I can’t help but think after the financial crisis that we have drawn some wrong conclusions about systemic risk. Systemic risk is when the financial system as a whole threatens to fail, such that short-term obligations can’t be paid out in full.  It is not a situation where only big entities fail — the critical factor is whether it creates a run on liquidity across the system as a whole.

Why does a bank fail?  It can’t pay in full when there was a demand for liquidity in the short run.  Typically, there is an asset-liability mismatch, with a lot of payments payable now, and assets that cannot be easily liquidated for what their stated value reported to the regulators.

Imagine the largest bank failing, and no one else.  Yes, it would be a mess for the FDIC to clean up, but it could be done.   Stockholders and preferred stockholders get wiped out. Bondholders, junior bondholders, and large depositors take a haircut.  Future deposit insurance premiums might have to rise, but there would be enough time to do that, with banks adjusting their prices so that they could afford it.

But banks don’t fail one at a time, except perhaps in good times with a really incompetently managed bank.  Why do some banks tend to fail at the same time?

  • They own many of the same debt securities, or same types of loans where the underlying asset values are falling.
  • They own securities of other banks, or other deposit-taking institutions.
  • Generalized panic.

What can stop a bank from failing?  Adequate short-term cash flow from assets.  Why don’t banks make sure that they always have more cash coming in than going out?  That would be a lower profitability way of running a bank.  It is almost always more profitable to borrow short and lend long, and make money on the natural term spread that exists — but that creates the very conditions that makes some banks run out of liquidity in a panic.

You will hear the banks say, “We are solvent, we just aren’t liquid.” That statement is always hogwash.  That means that the bank did not adequately plan to have enough liquidity under all circumstances.

Thus, planning to avoid systemic risk across an economy as a whole should focus on looking for the entities that make a lot of promises where payment can be demanded in the short run with no adjustments for market conditions versus assets available to make payments.  Typically, that means banks and things like banks that take deposits, including money market funds.  What does it not include?

  • Life insurers, unless they write a lot of unusual annuities that can get called for immediate payment, as happened to General American and ARM Financial in 1999.  The liability structure of life insurance companies is so long that there can never be a run on the bank.  That doesn’t mean they can’t go insolvent, but it does mean they won’t be part of a systemic panic.
  • Property & Casualty and Health insurers do not have liabilities that can run from them.  They can write bad business and lose money in the short-run, but that doesn’t lead to systemic panic.
  • Investment companies do not have liabilities that can run from them, aside from money-market funds.  Since the liabilities are denominated in the same terms as the assets managed, there can’t be a “run on the bank.”  Even if assets are illiquid, the rules for valuing illiquid assets for liquidation are flexible enough that an investment firm can lower the net asset value of the payouts, while liquidating other assets in the short run.
  • Even any large corporation that has financed itself with too much short-term debt is not a threat to systemic panic.  The failure would be unique when it could not roll over its debts.  Further, it would take some effort to actually do that, because the rating agencies and lenders would have to allow a non-financial firm to take obvious risks that non-financial firms don’t take.

What might it include?

  • Money market funds are different because of the potential to “break the buck.”
  • Any financial institution that relies on a repurchase [repo] market for financing is subject to systemic risk because of the borrow short to finance a long-dated asset mismatch inherent in the market.
  • Watch any entity that has to be able to post additional margin in order maintain leveraged asset finance.

How then to Avoid Systemic Risk?

  • Regulate banks, money market funds and other depositary financials tightly.
  • Don’t let them invest in one another.
  • Make sure that they have more than enough liquid assets to meet any conceivable liquidity withdrawal scenario.
  • Regulate repurchase markets tightly.
  • Raise the amount of money that has to be deposited for margin agreements, until those are no longer a threat.
  • Perhaps break up banks by ending interstate branching.  State regulation is good regulation.

But aside from that, there is nothing to do.  There are no systemic risks from investment companies or those that manage them, because there can’t be a self-reinforcing “run on the bank.”  Insurance companies are similar, and their solvency is regulated far better than any bank.

Thus, there shouldn’t be any lists of systematically important financial institutions that contain investment managers or insurance companies.  Bigness is not enough to create a systemic threat.  Even GE Capital could have failed, and it would not have had significant effects on the solvency of other financials.

I think it is incumbent on those that would call such enterprises systemically important to show one historical example of where such enterprises ever played a significant role in a financial crisis like the ones that happened in the 1870s, 1900s, 1930s, or 2000s.  They won’t be able to do it, and it should tell them that they are wasting effort, and should focus on the short-tailed liabilities of financial companies.

I imagine the SEC (or the Fed, IRS, or the FSOC) saying: “If we only have enough data, we can answer the policy questions that we are interested in, create better policy, prosecute bad guys, and regulate markets well.”

If they deigned to listen to an obscure quantitative analyst like me, I would tell them that it is much harder than that.  Data is useless without context and interpretation.  First, you have to have the right models of behavior, and understand the linkages between disparate markets.  Neoclassical economics will not be helpful here, because we aren’t rational in the ways that the economists posit.

Second, in markets you often find that causation is a squirrelly concept, and difficult to prove statistically.  Third, the question of right and wrong is a genuinely difficult one — what is acceptable behavior in markets?  Do we run a market for “big boys” who understand that this is all “at your own risk,” or a market that protects the interests of smaller players at a cost to the larger players?  Do we run a market that encourages volume, speed and efficiency, or one that avoids large movements in prices?

This article is an attempt to comment on the Wall Street Journal article on the SEC’s effort to create the Consolidated Audit Trail [CAT], in an effort to prevent future “flash crashes,” like the one we had five years ago.  I don’t think the efforts of the SEC will work, and I don’t think the goal they are pursuing is a desirable one.

People take actions in the markets for a wide number of reasons.  Some are hedging; some are investing; others are speculating.  Some invest for long periods, and others for seconds, and every period in-between.  Some are intermediaries, while others are direct investors.  Some are in one market, while others are operating in many markets at once.  Some react rapidly, and others trade little, if at all.  Just seeing that one party bought or sold a given security tells you little about what is going on and why.

Following price momentum works as an investment strategy, until the volume of trading following momentum strategies gets too high.  Then things go nuts.  Actions that by themselves are innocent may add up to an event that is unexpected.  After all, that is what dynamic hedging led to in 1987.  There was no sinister cabal looking to drive the market down.  And, because the event did not reflect any fundamental change to where valuations should be, price came back over time.

My contention is even with the huge amount of data, there will still be alternative theories, information that might be material excluded, and fuzziness over whether a given investment action was wrong or not.

After that, we can ask whether the proposed actions of the government provide any significant value to the market.  Some are offended when markets move rapidly for seemingly no reason, because they lose money on orders placed in the market at that time.  There is a much simpler, money saving solution to that close to home for each investor: DON’T USE MARKET ORDERS!  Set the price levels for your orders carefully, knowing that you could get lifted/filled at the level.

This is basic stuff that many investors counsel regarding investing.  If you use a market order you could get a price very different than what you anticipate, as I accidentally experienced in this tale.  I could complain, but is the government supposed to protect us from our own neglect and stupidity?  If we wanted that, there is no guarantee that we would end up with a better system.  After all, when the government sets rules, it does not always do them intelligently.

One of the beauties of capitalism is that it enables intelligent responses as a society to gluts and shortages without having a lot of rules to insure that.  Volatility is not a problem in the long run for a capitalist society.

If you lose money in the short run due to market volatility, no one told you that you had to trade that day.  Illogical market behavior, as in 1987 or the “flash crash” could be waited out with few ill effects.  Most of the difficulties inherent in a flash crash could be solved by people taking a longer view of the markets, and thinking like businessmen.

“It’s Baseball, Mom.”

I often spend time watching two of my younger children play basketball, baseball and softball.  They are often in situations where they might get hurt.  In those situations, after an accident, my wife gets antsy, while I watch to see if a rare severe injury has happened.  My wife asked one of my sons, “Don’t you worry about getting hurt?”  His response was, “It’s Baseball, Mom.  If you don’t get hurt every now and then, you aren’t playing hard enough.”  That didn’t put her at ease, but she understood, and accepted it.

In that same sense, I can tell you now that regardless of what the SEC does, there will be accidents, market events, and violent movements.  There will be people that complain that they lost money due to unfair behavior.  This is all a part of the broader “game” of the markets, which no one is required to play.  You can take the markets on your own terms and trade rarely, and guess what — you will likely do better than most, and avoid short-term volatility.

The SEC can decide what it wants to do with its scarce resources.  Is this the best use for the good of small investors?  I can think of many other lower cost ways to improve things… even just hiring more attorneys to prosecute cases, because most of the true problems the SEC faces are not problems of knowledge, but problems of the will to act and bear the political fallout for doing so.  And that — is a different game of baseball.

Photo credit: jonesylife

Photo credit: jonesylife || Oh look, there are twelve doves flying!

March 2015April 2015Comments
Information received since the Federal Open Market Committee met in January suggests that economic growth has moderated somewhat.Information received since the Federal Open Market Committee met in March suggests that economic growth slowed during the winter months, in part reflecting transitory factors.Shades GDP down.  Why can’t the FOMC accept that the economy is structurally weak?
Labor market conditions have improved further, with strong job gains and a lower unemployment rate. A range of labor market indicators suggests that underutilization of labor resources continues to diminish.The pace of job gains moderated, and the unemployment rate remained steady. A range of labor market indicators suggests that underutilization of labor resources was little changed.Shades labor use down.
Household spending is rising moderately; declines in energy prices have boosted household purchasing power. Business fixed investment is advancing, while the recovery in the housing sector remains slow and export growth has weakened.Growth in household spending declined; households’ real incomes rose strongly, partly reflecting earlier declines in energy prices, and consumer sentiment remains high. Business fixed investment softened, the recovery in the housing sector remained slow, and exports declined.Shades down their view of household spending.  Adds a comment on consumer sentiment.

Also shades down business fixed investment and exports.

 

Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.Notes lower prices of energy and imports.

TIPS are showing lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.10%, up 0.16% from January.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.Although growth in output and employment slowed during the first quarter, the Committee continues to expect that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.No real change. They are fitting Einstein’s definition of insanity – doing the same thing, and expecting a different outcome.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of energy price declines and other factors dissipate. The Committee continues to monitor inflation developments closely.The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.CPI is at -0.0% now, yoy.  No change in language.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.
Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting. Deleted
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.No change.

No rules, just guesswork from academics and bureaucrats with bad theories on economics.

This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range. Deleted
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.“Balanced” means they don’t know what they will do, and want flexibility.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.No change, sadly.

We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Comments

  • With this FOMC statement, people should conclude that they have no idea of when the FOMC will tighten policy, if ever. This is the sort of statement they issue when things are “steady as you go.”  There is no hint of imminent policy change.
  • The FOMC has a weaker view of GDP, labor use, household spending, business fixed investment and exports.
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Forward inflation expectations have reversed direction and are rising, and the twitchy FOMC did not note it.
  • Equities rise and long bonds rise. Commodity prices fall and the dollar rises.  The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
  • We have a congress of doves for 2015 on the FOMC. Things will be boring as far as dissents go.  We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Photo Credit: Matthias Ripp

Photo Credit: Matthias Ripp || Some bad ideas should be locked away…

Dan Primack of Fortune wrote in his daily email:

Saving unicorns from themselves? There was an interesting piece last week from Martin Peers in The Information (sub req), arguing that the private markets need some sort of shorting mechanism so that there is a check on unreasonable valuation inflation. It would make the market more efficient, Peers argues, even though implementation would require several structural changes (particularly to stock transfer rules). He writes:

“Private companies will probably resist the development of a short-selling market, given it would hurt valuations, which in turn can undermine the value of employee option programs, and give them less control over their shareholder group. But those risks are likely to be outweighed by the long term benefits of bringing more buyers into the market and ensuring the company’s valuation can be sustained outside of the constraints of the private market.”

Leaving out the technical difficulties — including the lack of ongoing price discovery — one big counter could be that shorts didn’t so much to stop the earlier dotcom bubble (which largely took place in the public markets).

Adam D’Augelli of True Ventures pointed me to a 2002 academic paper (Princeton/London Biz School) that found “hedge funds during the time of the technology bubble on the Nasdaq… were heavily tilted towards overpriced technology stocks.” They add that “arbitrageurs are concerned about attacking the bubble too early without support from their peers,” and that they’re more likely to ride the bubble until just a few months before the end.

That would seem to be too late to impose price discipline in private markets, but I’m curious in your thoughts. Does some sort of private shorting system make sense? And, if so, how would it be structured?

I’m going to take a stab at answering the final questions.  There is often a reason why the financial world is set up the way it is, and why truly helpful financial innovations are rare.  The answer is “no, we should not have any way of shorting private companies, and it is not a flaw in the system that we don’t have any easy way to do it.”

Two notes before I start: 1) I haven’t read the paper at The Information, because it is behind a paywall, but I don’t think I need to do so.  I think the answer is obvious.  2) I ran into this question answered at Quora.  The answers are pretty good in aggregate, but what exists here are my own thoughts to present the answer in what I hope is a simple manner.

What is required to have an effective means of shorting assets

  1. An asset must be capable of being easily transferred from one entity to another.
  2. Entities willing to lend the asset in exchange for some compensation over a given lending term.
  3. Entities willing to borrow the asset, put up collateral adequate to secure the asset, and then sell the asset to another entity.
  4. An entity or entities to oversee the transaction, provide custody of the collateral, transmit payments, assure return of the asset at the end of the lending term, and gauge the adequacy of collateral relative to the value of the asset.

Here’s the best diagram I saw on the internet to help describe it (credit to this Latvian website):

short selling

I’m leaving aside the concept of naked shorting, because there are a lot of bad implications to allowing a third party to create ownership interests in a firm, a power which is reserved for the firm itself.

The Troubles Associated with Shorting Private Assets

I can think of four troubles.  Here they are:

  1. The ability to sell, lend, or buy shares in a private company are limited by the private company.
  2. Lending over long terms with no continuous price mechanism to aid in the gradual adjustment of collateral could lead to losses for the lender if the borrower can’t put up additional capital.
  3. The asset lender can decide only to lend over lending terms that will likely be disadvantageous to the borrower.  Getting the asset returned at the end of the lending term could be problematic.
  4. It is difficult enough shorting relatively illiquid publicly traded assets.  Liquidity is required for any regular shorting to happen.

The first one is the killer.  There are no advantages to a private company to allow for the mechanisms needed to allow for shorting. That is one of the advantages of being private.  Information is not shared openly, and you can use the secrecy to aid your competitive edge.  Skeptical short-sellers would not be welcome.

The second problem is tough, because sometimes successive capital rounds are at considerably higher prices.  The borrower will likely not have enough slack assets to increase his collateral, and he will be forced to buy shares in the round to cover his short because of that.  The lender could find that the borrower cannot make good on the loan, and so the lender loses a portion of the value his ownership stake.

But imagining the first two problems away, problem three would still be significant.  If the term for lending were not all the way to the IPO, next capital round or dissolution/sale, at the end of the term, the borrower would have to look for someone to sell shares to him.  It is quite possible that no one would sell them at any reasonable price.  They know they have a forced buyer on their hands, and there could be informal collusion on the price of a sale.

Perhaps another way to put it is don’t play in a game where the other team has significant control over the rules of the game.  One of the reasons I say this is from my days of a bond manager.  There were a lot of games played in securities lending, and bonds are not the most liquid place to short assets.  I remember it being very difficult to get a bond back from an entity that borrowed it, and the custodian and trustee did not help much.  I also remember how we used to gauge the liquidity of bonds we lent out, and if one was particularly illiquid, we would always recall the bond before selling it, which would often make the price of the bond rise.  Games, games, games…

What Might Be Better

Perhaps using collateralized options or another type of derivative could allow bets to be taken, if the term extended all the way to the IPO, the next capital round, or dissolution/sale of the company.  The options would have to be limited to the posted collateral being the most the seller of the option could lose.  Some of the above four issues would still be in play at various points, but aside from issue one, this would minimize the troubles.

What Might Be Better Still

The value of the shorts is that they share information with the rest of the market that there is a bearish opinion on an asset.  Short-sellers are nice to have around, but not necessary for the asset pricing function.  It is not unreasonable to live with the problem that some assets will be overvalued in the intermediate-term, rather than set up a complex method to try to enable shorting.  As Ben Graham said:

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

The weighing machine will do its job soon enough, showing that the overvalued asset will never produce free cash adequate to justify its current high price.  Is it a trouble to wait for that to happen?  If you don’t own it, you shouldn’t care much.

If you want to short it, I’m not sure that will hasten the price adjustment process that much, unless you can convince the existing owners of the asset that it isn’t worth even the current price.  Given that buyers have convinced themselves to own the asset, because they think it will be worth more in the future, intellectually, convincing them that it is worth less is a tough sell.

In the end, only asset and liability cash flows count, regardless of what secondary buyers and sellers do.  Secondary trading does not affect the value of assets, though it may affect the perception of value in the short run.  Thus, you don’t need short sellers to aid in setting secondary market prices, but they are an aid there.  In the primary markets, where whole companies are bought and sold, the perceived cash return is all that matters.

Conclusion

Ergo, live with short run overvaluation in private markets.  It is a high quality problem.  Sell overvalued assets if you own them.  Watch if you don’t own them.  Shorting, even if possible, is not worth the bother.

Despite the large and seemingly meaty title, this will be a short piece.  I class these types of investors together because most of them have long investment horizons.  From an asset-liability management standpoint, that would mean they should invest similarly.  That may be have been true for Defined Benefit [DB] pension plans and Endowments, but that has shifted over time, and is increasingly not true.  In some ways, the DB plans are becoming more like life insurers in the way they invest, though not totally so.  So, why do they invest differently?  Two reasons: internal risk management goals, and the desires of insurance regulators to preserve industry solvency.

Let’s start with life insurers.  Regulators don’t want insolvent companies, so they constrain companies into safe assets using risk-based capital charges.  The riskier the investment, the more capital the insurer has to put up against it.  After that, there is cash-flow testing which tends to push life insurers to match assets and liabilities, or at least, not have a large mismatch.  Also, accounting rules may lead insurers to buy assets where the income will show up on their financial statements regularly.

The result of this is that life insurers don’t invest much in risk assets — maybe they invest in stocks, junk bonds, etc. up to the amount of their surplus, but not much more than that.

DB plans don’t have regulators that care about investment risks.  They do have plan sponsors that do care about investment risk, and that level of care has increased over the past 15 years.  Back in the late ’90s it was in vogue for DB plans to allocate more and more to risk assets, just in time for the market to correct.  (Note to retail investors: professionals may deride your abilities, but the abilities of many professionals are questionable also.)

Over that time, the rate used to discount DB plan liabilities became standardized and attached to long high quality bonds.  Together with a desire to minimize plan funding risks, and thus corporate risks for the plan sponsor, that led to more investments in bonds, and less in equities and other risk assets.  Some plans try to cash flow match expected future plan payments out to a horizon.

Finally, endowments have no regulator, and don’t have a plan sponsor that has to make future payments.  They are free to invest as they like, and probably have the highest degree of variation in their assets as a group.  There is some level of constraint from the spending rules employed by the endowments, particularly since 2008-9, when a number of famous endowments came to realize that there was a liability structure behind them when they ran low on liquidity amid the crisis. [Note: long article.]  You might think it would be smart to have the present value of 3-5 years of expenditures on hand in bonds, but that is not always the case.  In some ways, the quick recovery taught some endowment investors the wrong lesson — that they could wait out any crisis.

That’s my quick summary.  If you have thoughts on the matter, you can share them in the comments.

 

Data Credit: CIA FactbookI write about this every now and then, because human fertility is falling faster then most demographers expect. Using the CIA Factbook for data, the present total fertility rate for the world is 2.425 births per woman that survives childbearing. That is down from 2.45 in 2013, 2.50 in 2011, and 2.90 in 2006. At this rate, the world will be at replacement rate (2.1), somewhere between 2025 and 2030. That’s a lot earlier than most expect, and it makes me suggest that global population will top out at 8.5 Billion in 2050, lower and earlier than most expect.

Have a look at the Total Fertility Rate by group in the graph above. The largest nations for each cell are listed below the graph. Note Asian nations to the left, and African nations to the right.

Africa is so small, that the high birth rates have little global impact. Also, AIDS consumes their population, as do wars, malnutrition, etc.

The Arab world is also slowing in population growth. When Saudi Arabia is near replacement rate at 2.17, you can tell that the women are gaining the upper hand there, which is notable given the polygamy is permitted.

In the Developed world, who leads in fertility? Israel at 2.62. Next is France at 2.08 (Arabs), New Zealand at 2.05, and the US at 2.01, slightly below replacement. We still grow from immigration, as does France.

Most of the above is a quick update of my prior piece, which has some additional crunchy insights.  This evening, I would like to highlight two articles that I saw recently — one on troubles with municipal pensions, and one on how some areas of China are dying.  They are at root the same story, but with different levels of potency.

Let me start with the amusing question where Arnold Schwarzenegger asks Buffett via CNBC what can be done to solve the municipal defined benefit pension problem, which Becky Quick then asks Buffett.  For the next 80 seconds, Buffett says it is a messy problem created by politicians that voted for high municipal pensions, because future generations would pay the bill, and not current taxpayers.  The politicians that voted for them are long gone.  Buffett offers no solutions, and I don’t blame him because all of the solutions are ugly.  Here they are:

  • If state law allows, terminate the current plans and replace them with Defined Contribution plans, or reduce the rates of future accrual.  If those can’t be done, create a new Defined Contribution plan for all new employees, who will no longer participate in the Defined Benefit plans.  Even the last of these will be fiercely resisted by municipal unions.
  • Cancel the cost of living adjustment, if you can do so legally.
  • Raise taxes — I’m sure younger people will enjoy paying for past services of municipal employees.
  • Impose excise (or something like that) taxes on municipal pension payments, and rebate the money back to the plans.
  • Declare or threaten bankruptcy if you can legally do it, and try to extract concessions from the representatives of pensioners.
  • Amend the state constitution to change the status of pension benefits, including adding an exception adding legality to adjust benefits after the fact. (ex post facto)

Don’t get me wrong.  I don’t think the radical solutions could/would ever be done, and the National government would probably slap down any state that actually tried something draconian.  Remember, states are practically administrative units of the national government.  States’ rights is a nice phrase, but often very empty of power.

Here are some non-solutions:

  • Float pension bonds — just a form of leverage, substituting a fixed liability for a contingent liability, and assuming that you can earn more than the rate paid on the pension bonds.
  • Invest more aggressively.  Sorry, taking more risk won’t do it.  Returns are only weakly related to risk, and often taking high risks leads to lower returns.  The returns you are likely to get depend mostly on the entry prices you pay for the underlying cash flow streams in question.
  • Invest in alternative assets.  Sorry, you are late to the game.  Alternatives offer little more than conventional assets at present, and they carry high fees and illiquidity.
  • Adjust the discount rate, or salary increase rate assumption.  That may make the current problem look smaller, but it doesn’t change the underlying benefits to be paid, or the returns the assets will earn.  If anything, the assumptions are too aggressive now, and plan assets are unlikely to return much more than 4%/year over the next 10 years.

Buffett gave one cause for the problem, but there is one more — if the US population were growing rapidly, there would be a larger base of taxpayers to spread the taxes over.  Diminished fertility feeds into the problems in the states, as well as other social insurance schemes, like Social Security and Medicare.  You could loosen up immigration to the US, particularly for younger, wealthy, and or/skilled people, but that has its controversial aspects as well.

Here’s another way of phrasing it — it’s difficult to create workers out of thin air.  Governments would like nothing better than to have more working age people magically appear.  It would solve the problem.  Alas, those decisions were largely made 20-40 years ago also.  There is even competition now for the best immigrants.

That brings me to the article on China. Rudong, a city in China where the one-child policy began, is now an elderly place with few younger people to take care of the elderly.  Kind of sad, even if the problem was partially self-inflicted, and partially inflicted by conceited elites who thought they were doing a good thing.

A few quotations from the article:

“China will see more places like Rudong very soon,” said Wang Feng, a professor of sociology at the University of California at Irvine. “It’s a microcosm of the rapid demographic and economic transformation China has been experiencing the last decades. There will be more ghost villages and deserted or sleepy towns.”

also:

“China is quickly turning gray on an unprecedented scale in human history, and the Chinese government, even the whole Chinese society, is not prepared for it,” Yi said. “In many places, including my hometown in western Hunan, it’s hard to find a young man in his 20s or 30s.”

and also:

What’s different in China is that the one-child policy accelerated the process, removing hundreds of millions of potential babies from the demographic pool. China’s old-age dependency ratio — a measure of those age 65 or over per 100 of working age — is set to triple by 2050, to 39.

The one-child policy created possibly the sharpest demographic shift in the world.  It is largely irreversible; once women as a culture stop having children, they don’t start having more when benefits are offered or penalties are lowered.  It would take a big change in mindset in order to get that to shift, like a religious change, or the aftermath of a big war.

The Christians are growing in China, and many of them would have larger families, but even if Christianity gets a lot bigger, and the Party tolerates it, that won’t come fast enough to deal with the problems of the next 30 years, but it could help with the problems after that.

In closing, there is enough pity to go around.  Pity for the elderly that will not get taken care of to the degree that they would like.  Pity for those younger who cannot afford the time or monetary costs of taking care of the elderly.

I think the only solution to any of this would be shared sacrifice, where everyone gets hurt somewhat.  My question would be what places in the world have the requisite maturity to achieve such a solution.  Optimistically, the answer would be many, but only after a lot of sturm und drang.

Photo Credit: Tulane Public Relations || James Carville wants to be "reincarnated" as the bond market, to scare everyone -- boo!

Photo Credit: Tulane Public Relations || James Carville wants to be “reincarnated” as the bond market, to scare everyone — boo!

I was reading this article at Reuters, and musing at how ludicrous it is for the Fed to think that it can control the reaction of the bond market to tightening Fed policy, should it ever happen.  The Fed has never been able to control the bond market, except on the short end, and only with the highest quality paper.

The long end is controlled by the economy as a whole, and its rate of growth, while lower quality bonds and loans also respond more to where the credit cycle is.  The Fed has never been able to tame the credit cycle — the boom and the bust.  If anything, they make the booms and busts worse.

Now they think that their new policy tools will enable them to control the bond market.  The new tools are nothing astounding, and still mostly affect short and high quality debts.

One thing is certain — when the Fed starts tightening, some levered parties will blow up.  Even the mention of the taper caused shock waves in the emerging bond markets.  And when something big blows up, the Fed will stop tightening.  It always happens, and they always do.

So please give up the idea that the Fed can do what it wants.  It looks like it can in the short-run, but in the long run markets do what they want, and the Fed has to respond, rather than lead.

Crawling to the first tightening move

Crawling to the first tightening move

There was a lot of hoopla yesterday over the FOMC removing the word “patient” from its statement.  But when you read the sentence that replaced the sentence containing the word patient, you shouldn’t think that much has changed:

Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range.

There are two contingencies here, which are both subject to considerable latitude in interpretation:

  • Seeing further improvement in the labor market
  • Being reasonably confident that inflation will move back to its 2 percent objective over the medium term

I have long argued that the FOMC doesn’t have a strong theory for what they are doing, and have designed their language in speaking to the markets to maximize their flexibility.  It has not been the obfuscation of the overly confident Greenspan era, but the endless blather that comes from trying to be “transparent” and drown the market in communications, because they never quite understand us properly.

Now, for the first time in a while, the FOMC statement shrank, and for that, I thank the FOMC.  It should shrink further, and it would be better if the FOMC said nothing, and went back to pre-Greenspan practices, and let the actions of the Open Markets Desk at the New York Fed do the talking.  Deeds, not words.

Now, data isn’t the same as deeds, and they aren’t always as clear as words, but the FOMC gave us a release of the forecasts of its members yesterday.  The graphs in this piece reflect the central tendency of their estimates, giving proper weight to the dominant views, as well as less weight to the views from the outliers.

Start with the graph at the top of this article.  The average of all of the views suggests tightening in September.  Now, with 15 favoring a move in 2015, a move will likely happen this year.  If you look back through their data releases, a preponderance of opinion has pointed to 2015 since September of 2012, with never fewer than 12 members pointing to a move in 2015 since then.

But what of the shift in opinions regarding the level of the Fed Funds rate over time?  What happened to that with the removal of the “patient” language?

My but they got more dovish...

My but they got more dovish…

Look at the reduction in the expected end of year Fed Funds rate — down 0.35% in 2015 (to 0.77%), 0.51% in 2016, 0.32% in 2017, and 0.12% in the long run.  That last number is significant, because of the change in composition of those giving opinions, and it indicates a more generally dovish group.

But the downward moves in values indicate fewer tightening moves for 2015 — at present the estimate would be 2-3 quarter-percent moves. (And five more eaches in 2016 and 2017, for those who dream that savers might get some compensation, and that the government’s budget works at higher levels of interest rates)

A big reason for the shift is the move in views on PCE inflation:

Still behind the deflationary curve...

Still behind the deflationary curve…

That’s a 0.59% move down in PCE inflation estimates for 2015. Odds are, it will be lower than that. The FOMC as forecasters always chase trends, and rarely get ahead of them. They also believe in the power of monetary policy to produce inflation, and more perversely, growth. As it is, their actions have produced little of either.

It does explain why their estimates for 2016 and beyond are so high. Would any of the members dare to break from the lockstep, and concede that monetary policy does not have significant power to affect the economy for good?

Here is the real GDP graph:

Down, down, down...

Down, down, down…

Note the continued move down in estimates for all future periods. Interesting to see the pessimistic shift.

Finally, the unemployment rate graph:

Discouraged workers of the world unite, you have nothing to lose but...

Discouraged workers of the world unite, you have nothing to lose but…

There are many jobs to be had, if people will search for them, and if they think the wages are worth taking, versus alternatives of leisure, working in unreported labor markets, etc…

Conclusion

Looking at the data, the FOMC certainly isn’t hawkish at present. That is consistent with the change in language in the statement, which left timing for any future hikes in the Fed Funds rate vague, and subject to interpretation. This explains the fall in the US Dollar, and the rise in the prices of stocks, long bonds, and commodities. The markets viewed it all as continued monetary lenience, and given the composition of voting members on the FOMC, that should come as no surprise at all.

Until something breaks, expect the FOMC to continue to err on the side of monetary lenience… it’s the only thing they know.

Photo Credit: Day Donaldson

Photo Credit: Day Donaldson

January 2015March 2015Comments
Information received since the Federal Open Market Committee met in December suggests that economic activity has been expanding at a solid pace.Information received since the Federal Open Market Committee met in January suggests that economic growth has moderated somewhat.Shades GDP down.
Labor market conditions have improved further, with strong job gains and a lower unemployment rate.  On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish.Labor market conditions have improved further, with strong job gains and a lower unemployment rate. A range of labor market indicators suggests that underutilization of labor resources continues to diminish.No change.
Household spending is rising moderately; recent declines in energy prices have boosted household purchasing power.  Business fixed investment is advancing, while the recovery in the housing sector remains slow.Household spending is rising moderately; declines in energy prices have boosted household purchasing power. Business fixed investment is advancing, while the recovery in the housing sector remains slow and export growth has weakened.Shades down their view of exports.

 

Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices.  Market-based measures of inflation compensation have declined substantially in recent months; survey-based measures of longer-term inflation expectations have remained stable.Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.Notes flattening of implied future inflation rates.  TIPS are showing lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 1.94%, down 0.09% from January.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.No change. They are no longer certain that inflation will rise to the levels that they want.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced.  Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.  The Committee continues to monitor inflation developments closely.The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of energy price declines and other factors dissipate. The Committee continues to monitor inflation developments closely.CPI is at -0.2% now, yoy.  No change in language.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate.  In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation.  This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.  However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated.  Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range.Removes the concept of patience.  Looks for further labor market improvement, and an increase in inflation expectations – this is less than meets the eye, because it all still remains contingent.  It is in the eye of the beholder.

No rules, just guesswork from academics and bureaucrats with bad theories on economics.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.  This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.Deleted.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.Deleted.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.  The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.“Balanced” means they don’t know what they will do, and want flexibility.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Comments

  • I will still argue that this was a nothing-burger. The patience language was eliminated, but what were left in its place were contingent conditions that are subject to a wide degree of interpretation.
  • Pretty much a nothing-burger. Few significant changes.  The FOMC has a weaker view of GDP and exports.
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Forward inflation expectations have continued to fall.
  • Equities rise and long bonds rise. Commodity prices rise and the dollar falls.  The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The FOMC actually chops out “dead wood” from its statement. Brief communication is clear communication.  If a sentence doesn’t change often, remove it.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
  • We have a congress of doves for 2015 on the FOMC. Things will be boring as far as dissents go.  We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Photo Credit: Zach Copley

Photo Credit: Zach Copley

I’ve generally been quiet about Bitcoin.  Most of that is because it is a “cult” item.  It tends to have defenders and detractors, and not a lot of people with a strong opinion who are in-between.  There’s no reward for taking on something that has significance bordering on religious for some… even if it proves to be a bit of a “false god.”

I view Bitcoin as a method of payment, a collectible item, a commodity that is not fully fungible, and not a store of value.  It is not a currency, and never will be, unless a government takes it over and adopts it.

In order for a tradable item to be a store of value, the amount of variation in value in the short- to intermediate-term versus other items that has to be limited.  If there are other tradable items with greater stability toward the other items, those tradable items would be better stores of value.  Thus Bitcoin is inferior as a store of value versus the US Dollar, the Euro, the Yen, etc.  It is far more volatile versus goods and assets that one might want to buy, and goods and liabilities that one might want to fund.

Now as an aside, the same thing happens in hyperinflationary economies.  Merchants have to change their prices frequently, because the currency is weak.  Often another currency will begin to replace the weak local currency, like the US Dollar or the Euro, even if that is not legal.

Fungibility implies that any Bitcoin is as good as any other Bitcoin.  But with failures like Mt. Gox, a Bitcoin exchange that had Bitcoins under its care stolen from it, a Bitcoin under the care of Mt. Gox was not as valuable as one elsewhere.  (Another aside: that happened in a minor way with the Euro when Euros in Cypriot banks were forced to have a “haircut,” while Euros elsewhere were unaffected.)

Bitcoin is a means of payment, a way of transferring value from one place/person to another.  It seems Bitcoins move well, but they are less good at being safely stored.

The theft of Bitcoins points out the need for there to be a legal system to protect property rights.  Licit participants in Bitcoins as a group have not been adequate to assure that the rightful owners might not lose them as the result of computer hacking.  Contrast that with the protections that credit card holders have when false transactions are applied against credit card accounts.  The credit card companies eat the losses, funded by profits from interest charged an interchange fees.

The libertarian vision of a currency that does not require a court, a government to protect it is misguided.  Where there are thieves, there is a need for courts to try cases of theft, and deal with questions of equity if theft leads to an insolvency.

Now, governments can be less than fair with their own judicial systems.  I think of Dennis Kozlowski, formerly CEO of Tyco, who was barred from using his own money in self-defense when the US Government brought him to trial.  Much as you might like to have value protected from the clutches of the government, that is easier said than done, and there are thieves that will pick away at those who get value away from governments, because ultimately in an interconnected world, you have to trust other people at some points, and trust can be violated as much as the rights of a citizen can be violated.  Repeat after me: THERE IS NO PERFECTLY SAFE PLACE ON EARTH TO STORE VALUE!  That said, though, there are safer places than others, and so you have to live with the risks that you understand, and are prepared to take.

If you think that Bitcoin fits that bill, well, knock your socks off.  Have at it.  I will stick with US Dollars in banks, money market funds, bonds, and public and private stocks.  Maybe I will even buy some gold that does nothing, just for the sake of diversification.  But ultimately my store of value is in the bank of Heaven, as it says in Matthew 6:19-21:

“Do not lay up for yourselves treasures on earth, where moth and rust destroy and where thieves break in and steal; but lay up for yourselves treasures in heaven, where neither moth nor rust destroys and where thieves do not break in and steal. For where your treasure is, there your heart will be also.”

There is no perfect security on Earth, try as hard as you like.  Bitcoins may keep value away from the government under some conditions, but who will protect your property rights in Bitcoins in the event of theft?  You can’t have it both ways, so Bitcoins as property would either be taxed and regulated by governments, or be totally underground, which would diminish utility considerably.

One final note: Bitcoins can’t be used of themselves to produce something else.  They are a fiat currency, and only has value to the degree that users place on it.  I liken it to penny stocks, where traders can bounce the price around, because there is nothing to tether the price to.  At least with gold, you have jewelers demanding it to turn it into jewelry, and a broader pool of people who are somewhat less jumpy about what the proper exchange rate between gold and dollars should be.

But, gold can be stolen… again, no Earthly store of value is perfect.  All for now.