When I started this irregular series on personal finance, I didn’t think it would live this long. Maybe it’s appropriate then that this piece deals with longevity risk. After all, my prior piece dealt the the concept of the PRIER [Personal Required Investment Earnings Rate].

One of the main ideas there is that you have to take enough risk so that you earn enough money to meet all of your goals. One of those goals would likely be having enough to live off of if you live to a ripe old age, like 100. 100 sounds old; after all, it serves our fascination with watching the odometer roll over. Old age mortality has been improving, though and the number of centenarians is growing rapidly. The same is true of those living into their 90s. Yet many people plan retirement as if they were only going to live to 85.

The destitute elderly definitely have it worse than those with resources. What if you could eliminate some of the risk of outliving your income? I have a product that could help you — the life-contingent immediate annuity. Life-contingent immediate annuities pay a stream of income for the life of the annuitant (or joint lives of two annuitants). They give an income that cannot be outlived. Today, a number of insurance companies do that one better, and offer inflation adjustments on the payments, with the trade-off being accepting a lower initial payment than the unadjusted annuity. The only remaining risk is insurance company solvency, but only buy from reputable firms. That said, remember that the state guarantee funds stand behind the companies, and the benefit payments they are least likely to cut off in an insolvency are death benefits, disability payments, and immediate annuity payments.

Immediate annuities are bought, not sold, unlike other life insurance products. Why? Because once they are bought, there are usually no ways to surrender the policy. You can only take payments over time. Agents don’t like selling immediate annuities, because they will never derive another commission from that money. They would rather sell a variable annuity with a living benefit rider, because it will be possible to roll the policy at a later date to a “better” policy (surrender charges are low), and earn another commission.

Though I am not crazy about variable annuities with living benefit riders, if you own one, be careful before you surrender it. You may have a valuable option to have the company pay a fixed amount for a long time that is worth more than your surrender value rolling into a new policy. In general, be careful in buying any deferred annuities, because the fees are stiff. Be most careful if the agent comes to you when the surrender charge is gone, and encourages you to “roll” to a new product. His interests are different than your interests. You are likely better off staying in your existing deferred annuity.

Are there any other solutions to longevity risk? There are a few. First, cultivate younger friends and family who will be advocates for you in your dotage. They are necessary for kind treatment on the part of the staff of any old age home that you might enter. Those that have no advocates don’t fare well. (For those who are really young, marry, and have more than two kids! Love them, and they will love you.) Second, have an investment policy that reflects the longer-term, realizing you might live longer than average for those that have attained your age. This means more risk assets (stocks) on average than what is commonly recommended, but I would temper this with two caveats:

1) Remember that the Baby Boomers are graying, and will need to liquidate assets to support their old age.

2) Sometimes the markets are overvalued, and it is time to preserve capital, not go for capital gains. Tweak you asset allocation to reflect asset valuations.

A long life is a blessing, and even more so when you have friends, family, good health, and peace with God. Plan now to live longer than you expect. Save more, invest wisely, and buy some longevity insurance.

PS — Don’t go “hog wild” with any single pecuniary strategy for your old age. This is another area where diversification pays, so don’t put all of your eggs in one basket.

PPS — Some of the larger insurers (Pru, Met, Hartford) allow you to buy future income streams should you be alive to receive them. They are an inexpensive way for younger people to put money away for retirement, though there are risks of early death, company insolvency and inflation.

Full disclosure: long HIG

Everybody has a series of longer-term goals that they want to achieve financially, whether it is putting the kids through college, buying a home, retirement, etc.  Those priorities compete with short run needs, which helps to determine how much gets spent versus saved.

To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.  Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.  Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].

I’m treating financial planning in the same way that a Defined Benefit pension plan analyzes its risks.  There’s a reason for this, and I’ll get to that later.  Just as we know that a high assumed investment earnings rate at a defined benefit pension plan is a red flag, it is the same to an individual with a high PRIER.

Now, suppose at the end of the exercise one finds that the PRIER is greater than the yield on 10-year BBB bonds by more than 3%.  (Today that would be higher than 9%.)  That means you are not likely to make your goals.   You can either:

• Save more, or,
• Reduce future expectations,whether that comes from doing the same things cheaper, or deferring when you do them.

Those are hard choices, but most people don’t make those choices because they never sit down and run the numbers.  Now, I left out a common choice that is more commonly chosen: invest more aggressively.  This is more commonly done because it is “free.”  In order to get more return, one must take more risk, so take more risk and you will get more return, right?  Right?!

Sadly, no.  Go back to Defined Benefit programs for a moment.  Think of the last eight years, where the average DB plan has been chasing a 8-9%/yr required yield.  What have they earned?  On a 60/40 equity/debt mandate, using the S&P 500 and the Lehman Aggregate as proxies, the return would be 3.5%/year, with the lion’s share coming from the less risky investment grade bonds.  The overshoot of the ’90s has been replaced by the undershoot of the 2000s.  Now, missing your funding target for eight years at 5%/yr or so is serious stuff, and this is a problem being faced by DB pension plans and individuals today.

While the ’80s and ’90s were roaring, DB plan sponsors made minimal contributions, and did not build up a buffer for the soggy 2000s.  Part of that was due to stupid tax law that the government put in because they didn’t want pension plans to shelter income from taxes for plan sponsors.  (As an aside, public plans did less than corporations, even though they did not face any tax consequences.)

But the same thing was true of individuals.  When the markets were good, they did not save.  Now when the markets are not good, the habit of not saving is entrenched, and now being older, saving might be more difficult because of kids in college, interest on a mortgage for a house larger than was needed, etc.

Now, absent additional saving, when investment earnings lag behind the PRIER, that makes the future PRIER rise, to try to make up for lost time.  Perhaps I need to apply the five stages of grieving here as well… trying to earn more to make up for lost time is a form of bargaining.  It rarely works, and sometimes blows up, leaving a person worse off than before.  Most aggressive asset allocation strategies only work over a long period of time, and only if a player is willing to buy-rebalance-hold, which only a few people are constitutionally capable of doing.  Most people get scared at the bottoms, and get euphoric near tops.  Few follow Buffett’s dictum, “Be greedy when others are fearful, and fearful when others are greedy.”  Personally, I expect the willingness to take investment risk over the next five years to rise, but over the next ten years, I don’t think it will be rewarded.

Now, as time progresses, and the Baby Boomers gray, unless the equity markets are returning the low teens in terms of returns, there will be a tendency for the average PRIER to rise, absent people realizing that they have to save more than planned, or reduce their goals.  This problem will be faced in the ’10s, bigtime.  The pensions crisis will be front page news, and I’m not talking about Social Security and Medicare, though those will be there also.  The demographics will be playing out.  After all, what drives the funding of retirement at a DB plan, but aging, where the promised expected payments get closer each day.

Well, same thing for individuals.  Every day that passes brings a slow weakening of our bodies and minds.  Dollars not saved today, or bad investment returns mean the PRIER rises, making the probability of attaining goals less achievable.

Now, is there nothing that can be done aside from increasing savings and reducing future plans?  In aggregate, no.  You will have to be someone special to beat the pack, because few do that.  Better you should take the simple solution, which is a humble one: save more, expect less.  For those that do have the talent, you will have to take the risks that few do, and be unconventional.  Note: for every four persons that think they can do this, at best one will succeed.  My own methods are always leaning against what is popular in the markets, and I think that I am one of those few, but it takes work and emotional discipline to do it.

Then again, I have done it, as far as my PRIER is concerned — it is below the rate on 10-year Treasuries.  Most of that is that my goals are modest, aside from putting my eight kids through college, and I am not planning on retiring.

With that, I leave to consider a post I wrote at RealMoney two years ago.  It’s kind of a classic, and Barry Ritholtz e-mailed me to say that he loved it.  Given what we are experiencing lately, it seems prescient.  Here it is:

		David Merkel
		Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
		3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples. In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

Tonight I want to point you to something that might make you uncomfortable.  Don’t worry, it is for a good purpose.

Depending on where you live in the US, various states and municipalities are more or less prepare for the onslaught of cash flow that they will have to pay baby boomer employees after they retire.  Here’s a very good summary of which states are prepared, and which are not, from the Pew Charitable Trusts.  As for pension benefits, they are relatively well funded, with 85% of the accrued benefits funded.  Other Retiree benefits (mainly health care) are only 3% funded.

Only ten states are more than 96% funded on pensions: Oregon, Utah, South Dakota, Wisconsin, Tennessee, Georgia, Florida, North Carolina, Delaware and New York.  Ten states are less than 70% funded on pensions: Hawaii, Kansas, Oklahoma, Louisiana, Illinois, Indiana, West Virginia, Connecticut, Rhode Island, and New Hampshire.

But as for other retiree benefits, 32 states have funded nothing at all (0%).  See the graph on page 42.  They will either pay it out of cash flow (from increased taxes), or decrease the benefits, because they are not guaranteed as pension benefits are.   Only one state is in good shape, Wisconsin (my home state), which has its other retiree benefits 99% funded.  Next best are Arizona (72%), Alaska (65%), and North Dakota (41%).   In a word — ugly.  Either promises will have to be rescinded, or taxes raised.

It’s worth looking at this report because these matters will be upward drivers of taxes starting about five years from now, and lasting for two decades beyond that.  It will be a big political fight.  Taxpayers will do their best to reduce benefits to state and local government workers who worked at lower salaried jobs, knowing that they would make it up on better benefits.  Alas, but the benefits may be less than expected.

Now as far as the US goes, Federal DB plans are unfunded, including Federal Employees, Social Security and Medicare.  Holding US Government bonds doesn’t count, those are just indicators of future taxation.  Higher future taxation from the US government will be a fact of life.  I don’t argue with it.  They’re bigger than me.

States and municipalities may be another matter, though.  Many municipalities are even worse funded than the states, and their taxation capabilities are more limited.  People can leave to go to other places in the US.

My advice: review the pension and other benefit funding levels of your state, and any other places that you get taxed (county, city, assessment district).  Figure out now whether your taxes are likely to rise or not, and ask yourself whether you can live with it or not.  This is somewhat cold-blooded, but you need to act on this in the next 2-3 years.  Five years out, and this will factor into land values and a wide number of other economic variables, making any move less economic.

1. Superstition is alive and well.  Google at $666?  Personally, I think it is all hooey.  There has always been a morbid fascination about the Antichrist in Western Culture.  Would that they had more concern about Christ.
2. Longtime readers know I am no fan of FAS 157 or FAS 159.  From the Accounting Onion, here is a good demonstration of what could go wrong as FAS 157 is implemented.  In my opinion, the concept of fair market value allows managements too much flexibility.  For assets that have a liquid market bigger than the holdings of the company in question, fair market value is not a problem.  It is a misleading concept otherwise, because the ability to realize that asset value in a sale is questionable.
3. This is an “uh-oh” moment on two levels.  Level one is defined benefit pension plans exiting US equities.  They are big holders, and a reallocation could hurt US stock prices.  Level two is that foreign markets have outperformed the US by a great deal over the last few years.  Perhaps the DB pension plans are late to the party?
4. There are no “almosts” in investing.  I have owned Genlyte twice in my life.  Great company.  I had it on my candidate list in my last reshaping.  I didn’t buy it then.  Now it is being bought out by Philips Electronics.  Good move for Philips; the only way they could make it better would be to take the management team of Genlyte, and have it run Philips.  That won’t happen; it is more likely that Philips will ruin Genlyte.
5. Activist hedge funds don’t always know best.  Smart managements and boards don’t get scared.  They calculate.  What’s the best thing for shareholders in the long run?  Do the hedge funds really have the willingness to fight?  Personally, I think it is usually best for managements to “call their bluff” and make the hedge funds work for control, rather than wave the white flag early.
6. Higher US dollar oil prices are only partly a dollar phenomenon.  Oil prices are rising in almost every currency; there is a relative shortage of crude oil globally.
7. Want an antidote to pessimism?  Read this post from VOX.  Personally, I think the lending issues are bigger than they think, but it is true that corporate balance sheets are in good shape.  Would that we could say the same for the consumer or the government.
8. Appreciation of the Chinese Yuan versus the Dollar may be accelerating.  Alongside that, many of the Gulf States are re-evaluating their peg to the US Dollar.  Given the inflation, who can blame them?
9. $300 Billion in losses from US residential mortgages?  That’s a believable figure to me.  Underwriting got progressively worse from 2003 to the first quarter of 2007.  Needless to say, that would kill a lot of non-bank mortgage lenders, and a few banks as well.
10. Could Japan be the great countercyclical asset in this market phase?  There is more speculative fervor in Japan at present, and many Japanese investors are buying stocks and selling bonds, partly due to relative yield measures.

That’s all for now.  More to come.

From Tuesday’s Columnist Conversation over at RealMoney.com:

		David Merkel
		Thinking About the Fed
		11/20/2007 1:51 PM EST

One of my maxims of the Fed is that it is better to watch what they do, and pay less attention to what they say. The markets are saying that they expect Fed funds at 3% sometime in 2008. The Fed governors see that also, and are being dragged there, kicking and screaming. They don’t want to do it; there is real risk to the US Dollar, and there are inflation risks as well. As they measure it, the economy is growing adequately, and labor employment is fairly full. But as Cramer and others point out, the financial system is under stress, manifesting most sharply in mortgage lenders and insurers. Secondary stress is in the investment banks and financial guarantors.

But what exactly has the Fed done so far? Most of the monetary easing has not come through growth in the monetary base, but from continued relaxation of reserve requirements. Given that the Fed is loosening, I would have expected a permanent injection of liquidity by now. As it is, the last one was May 3rd, when there was no hint of the loosenings coming.

So what then for future FOMC policy? The banks are increasingly incapable of levering up more. The monetary base will have to grow. With the Treasury-Eurodollar spread at over 170 basis points, the big banks don’t trust each other. Again, this measure points to 3.00-3.25% Fed funds sometime in 2008.

I see them getting dragged to cuts, kicking and screaming, until a combination of inflation and the dollar force them to change. Then the real fun begins.

Fed minutes out soon. Watch them make a fool out of me.

Okay, the FOMC minutes did not make a fool out of me.  Neither did the market action.  I’m in the weird spot of thinking that nominal economic activity is higher than expected, on both an inflation and real GDP basis.  I don’t like the mortgage and depositary financial sectors at present, two areas that are dear to the FOMC.  That’s where I stand.

One reader asked, what do you mean by, “Then the real fun begins.”?  Maybe I have to do a book review on James Grant’s, “The Trouble with Prosperity.”  James Grant is very often correct, but usually way too early, which is why it is hard to make money off of his insights.  The “real fun” is watching FOMC policymakers squirm as they balance off costs of inflation and economic growth on the negative side, as it was in the late 70s and early 80s.  It is also the fun of watching policymakers at the Treasury Department squirm as they realize that the the fiscal wind is in their face and not at their backs anymore, as the demographic winds spin 180 degrees.

Other readers e-mailed, asking the practical question of how to invest in such an environment.  First, don’t overdo it.  Invest for a normal market scenario, and then tweak it to add more short bonds, TIPS, Commodities, Foreign bonds, and stocks with good inflation pass-through.

I got a few questions asking me to justify my bearish view on the US Dollar.  On, a purchasing power parity basis, the US Dollar is fairly valued now.  (What goods can the Dollar buy versus other currencies?) Unfortunately, currencies react more to forward covered interest parity in the short run. (What will I be able to earn by investing my money in dollar denominated debt, instead of another currency?)  Low intermediate term interest rates in the US portend bad returns from investing in US Dollar denominated debt, so the US Dollar declines.  The rest of the world seems to be bracing for more inflation and more growth.  Because US policy is headed the other way, the US Dollar is weakening.

As for my longer-run negative view on US Bonds, US government policies are designed to undermine bonds.  They have made more future promises than they can keep.  Who will they renege on their promises?  Bond investors are the easiest target; they don’t vote in large numbers.  It will be harder to turn their backs to those receiving social insurance payments, at least in nominal terms.  They have a lot of votes.

That’s all for now.  More tomorrow.

Recently I had dinner with a college friend of my oldest son.  It surprised me, but he was interested in how the US dollar was doing.  I likened the current situation to the five stages of grieving.

The first stage is denial.  As it respects the US Dollar, in the initial phases in the decline of the US Dollar, most foreign  finance ministers and central bankers are pretty happy.  After all, foreign exchange reserves are at an all time high.  Export industries are booming.  The government loves the exchange rate policy that keep the US Dollar artificially rich against the foreign currency.  The banks are flush, credit is booming… what could be better?  After all, you can’t have too much in the way of US Dollar reserves, can you?  (They never have to worry about a currency crisis again!)  The government is happy with them, especially since they are supported by the exporters.

Anger is the second stage.  The dollar reserves are worth less and less on a relative basis, and they keep coming in.  The wisdom of having a fixed rate, crawling peg, or dirty float against the dollar is questioned.  Goods inflation is rising in the foreign market, and credit creation is getting out of control.  The finance minister or central banker face the hard choice of revaluing the currency up versus the US Dollar, which slows the economy, particularly exports, or let the situation continue, and build up more US Dollar reserves.  (”What will we ever use all these Dollar reserves for?” they might ask in a moment of lucidity. “What if the US Dollar fell a lot further?  That would reduce the value backing our currency…  Why is the Fed loosening so much?  Don’t they care about the Dollar?”)

So, some of them revalue their currency upward versus the US Dollar, some reduce the basket weight of the Dollar, some let the peg crawl faster, and some do nothing… and the US Dollar predominantly falls in value.  Some finance ministers complain about the Dollar, and net exports to the US begin to decline.  This is where we are now, and I don’t know how long it will take to get to the next stage.

The third stage is bargaining.  The foreign finance ministers and central bankers are stuck.  They are getting pressure to lower the value of the currency against the dollar from exporters, and the politicians that they support.  They wonder if an intervention on the foreign exchange market might do it.  They call their opposite numbers around the globe, proposing an intervention to raise the value of the dollar.  Enough agree to do it, and the coalition of the willing does what they don’t want to do.  They sell their own foreign currencies, and buy more dollars.  The surprise works!  They caught the FX traders leaning the wrong way, on a day when economic news was going their way, they cooperated, and they did it BIG!  The US Dollar rises a full five percent. (”See you at the party tonight!”)

Only one problem, which is clear the next day to Finance ministers, Central bankers and FX traders alike.  (”What are we going to do with all the new US Dollar reserves that we bought?  We already have too much of that…”)  The FX traders pounce, and take the opposite side of the trade, and push the US Dollar lower.

Stage four is depression.  (”There’s no way out, and we got snookered by the neo-mercantilist exporters who got us to keep the currency too low versus the US Dollar.”)  The US Dollar is below the earlier intervention level, and there have been a few additional failed interventions, where the FX traders ate the central banks for lunch.  The US Dollar continues to fall.

Finally, stage five, acceptance.  The foreign currencies rise to sustainable levels versus the US dollar.  Inflation and real economic activity decline in the foreign countries.  They begin buying more goods and services from the US, and dollar claims are redeemed.  Inflation and interest rates rise in the US, as we have to produce more to pay off the dollar reserves now being redeemed by foreigners.  (Send us goods and it will pay off your debts!  Amazing how the US got good terms on both sides of the transaction.”)

Well, maybe.  It will take a while before all major trading parties in the world float/adjust their currencies to fair levels.  At  the time that happens, though, it will be obvious that the US is less important to the global economy.  The relative value of all US assets will be a smaller proportion of global assets, though it will still likely be the largest share in the world.  My view is this process to get to stage five will take no more than 10 years.  By that point, the hopelessness of Federal social insurance programs like Social Security and Medicare, plus underfunded Federal and state retirement plans, will force benefit reductions and tax increases on the US, and crimp borrowing capacity, unless they borrow in a currency other than dollars.  There are five stages of grieving for US social welfare programs as well, but I am afraid we are only in the first stage now, denial.

That is a topic for another day, and not one that I am excited to talk about.

1. Kinda weird, and it makes you wonder, but on the WSJ main page, I could not find a link to Barron’s. I know I’ve seen a link to Barron’s in the past there; I have used it, which is why I noticed its absence today.
2. I found it amusing that the mutual fund that Barron’s would mention on their Blackrock interview, underperformed the Lehman Aggregate over 1, 3 and 5 years. Don’t get me wrong, Blackrock is a great shop, and I would work there if they offered me employment that didn’t change my location. Why did Barron’s pick that fund?
3. I’m not worried about the effect of a financial guarantor downgrade on the creditworthiness of the muni market. Munis rarely fail. Most of those that do fail lacked a real economic purpose. What would be lost in a guarantor downgrade is liquidity. Muni bond insurance is a substitute for analysis. “AAA insured, I’ll buy that.” Truth, an index fund of uninsured munis would beat an index of insured munis, because default rates are so low. But the presence of insurance makes the bonds a lot more liquid, which makes portfolio management easier.
4. I’ve been a US dollar bear for the last five years, and most of the last fifteen years. Though we have had a little bounce recently, the dollar has of late been at record lows against currencies that trade freely against the dollar. I expect the current bounce to persist in the short term and fail in the intermediate term. The path of the dollar is lower, unless the Fed decides to not loosen more. Balance needs to be restored in the global economy, such that the rest of the world purchases more goods and services, and fewer assets from the US.
5. I don’t talk about it often, but when it comes up, I have to mention that municipal pensions in the US are generally in horrid shape. The Barron’s article focuses on teachers, but other municipal worker groups are equally bad off. The article comments on perverse incentives in teacher retirement, which leads older teachers to retire when it is feasible to do so. For older teachers, I would not begrudge them; they weren’t paid that well at the start, and the pension is their reward. Younger teachers have been paid pretty well. I would not expect them to get the same pension promises.
6. I like Japan. I own shares in the Japan Smaller Capitalization Fund [JOF]; it’s my second-largest position.

   Japan is cheap, and small cap Japan is even cheaper. I would expect a modest bounce on Monday.

7. We still need a 15-20% decline in housing prices to bring the system back to normal. There might be an undershoot in price from the sales that forced sellers must do. Hopefully it doesn’t turn into a self-reinforcing decline, but who can be sure about that? At that level of housing prices, man recent conforming loans will be in trouble, much less non-conforming loans.

Full disclosure: long JOF

Here’s another recent post from RealMoney:

		David Merkel
		Contemplating Life Without the Guarantors
		11/1/2007 1:30 PM EDT

Hopefully this post marks a turning point for the Mortgage Insurers and the Financial Guarantee Insurers, but when I see Ambac trading within spitting distance of 50% of book, I cringe. I’ve never been a bull on these companies, but I had heard the bear case for so long that my opinion had become, “If it hasn’t happened already, why should it happen now?” Too many lost too much waiting for the event to come, and now, perhaps it has come. But, what are all of the fallout effects if we have a failure of a mortgage insurer? Fannie, Freddie, and a number of mortgage REITs would find their credit exposure to be considerably higher. The Feds would likely stand behind the agencies, because Fannie and Freddie aren’t that highly capitalized either. That said, I would be uncomfortable owning Fannie or Freddie here; just because the government might stand behind senior obligations doesn’t mean they would take care of the common and preferred stockholders, or even the subordinated debt.

Fortunately, the mortgage insurers don’t reinsure each other; there won’t be a cascade from one failure, though the same common factor, falling housing prices will affect all of them.

Other affected parties will include the homebuilders and the mortgage lenders, because buyers without significant down payments will be shut out of the market. Piggyback loans aren’t totally dead, but pricing and higher underwriting standards restrict availability. Third-order effects move onto suppliers, investment banks and the rating agencies. More on them in a moment… this will have to be a two-parter, if not three.

Position: none

And since then, the mortgage insurers have fallen a bit further.  On to part two, the financial guarantors:

Unfortunately, the financial guarantors have had a tendency to reinsure each other.  MBIA reinsures Ambac, and vice-versa.   RAM Holdings reinsures all of them.  The guarantors provide a type of “branding” to obscure borrowers in the bond market.  Rather than put forth a costly effort to be known, it is cheaper to get the bonds wrapped by a well-known guarantor; not only does it increase perceived creditworthiness, it increases liquidity, because portfolio managers can skip a step in thinking.

Now, in simpler times, when munis were all that they insured, the risk profiles were low for the guarantors, because munis rarely defaulted, particularly those with economic necessity behind them.  In an era where they insure the AAA portions of CDOs and other asset-backed securities, the risk is higher.

Now, guarantors only have to pay principal and interest on a timely basis.  Mark to market losses don’t affect them, they can just pay along with cash flow.  The only trouble comes if they get downgraded, and new deals become more scarce.  Remember CAPMAC?  MBIA bought them out when their AAA rating was under threat.  Who will step up to buy MBIA or Ambac?  (Mr. Buffett! Here’s your chance to be a modern J. P. Morgan.  Buy out the guarantors! — Never mind, he’s much smarter than that.)

Well, at present the rating agencies are re-thinking the ratings of the guarantors.  This isn’t easy for them, because they make so much money off of the guarantors, and without the AAA, business suffers.  If the guarantors get downgraded, so do the business prospects of the ratings agencies (Moody’s and S&P).

Away from that, municipalities would suffer from lesser ability to issue debt inexpensively.  Also, stable value funds are big AAA paper buyers.  They would suffer from any guarantor getting downgraded, and particularly if Fannie or Freddie were under threat as well.   All in all, this is not a fun time for AAA bond investors.  A lot of uncertainties are surfacing in areas that were previously regarded as safe.  (I haven’t even touched AAA RMBS whole loans…)

This is a time of significant uncertainty for areas that were previously regarded as certain.  Keep your eyes open, and evaluate guaranteed investments both ways.  I.e., ABC corp guaranteed by GUAR corp, or GUAR debt secured by an interest in ABC corp. This is a situation where simplicity is rewarded.

Wouldn’t you know it, the first Baby Boomer filed for Social Security yesterday.  Good background information in the article, though a few of the figures can be questioned within bounds.

Full disclosure: long one autographed copy of A. Haeworth Robertson’s The Big Lie.

Actuaries are bright people.  Okay, present writer excepted.  That’s a danger when you give a talk to a bunch of them.  Every now and then you will end up with a questioner who is a bit of a crank.  Now, I have a soft spot in my heart for actuarial cranks, because I have done more than my fair share to question other presenters over the years.

At my talk yesterday, one actuary suggested turning the Social Security system into a defined benefit plan, and having it invest in stocks, which would provide cheap capital to corporations.  The Social Security system gets better returns. Everyone wins, right?

Well, no.  Here is what is amiss with the idea:

1. It would favor public companies over private companies.
2. Active managers would be useless, because the fund would be too big.  They would have to index.
3. Initially the stock market would shift up as the money began to be invested, but once fully invested, P/E multiples would be so high that future returns would be lousy.  Once the liquidation phase began, this fund would be so big that stocks would fall in advance of the liquidation, even if everything were indexed.
4. Marginal companies with lousy profitability would come public to take advantage of the cheap funds.
5. Corporate governance issues would be tough; how does the government vote its proxies?  How would activist investors get treated?  Which side would the government favor?  If they left this in the hands of active managers to take care of, could the managers stand up to all of the political pressure?
6. Do we really want the Socialism associated with the government owning 20% of every corporation?  What additional regulations might be put on corporations that are owned or not owned by the government?
7. Would we give the Fed a third mandate to try to improve corporate profitability, because it would have a greater effect on the economy?
8. Why limit the asset classes invested in?  Why not other bonds, loans, commodities, real estate (commercial and residential) and perhaps international investments?  At least if we liquidate international investments, we don’t hurt our own economy.
9. For that matter, the US government could contribute all of its property to a great big REIT, and use it to fund a small portion of Social Security.  Of course, the deficit would rise as the government made dividend payments.
10. Medicare is the tougher issue to solve; Social Security is small compared to it.  Solve that one first.

My last reason is that for the most part, stocks don’t care who owns them.  In the long run, they are weighing machines, and not voting machines.  They will produce the stream of cash flows as a group that will be pretty invariant to who owns them.  Activist investors may have an effect in the short run, but on the whole, the effects of activism on the index returns as a whole will be paltry at best.

This tired idea of investing the Social Security trust funds in equities came up during the Clinton Administration (hopefully there will not be a second one).  I view it as the ultimate “dumb money” for the stock market.  If it were ever implemented, you would invest into the wave of new money, and create IPOs to sop up money.  Then once the money flow was largely deployed, you would sell along with other smart investors, and invest overseas.

My own view is that Social Security and Medicare should be wound down over a 80-year period.  They were bad ideas to begin with, but getting us out of that business with fairness to promises made would have to take two generations or so to complete.  I know, that’s a non-starter, but most reasonable ideas regarding social insurance programs are.  The eventual “solution” will come through higher ages for benefit receipt, lower benefits, higher taxes, limitation of inflation adjustments (already done, and quietly) and means-testing.  Not that I like it, but we will have to face realities eventually.

The same issues will apply to Medicare.  Eventually we will have a two-tier healthcare system (we won’t call it that), because we can’t afford the promises made to Medicare recipients.  It will be “The government pretends to pay us, and we pretend to treat you.”  It will be a mess, and that one should begin to come into clear focus within ten years.

PS — My talk went well yesterday.  If there is ever a recording of it on the web, I will put a link at my blog.