and they need to make cash contributions in order to fund the pension plan.  That said, they could terminate the plan, and I suspect many current defined benefit plan sponsors will do so.

And given that, there is one more implication: if you are employed by, or are a beneficiary of a defined benefit pension plan, take a look at the form 5500, or at the company’s financial statements and look at the size of the deficit.  Take a look at what the PBGC will guarantee for you, and adjust your plans so that you are not relying on the continued well-being of the defined benefit pension plan.

I wish I could be the bearer of better news than this, but it is better to be aware of problems, then to learn that what you don’t know can hurt you.

For what it is worth, I don’t encourage calling me “Dave.”  My wife, my pastor, and some close friends call me that.  I learned to love my given name when I became an adult — David is a wonderful name, and I am glad my parents gave me that name.  It is an informal age, with the benefits and problems thereof.

On with the scenarios:

4) I have had short jobs: helping a young man to decide whether to buy a house or not.  My counsel: not.  So far so good.  Helping an older lady figure a complex tax basis of stock her father left her inside a DRIP.  A pain but a finite process.

5) A friend my age (50s) who runs a successful business asked me for advice ten years ago.  My advice was don’t run with negative working capital; leave some margin for error.  It took him nine years to figure out that I was right, and the business suffered 3-4 near death experiences en route.  Now he is more profitable than ever, and was grateful for my advice.  As a shareholder, I am glad that he listened.

6) A younger friend (30s) who runs a successful small business who asks what he should do with his excess money.  I told him to put it in Vanguard’s Balanced Fund, or the STAR fund, if he really did not need it for his business.  But he is the sort that always wants to do the best, and feels mediocre results are laziness.  I have told him, focus on your business; it is what you are best at.  What you earn on spare cash balances, particularly in this low-return era, will not avail as much as you could by selling more, and providing good service.

7) A friend (50s) a few years older than me has been put to the test.  His employer has offered him a severance package if he leaves of a little more than one year’s income.  His pension, if taken today, will barely cover expenses, but is roughly equal to his salary.  He has no savings, and has helped put 3 of his 5 kids through college, with 2 to go.  I advise that he continues to work, and that he turn down the package, because it is unlikely that he could get work nearly as remunerative.  Risk: his company folds, and he loses the package.

8 ) A friend (50s) who has planned asks whether his plan is wise.  I told him that the asset allocator using DFA is pretty smart, and and the cost is reasonable.  Beating the S&P 500 over 9 years by 4%/year is hot stuff.  My only critique is that it is a 100% equities program, which is fine if you can live with that level of volatility.

9) My pastor came to me in 2007, asking whether he should still be in the money market fund for his defined contribution plan.  I had been waiting for this moment, because he was too cowardly in investing, but it was the wrong moment.  I told him to take the moderate allocation, because moderate and aggressive allocations do the same over time, but the moderate will let you sleep.  He came through 2008 like a trooper, with the losses, and bounced back in 2009.  The mix will do him well over the long run.

His case made me look over the denominational plan.  I concluded that the asset allocations were set one notch too high at each level… technically, the percentages allocated between risky and safe assets might be correct when thinking about lifespan, certainty of future earnings, but does not take into account the fear factor so well, i.e., people changing their strategy in the midst of panic, at the wrong moment.

So I let the pastors know that, and told them to shade their asset allocations to the conservative side last June.  It does not help that we are in a period of debt deflation, which will retard asset appreciation for some time.  It is harder for asset prices to rise, when the buying power from debt is diminishing.

And yet there are more who want my advice but haven’t sent me the documents yet… It reinforces to me that most don’t know what to do with excess money.

Perhaps that is a lesson — most people are technical specialists, and do their jobs well, but many are ill-adapted to managing their excess funds wisely.  Another reason to end Participant-directed defined contribution pension plans, and create trustee-directed plans, or even defined benefit plans.

Yes, this is a paternalistic view, and is at odds with my normal libertarian ways of thinking.  As policy goes, let people be free to have whatever savings/investment plan they like.  But if you care for those that you have some charge over, create a plan that takes the investing out of their hands.  Then make sure that it is prudently invested.

And in the end, remember, though it is almost always better to have more than less, invest in such a way that you, and those that rely on you will make it to your goal comfortably.  Just as valuable is the ability to sleep at night, and know that your plan has enough slack to enable you to take some hits, and come through fine.

I get requests from local friends fairly regularly for aid in understanding their finances.  While coming home from church recently, I mentioned to my wife that many were seeking my opinion in our congregation.  Her response was, “So what else is new?”  Then I began to list it, family by family, and the congregations that were seeking my opinion for their building/endowment funds, and/or borrowing needs.  As I went down the list, my wife’s responses were “Not them!”, and “Them too?!” and “No!”

What can I say? My wife is the best wife I have ever heard of, but even married to me, economics is a distant topic.  Her father was well-off, but humble, and I am well-off, and I try to be humble.  You can be the judge there.

I say to my friends asking advice, “Remember, I am your friend.  I will take no money, but I won’t hold your hand and guide you either.  I will give you very basic advice, and it is up to you to learn and implement it.”  I don’t want to be a financial planner, but I don’t want to leave friends in a lurch.

With that, the scenarios:

1) 90-year old widow, who lives with her daughter and son-in-law.  Another son-in-law, given to incaution, is advising putting everything into gold and silver.  What to do?

She has adequate assets to support her through the rest of her life.  Her husband was responsible.  I asked her if she needed more income, and she said no.  I told her, then relax, ignore the other son-in-law (I know him to a degree), but if you want to, invest 3-5% in precious metals.  She didn’t see the need, and I told her that was fine.  She asked me what I would do in her shoes, and I said that it was a very difficult environment to be investing in, and that we could not tell what the government might do in a crisis, so the best thing to do was to stay diversified, and invested in companies which would have continued demand.  But if you don’t need the money, don’t take the risk now.

2) 80-year old widow, assets in even better shape.  Her husband was a great guy; an inspiration to me in many ways.  He was a mutual fund collector, and left her a basket of 30+ funds, as well as two homes free and clear.  What to do?  I suggested that she harvest funds that had been doing particularly well and reinvest in funds that had lagged.  I suggested purging certain funds that were likely mismanaged.  I also suggested liquidating one property if she could get an acceptable bid.

3) 50-year old bachelor, never married.  Funds are from TIAA-CREF.  We decided on a 50-50 stock-bond mix three years ago.  Recently we rebalanced to add more equities.  He was disappointed that his portfolio had moved backward.  I said “Welcome to the club.”

I will continue with more in part two, but 2008 blew apart many people’s expectations over what their assets could deliver.  My stylized view of it stems from comments that I got at church.  In 1999, my friends were people into equities, as I was holding back.   In 2002, many said they were exiting equities, and moving to what they understood, residential real estate.  I was adding fresh cash to my positions, and paying off my mortgage. By 2006-2007, they began getting interested in stocks again.  By 2009, both stocks and residential real estate was tarnished, leaving bonds remaining.

Closing then, with three final notes:

a) The low interest rate policy is definitely hurting seniors, and I believe all investors.  We all become worse capital allocators when there is no safe place to put excess funds.  It tempts people to stupid decisions.  If Bernanke wants to do us a favor, let him resign, and put John Taylor or Raghuram Rajan in his place.  Tempting people to dumb investment decisions hurts the economy in the long run, it does not help us.

It may help the banks have a risk-free arb on short government bonds, but that’s not what we should want either.  If they are sound, they should be lending. Raise short rates, and let the banks have a harder time, and give investors a place to put money while they look for better opportunities.

b) Average people, and sadly, many professionals, are hopeless trend-followers.  They have no sense of looking through the windshield, rather they ask what has worked, and do that.  Mimicry can be a help in much of life, e.g., finding where to buy good furniture cheaply, but is harmful with investing where figuratively the devil takes the hindmost.

c) People get caught on eras, and have a hard time letting go of them.  The 70s biased many against inflation, and toward residential real estate. The residential real estate lesson got reinforced in the ’00s.  The equity markets seemed magical from 1975 to 2007, and asset allocators increased their allocations to equities in response.  Now you hear of “bonds only” asset allocations, just as the amount of juice available in most of the bond market is limited.

People got used to refinancing their mortgage every few years, and enjoying the extra cash flow.  The modern era reveals the hidden assumptions on that: that property values would never fall.

The point: markets aren’t magic.  They can only deliver what the real economy does.  Stocks only do well over the long run if profits do well. Valuations come and go.  Bonds make money off the stated interest (coupon) rate less default losses.  Valuations come and go.  Real estate is worth the stream of services that the land and improvements can deliver.  Valuations come and go.

Now, you can play the “come and go” if you are smart, but with the “come and go,” for every winner there is a loser.  But asset allocators need to be more humble in their assumptions for financial planning and not assume that they can earn more than 2% over the 10-year Treasury, or over expected growth in nominal GDP.  The share of income that goes to profits and interest also tends to mean-revert over time, so humility is needed when:

• Illustrating an investment plan for a family
• Setting the discount rate for a defined benefit pension plan
• Setting the spending rate on an endowment
• or even, setting assumptions for the Social Security trust funds.

Illiquidity is an underrated risk.  Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.  Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don’t trade often.

So where do we see failures due to illiquidity?

• Banks — too numerous to mention, though FDIC insurance restrains it now.
• Life insurers, particularly those that write a lot of deferred annuities.
• AIG and the GSEs — abominations all.
• Bear and Lehman — waiving the leverage limit was one of the stupidest regulatory decisions ever.
• Hedge funds – LTCM was the granddaddy of failures, but many have choked because redemptions forced liquidation of assets at unfavorable prices.
• No colleges, though those college that were too aggressive on illiquid assets got whupped in 2008.  Some were forced to raise liquidity in costly ways.  Same for many overly aggressive pension plans, many of whom came late to the game with Venture Capital, Hedge Funds, Timber, Commodities, etc.

Face it.  Most alternative asset classes involve additional illiquidity.  That is an additional risk, and when evaluating those investments, the expected rate of return must be greater than that for liquid investments.

As an aside, there is another factor to be considered with alternative investments.  That factor is strategy capacity.  Alternative investments do best when they are new.  Here is my version of the phases that they go through:

• New — few know about it except some business-minded investors.  Only the best deals get done.
• Growing — a modest number know about it, and a tiny number of consultants.  Only very good deals get done.
• Comes of age — many know about it, and most consultants pitch it to their clients as the way to go.  Good deals get done.
• Maturity — almost everyone knows about it, and it is a standard aspect of asset allocation for consultants, who have their means of differentiating between different providers, based on metrics that will later be revealed to be useless.  All reasonable deals get done.
• Post-maturity — Late bloomers make it to the party, and beg to get in, thinking that past is prologue, and do not realize that deal quality has eroded severely.
• Failure, which brings maturity — deals fail, leading the market to scrutinize all investments, leading to true risk-based pricing.  Later adopters abandon the market, and take losses.  Earlier adopters sharpen practices, and prepare for a more normal asset class.

So, when looking at illiquid assets, how do you determine how much to invest?  First determine how much of your funding base will never leave over the next 10 years.  When I was a corporate bond manager, that was 25% of the assets that I was managing, because of structured settlements and immediate annuities.

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.  Invest that much in short to intermediate bond investments.  You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

But after that, there is an additional way of controlling illiquidity risk — time once again for the fusion solution! Money market funds run a ladder of maturities.  Stable value funds run a longer ladder, as should commodity ETFs, rather than floating at spot.  Then there are clever advisers who run municipal and other bond ladders for wealthy and semi-wealthy clients.  Running a ladder of maturities is one of the most robust management techniques as far as interest rate risk is concerned.  There is always money coming out and in every year, which slowly leads the portfolio yield in the direction of average rates.

Now, if these bonds are less liquid muni bonds, but the credit risk is low, you don’t care as much about the illiquidity, because the ladder produces its own liquidity as bonds mature.  The key question is sizing the length of the ladder, which comes down to a question of analyzing the liquidity/income needs of the client, combined with a forecast on the secular direction of rates.  The forecast is the least important item, because it is the toughest to get right.  (An aside: who has been right on bond yields consistently for the last 20+ years?  Hoisington, my favorite deflationists.  Wish I had listened more closely.)

The same principle applies to pension funds, endowments, life insurers with a few twists.  Divide your liabilities in two.  What obligations do you know cannot be changed, except at your discretion?  That group of liabilities can have illiquid assets to fund them.  Try to match the payout streams, but if not, try to match them in broad with a ladder, keeping in mind what mismatches you will likely face over the next 1-2 years in order to properly size your cash position.

The rest of the liabilities need more intensive modeling, analyzing what could make them change.  You can try to buy assets that change along with the liabilities, but in practice that is hard to do.  (That said, there are no end of clever derivative instruments available to solve the problem in theory.  Caveat emptor.)  The assets have to be liquid for this portfolio.  Other aspects of portfolio choice will depend on valuation parameters, credit spreads, yield curve shape, market volatilities, as well as macroeconomic factors.

Three Closing Notes

1) Now, all that said, just because you can take on illiquidity doesn’t mean that you should.  A good manager has a feel from history for what the proper liquidity give up is in valuations for stocks and other risk assets, and credit spreads for fixed income assets of all sorts.

Was it worth moving from the:

• Relatively liquid AAA tranche to the illiquid AA, A or BBB tranche for 0.10%, 0.20%, 0.40%/year respectively?  As a bond manager at much larger insurance company said back in 2000 — “It’s free money.”  (That is almost always a dangerous phrase.) My view was there was more illiquidity and credit risk than we could consider.
• Relatively liquid large-issue BBB bank bond to the relatively illiquid small-issue BBB bank bond for 1% more in yield?  Hard to say.  There are a lot of factors involved here, and your credit analyst will have to be at the top of his game.  It also depends on where you are in the speculation cycle.
• Liquid public equities to private equity or hedge funds with lockups?  Tough question.  Try to figure out what the unlevered returns are for comparative purposes.  Analyze long-term competitive advantage.  Look at current deal quality and valuation metrics.  For hedge funds, look at how credit spreads moved over their performance horizon.  Anyone can make money when spreads are tightening, but who makes money when spreads are blowing out?  Analyze them over a full credit cycle.

2) Institutions that did not previously do more liquidity analysis because we had been in near-boom conditions for decades need to at least do scenario testing to assure that they aren’t overplaying their hands, such that they might be forced to make bad decisions if liquidity gets tight.  Safety first.  (This applies to governments and industrial corporations too, as we will experience over the next three years.)

3) Finally, if you decide to make a large illiquid purchase like Mr. Buffett did last year, make triple-sure of your logic and your liquidity positioning.  Nothing lives forever, but you can prolong the life of the institutions you serve by careful reasoning and planning, particularly regarding liquidity.  Get financing when you can, not when you need it. It takes humility to do so, but it yields the quiet reward of continued existence at a modest price.

1) Kind of like my thesis that the States give a better picture of the economy than the Federal Government, I agree with the idea that small banks better represent that health of the US economy.  Most small an medium-sized businesses rely on small banks.  Growth in employment relies on small and medium-sized businesses, because they typically have more room to expand.

2) I’ve been arguing for a weak economy before the double dip concept was derided.  Not that I make the Philly Fed survey a big part of my analysis, but the weak report is consistent with my view that the US economy is weak.

3) All developed markets where there is still confidence are finding long government yields hitting new lows.  No surprise, with so many investors and nations scared, that many would focus on sovereign governments for repayment.

4) So there are failures to deliver in the MBS market.  Part of it is due to the Fed sucking up a large part of the market.  Part due to the low cost of short term funds.  My question to anyone reading, are there any significant costs?

5) A crisis like this is divisive.  In the US, it separates the strong versus the weak states.  In the EU, it separates the strong versus the weak countries.  That is the nature of financial crises — they divide the healthy from the sick,with some slight tweaking from government action.  As it is now, there is a divergence where countries with some flexibility fight to maintain their independence.

6) Jake makes the argument that one would pay a lot for certainty of return of principal in this environment. SO, don’t sniff at low short term rates.

7) Ordinarily I agree w/Jesse.  For example, I agree that there could be a lot more extracted from the rich in taxes.  But I don’t think it would succeed.  There are too many holes in the tax code, and the wealthy would hire bright people to make the tax obligation go away.  I speak as one that has seen this in action.  Rich people are much smarter than poor people when it comes to money. It would take radical tax reform to change matters.

8 ) The ultimate stories on GM and AIG, as well as FNMA and FHCC, is that the government loses money on the deals, but spins them positively, in saying, “look, they are operational again.” Truth, better that they all failed, but the government aims at fixing things, even when it can’t.

9) This piece gets it right on Social Security in minor, blows it in major.  Yes, the bonds built up over the last 20 years will be paid out of current tax revenues, but will the US Government be able to bear the total burden as Medicare expenses go through the roof?

10) What a fight on stocks vs. bonds.  I favor bonds in the short run, stocks in the long run.  Where I disagree with both is that government action is needed to preserve value.

11) Are we turning into Japan? I have argued yes for some time because we are following the same government actions that Japan did.

12) How bad is the economy?  Bad enough that average people are liquidating 401(k)s.

13) China might finally be getting smart on population policy.  But getting women to have more kids once you have convinced them of the short-term value of not doing it — you will have a better career, and the long-term benefit of not doing it — we have too many people for the planet already; it’s pretty tough.  They take the easy road of not having kids, and it doesn’t matter how many economic incentives get kicked up — once women decide they don’t want to have children, there is no amount of economic policy that will change their minds.

But, there are other ways to do it: show reruns of happy families with many kids.  Waltons, Brady Bunch, Eight is Enough, etc.  We had eight kids, (we adopted five) and there is a lot of value in the many relationships that exist in a large family.

Okay, enough for now.  Time for sleep.  Just don’t go shorting bonds thinking I told you to do it.

I first became interested in Social Security back in the 80s.  In order to become a Fellow in the Society of Actuaries you had to study all manner of insurance programs, both private and social, to understand the framework in which insurance and pension products existed.

The Greenspan Commission back in 1981-1983 proposed another large increase to Social Security taxes.  The system only needed a small lift to get it past some demographic difficulties, but the Commission proposed, and Congress passed a large change, which would mean that the Social Security would develop a large base of Treasury Notes, because income to the system would outstrip benefit payments for a long time, and the proceeds would be invested in Treasuries, because they are a neutral asset.  Investing in other assets would invite socialism and cronyism.

But really, what was needed was to move to a pay-as-you-go system, as Pat Moynihan suggested in the early 1990s.

But the fix could never be permanent, because even as taxes were increased, the benefits increased along with them, and there would come a day of reckoning.  But when?  There are three dates that many would point to:

1. When the excess of taxes over benefits would peak.
2. When benefits and taxes would be equal.
3. When the trust fund would be broke.

I always looked at the first of these, whereas most commentators looked at the last of them.  My reasoning worked like this: the Federal Government has cynically integrated its budget with Social Security to make its deficits look smaller.  This is like a drug to the government; the real pain will come to it when the subsidy begins to fall.  By the time it goes negative, the US Government will account for it separately, so as to minimize the deficit again.

Given my view of how the US Government could no longer balance its books, the real change would come when they would have to increase their borrowing because there was not as much excess from the Social Security system.

When I first started looking at the Social Security system, the three dates in question were in the 2010s, the 2020s, and in the 2040s.  I thought that those dates were optimistic, but what I did not expect was that the current economic crisis would accelerate the first two dates dramatically.  As it is, date one has passed in 2008 (+/- a year), and I think the second date is happening in 2010.  Bruce Krasting’s post highlights the details, but I would concur, this recession will not end rapidly in the place where is counts for Social Security — employment.  We are not likely to see Social Security deliver surpluses to the US Government anymore.  Thus I expect deconsolidation of Social Security’s finances with that of the Federal Government.

What I never expected was that dates one and two would come so rapidly — almost together.  Let the morons who talk about trust fund exhaustion pontificate.  “We have all of these assets with which to pay future benefits….”  Nonsense.  As they sell bonds issued to the Social Security System, they must issue even more debt to the public.  How much can they bear, and at what yield?

Going back to my trip to the US Treasury, I want to remember one particular incident:

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?

The crisis has accelerated that date to 2010.  That’s a lot of change in just eight months.  The long-term problem is upon us now.  We are at the point of no return, absent large changes that those influenced by Keynesians will resist.

There are no good solutions now.  Budgetary cuts and tax increases reduce the possibility of government default.  They also will tend to slow the economy, unless the tax increases stem from cutting cheating, and the budget cuts affect only things that are a fraudulent waste.

Once you reach the point of no return, it doesn’t matter what prescriptions one follows — failure is coming.  One can shape the type of failure, but not that there will be failure.

All that said, there are still options, though none of them are good.  Will the currency be inflated?  Will the government default?  Will taxes be raised dramatically? I don’t know.  Be alert; be ready.  The endgame is here; we will see what moves the government makes.

PS — I have a signed copy of A. Haeworth Robertson’s book, Social Security: What Every Taxpayer Should Know.  He was the Chief Actuary of the Social Security System for a time, and a noted skeptic of the program.  He sent me the copy after I shared some of my misgivings with him in the 1990s.

Alas, but the average actuary has been skeptical of the Social Security system, and I have met many actuaries that work there, and they agree.  But leaders of the Society of Actuaries, when asked to give a clear warning on the troubles to come have refused.  I have my theories as to why — they curried favor with politicians for their own personal reasons.  Sad.

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Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Pardon the infrequency of posting.  I have been having internet issues.

1) A response to those commenting on my piece A Stylized View of the Global Economy: when I say stylized, is does not mean that every nation fits the paradigm, only that most do.  My view is that the debt overages will have to be liquidated, and there is no possible policy that can avoid it except large scale inflation.  Those looking for clever ways out of this bind will be disappointed by what I write.  When nations are heavily indebted their options decline, particularly when they don’t control their own currency.  For the US I say that we should have liquidated insolvent firms rather than bailing them out.

Also, read Falkenstein as he takes on the idea that stimulus spending works.  I have little confidence that the linear reasoning behind stimulus spending yields long-term economic benefits.

2) One blogger that I have some respect for, but have not mentioned often is Bruce Krasting.  He writes some good things on US social insurance programs. His recent post Social Security at Mid-Year highlighted what should shock many: we have hit the tipping point on Social Security.  From here on out it will be a drag on the federal budget.  Expect Congress to remove it from the federal budget.  It no longer aids the illusion of smaller deficits.  (What a cleverly hidden illusion.)

As he commented at the end of his article:

-SS is $2.5T of the $4.5T Intergovernmental account. I believe that this entire group is going cash flow negative. The IG account cost us ~$160 billion in interest last year, but some out there are pretending the IG account does not exist. An example of this is in the following link.

Sorry, U.S. Federal Debt Is NOT Approaching 100% Of GDP Anytime Soon

This kind of thinking is not only lunacy; it is dangerous.

And I agree.  There only two ways to look at the balance sheet of the US.  Look at explicit debt vs GDP, regardless of who is owed the debt.  Or, look at total liabilities vs GDP.  But never look at explicit debt not used to fund social insurance funds.  It is meaningless.  The total liabilities number tells the whole story.

3) Spain is in trouble.  Their banks are borrowing a lot from the ECB, with no end in sight.   Perhaps that leads them to push for stress testing across all European banks.  Or, maybe things are so bad that the banks are identified with the sovereign credit, and both are tarnished.

4) Or consider the Eurozone as a whole: the system begs for debt relief, but the Euro and ECB are tough taskmasters.  The Euro has been an excellent successor to the Deutschmark in terms of preserving purchasing power, but perhaps purchasing power needs to be sacrificed in order to relieve debtors.  The ECB is steps away from monetizing the debts of its governments.  Perhaps they could preserve the Eurozone by destroying the value of the Euro.  Germany might not stand for it, but it has significant unfunded liability issues as well.

As with the US, unless there is a large inflation, debts will eventually have to be liquidated, whether through austerity or default.  There is no other way.  Austerity will have its costs, but unless debts are inflated away or defaulted, those are costs that must be paid.

5) Can pensions be cut?  The typical answer is no, but what if a state pays less than what was promised in inflation-indexed terms?  That is what is being tested.  I think that eventually states and municipalities will be forced into bankruptcy because they can’t make employee benefit payments, and still maintain minimal services to the populace.

6) Debtors prison.  I have mixed feelings here, because I think that those that can’t pay should not be put there for long, if at all.  Those that can pay but won’t, should go there.  Regardless, this is a trend, and those that think they can walk away from debts should think twice before doing so.  You may be setting yourself up for prison.

This is just another front in the war against those who can pay but won’t.  More lenders are suing those who won’t pay, and going after their assets.  My only surprise is that it has taken so long for this to happen.

7) Fannie and Freddie are a giant black hole.  It astounds me that there is any respect given to two companies that have lost massive amounts of money since their inception.  The US would have been better off without them, and will be better off with them in bankruptcy.  The US should not promote single family housing as a goal, because it cannot create the conditions where marginal people can be capable of financing housing on their own.

So, when some suggest one last bailout, I say, let them fail.  Cancel the common and preferred stocks, and fold the remainder into Ginnie Mae.

8 ) Occasionally, there are really dumb articles, like this one.  The time for debt was November 2008 through March 2009, when I recommended investing in junk bonds.  There is little reason to borrow now; valuations are relatively high, don’t take your life into your hands.

9) And, occasionally, smart articles, like this one.  If you are in a volatile profession, reduce your risks by investing in high quality bonds.  If you are in a safe profession, invest in stocks.  When I went to work for a hedge fund, the first thing I did was pay off my mortgage, so that I could take more risk, without worrying about getting kicked out of my house.

10) Felix Zulauf has generally been a bearish guy, and so has done well over the past decade.  But is he right now?  Will stocks revisit their March 2009 lows?  It is possible, but I lean against it.  We would need a situation where most of the developed nations decided to aim for recession and stay there a while.  I do not see that yet.

11) Is it is liquidity problem or an insolvency problem?  If you have to ask, it is usually insolvency.  Consider Richard Koo, and his thoughts on the matter.

12) Using the rubric of the “Tragedy of the Commons” Kid Dynamite points out how it sets up the wrong incentives if we bail out profligate states and municipalities.  As a part of my “new mormal,” it is no surprise to me that this is happening.  It should be happening, and will happen for at least the next five years.

13) Because of my employment agreement, I can’t tell you exactly what I know about the demise of Finacorp.  But I can tell you that the article cited is wrong.  Finacorp never carried an inventory of assets.  It only crossed bonds between buyers and sellers.  The failure of Finacorp occurred for far simpler reasons.

Big Movers

Thoughts:

• Real Estate servicers and finance companies lead.  GSEs and guarantors trail.  Light corporate news day.
• AIG Bankers Said to Value Asia Unit at Up to $36 Billion in Stock Offering – dream, baby.  You can’t get as much as Pru plc was willing to overpay.
• Citi U.S. Consumer Unit to Show Profit by Shifting Loans, Closing Branches – Wisdom.  Shrink operations and focus on what makes money.  Universal banking does not work, because managements lack focus.
• Covered Bond Sales Surge, Transocean Falls, GE Buys CMBS – the panic in Europe takes a breather, but RIG has some worried about its survival.  For a primer on covered bonds look here: Covering Covered Bonds.
• Buffett Forced to Testify Backs Moody’s in Hearing Without `Candid’ Voice — well, what do expect when he is compelled to testify by a subpoena?  I would be careful about what I said as well.
• Buffett Expects ‘Terrible Problem’ for Municipal Debt – Buffett sounds the same themes as my “New Normal,” where municipalities will have a hard time for a long while.
• AIG’s Benmosche May Survive AIA Deal Failure – Who else has the chutzpah to take on the job?
• The short-term performance model for financial stocks recommends Real Estate Services, Real Estate Development, Residential REITs, Consumer Finance, Hotels, Office REITs, Diversified REITs, Multiline Insurance, Regional Banks, and Retail REITs.
• Whether insurers or banks, avoid equity-sensitive names here – aim at companies that don’t have a high degree of sensitivity to stock market performance.

Group Price Movements for this Morning

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

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

Disclosure: long ALL NWLI SAFT RGA AIZ PRE CB

The need for income naturally biases a portfolio long.  It is difficult to earn income without beneficial ownership of an asset – positive carry trades will almost always be net long, absent major distress or dislocation in the markets.  Those who need income to survive must then hope for a bull market.  They cannot live well without one, absent an interest rate spike like the late 70s/early 80s.  But in order to benefit in that scenario, they had to stay short.

More with Less.  Almost all of us want to do more with less.  Save and invest less today, and make up for it by investing more aggressively.  We have been lured by the wrongheaded siren song that those who take more risk earn more on average.  Rather, it is true 1/3rd of the time, and in spectacular ways.  Manias are quite profitable for investors until they pop.

As I have said many times before, the lure of free money brings out the worst in people.  Few people are disposed to say, “On a current earnings yield basis, these investments yield little.  I should invest elsewhere,”  when the price momentum of the investment is high.

I will put it this way: in the intermediate-term, investing is about buying assets that will have good earnings three or so years out relative to the current price.  Whether one is looking at trend following, or buying industries that are currently depressed, that is still the goal.  What good investments will persist?  What seemingly bad investments will snap back?

That might sound odd and nonlinear, but that is how I think about investments.  Look for momentum, and analyze low momentum sectors for evidence of a possible turnaround.  Ignore the middle.

Less with More.  Doesn’t sound so appealing.  I agree.  As a bond manager, I avoided complexity where it was not rewarded.  I was more than willing to read complex prospectuses, but only when conditions offered value.  Away from that, I aimed at simple situations that my team could adequately analyze with little time spent.

That is one reason why I am not sympathetic to those who lost money on CDOs.  We had two prior cycles of losses in CDOs — a small one in the late ’90s, and a moderate one around 2001-2003.  CDOs are inherently weak structures.  That is why they offer considerably more yield relative to similarly rated structured assets.

So, for those buying CDOs backed by real estate assets mid-decade in the 2000s, I say they deserved to lose money.  Not only were they relying on continued growth in real estate prices, but they were reaching for yield in a low yield environment.  Goldman and other investment banks may have facilitated that greed, but the institutional investors happily took down the extra yield.  No one held guns to their heads.  The only question that I would raise is whether they disclosed all material risk factors in their prospectuses.  (Not that most institutional investors read those — they call it “boilerplate.”)

Reaching for yield always has risks, but the penalties are most intense at the top of the cycle, when credit spreads are tight, and the Fed’s loosening cycle is nearing its end.  It is at that point that a good bond manager tosses as much risk as he can overboard without bringing yield so low that his client screams.

Perhaps the client can be educated to accept less yield for a time.  I suspect that is a losing battle most of the time, because budgets are fixed in the short-run, and many clients have long term goals that they are trying to achieve — actuarial funding targets, mortgage payments, college tuition, cost of living in retirement, endowment spending rule goals, implied cost of funds, etc.

That’s why capital preservation is hard to achieve, particularly for those that have fixed commitments that they have to meet.  It is impossible to serve two masters, even if the goals are preserving capital and meeting fixed commitments.  Toss in the idea of beating inflation, and you are pretty much tied in knots — it goes back to my “Forever Fund” problem.

This third subpart ends my comments on this rule.  You’ve no doubt heard the Wall Street maxim, “Bulls make money; Bears make money; Hogs get slaughtered.”  Yield greed is one of the clearest examples of hogs getting slaughtered.  So, when yield spreads are tight (they are tight relative to risk now, but could get tighter), and the Fed nears the end of its loosening cycle (absent a crisis, they are probably not moving until unemployment budges, more’s the pity), be wary for risk.  Preserve capital.

The peak of the cycle may not be for one to three years, or an unimaginable crisis could come next month.  Plan now for what you will do so that you don’t mindlessly react when the next bear market in credit starts.  It will be ugly, with sovereigns likely offering risk as well.  At this point, I wish I could give simple answers for here is what to do.  What I will do is focus on things that are very hard for people to do without, and things that offer inflation protection.  What I will avoid is credit risk.

Tonight’s post could be one in the “rules” series, but since I did not get this idea prior to 2003, when I started investment writing at RealMoney.com, it does not qualify for me.  But here it is:

At the end of the day, the world as a whole is owned 100%.  There are people with short positions, calls, puts, etc., and even things more exotic.  Those are noise around the real economy that produces the goods and services of our world.

Beyond that there are debt transactions in order to own assets, or purchase products and services.  But every debt is an asset to another party, and cancels out across the globe.  There are no debts on net in the world.

Does that mean that debts are irrelevant?  No.  Debts are relevant for two reasons: 1) Highly indebted economic systems are inflexible, because there are too many fixed claims.  They are far more prone to crises.  2) The debt of financial companies is very important because they often borrow short-term to finance longer-term assets.  In the current crisis, repo funding is the great example of this.

A financial firm thinking long run would not do repo financing because it can be easily pulled.  It would float long debt equal to the term of the assets that they want to finance.  But that might make their margins inadequate.  Don’t you know that short rates are volatile, and that they tend to be lower then long term rates most of the time?

Well, maybe.  But when debts increase, parties step forward to finance long credit via short borrowing.  That is an essential element of the credit system when it is in bubble mode.  (Side note: the exception to this is lending against sticky checking and savings account liabilities.  Those liabilities are sticky only because of deposit insurance.  The policy question there is whether the insurance premium is set too low. In hindsight, the answer is yes, though at my prior employer, we talked about the inadequacy of the FDIC, and bank reserving regularly.)

Though all debts net out to zero across the global economy as a whole, a lot depends on who owns the debts.  If the debts are owned by those who are borrowing money, risks of a debt crisis rise.  The layering of debt upon debt, and borrowing short to lend long decrease financial system resilience.

Finally, the willingness to make loans to marginal borrowers is really a statement that lenders are willing to make an equity investment in someone they are lending to, or some property that they are lending against.  Formally, it is all a loan, but economically the lender is betting on prosperity, much as a stock investor might.

When I wrote my piece on the residential housing bubble at RealMoney back in May of 2005, I did not focus on the high prices much; instead, I focused on the financing issues:

• Amount of debt vs assets
• Borrowing short term to buy a long-lived asset, a house.
• Quality of the debt underwriting

And, much the same when I wrote my piece on subprime mortgages in November 2006, too much leverage, the teaser rates are short term borrowing, and the loan underwriting was horrible.  As with residential mortgages generally, subprime mortgages were even more set up for failure.

If you want to find a bubble, focus on the financing.  The rise in asset prices is not sufficient, assets must be misfinanced for there to be a bubble.

When I was writing at RealMoney, I did a series of four articles to illustrate market dynamics:

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

I wanted them to have similar titles, but it was not to be.  Even for managing equities, understanding the balance sheets of companies, and those that own companies can make a difference.  When stocks are owned by those that can truly buy and hold, downside is limited.  When stocks are owned by those who are under pressure to earn money in the short run, upside is limited.

But what of liabilities for which there are no assets?  What of underfunded municipal and corporate pension plans?  With the corporate plans there is bankruptcy and the PBGC.  With municipalities, and the Federal Government it is more questionable.  There are few assets to lay claim to, even if there were a right to do so.  They rely on increased taxation, and the willingness of the courts to enforce pension promises.  This will prove politically difficult, and perhaps prove to be a greater challenge to the constitution than anything previous, because the economic demands are far greater than what the US taxpayer has been willing to bear.

Still, the greater challenge for countries is the ability to continue to manage debt issuance.  As we see with Greece today, that is not a simple thing.  Countries can be misfinanced, as much or more so than corporations.

Risk management is primarily management of liquidity, and planning to avoid  liquidity risks over the long haul.  Easy to state, hard to do.  The siren song of the short-run is so compelling, but the long–run eventually arrives, and when it does, it comes to stay.  Plan your life, or your corporation’s life such that you control your destiny, and are never in a spot where you are forced to do anything.  That takes discipline, but the man who controls his own soul is ready to rule things far greater.