This is just a “what if” piece. If one of my readers knows better than me, leave a comment, or email me. Thanks.

The Surprise Dividend

Imagine one day in 2019 that your favorite dividend-paying stock made the following announcement:

Dear Shareholder,

As you may know, we currently pay a dividend of $2/year to holders of our common stock for each share they hold.  In this current climate where there is uncertainty over whether dividends will be cut at some companies, we would like to guarantee the current payout, and give you more.

We are replacing the current dividend and declaring a special payout today — an unsecured perpetual junior subordinated bond that will pay 80 cents quarterly per current share, payable to all current shareholders as of June 1st, 2019.  It will be eligible to trade separately under the ticker [TICKER].  You are free to sell this income stream for a current gain, or you can continue to receive this income in perpetuity, as will any future holder of this bond.

Why are we doing this?  The Total Revenue And Safe Harbor Act of 2018 repealed special treatment of dividends, but interest is still tax-deductible to us as a corporation.  Much as we like the flexibility of dividends, our cash flow is more than sufficient, and can handle a higher payout.  This higher payout is possible partially because this is an interest payment, and we get to deduct the payment from taxable income.  With our current corporate tax rate of 35%, the effective cost of the new dividend to the corporation is $2.08 per current share.

Many of our shareholders are not taxable, or have taxes deferred.  Still others are retirees who are in lower personal tax brackets.  We expect that some current shareholders in higher tax brackets will choose to sell their bonds.  We would not be surprised to find life insurance companies as willing buyers, given our high credit rating, and their need for long bonds as investments.

Though in the near-term, we will not pay a dividend, that does not mean we will never pay a dividend again.  We will review our payout policy regularly, and make changes as we see best.  It is also possible that future shareholders could see further issuance of these securities if our reliable excess cash flow grows.

As always, we welcome your inquiries to our Investor Relations Department.  Please be aware that this does not constitute tax advice, nor will we provide that to you.  Please give your tax questions to your own personal tax adviser.

Many thanks for being one of our shareholders.  We hope you prosper in 2019 and beyond.

I left aside the argument that now shareholders could choose their own income preference, and also that the income from a junior subordinated bond could survive bankruptcy (though unlikely), and could control the company post-bankruptcy (also unlikely).  Mentions of bankruptcy don’t travel well, even in vague terms.

I also did not mention that the package of the junior bond and the post-dividend stock would likely trade at a higher price post-event.  Might some activist investors try some more severe proposals of this sort?

Your thoughts on this proposal are welcome.  I can’t think of any firm that has done something like this in the past.  Might they do it in the future?

I try not to be an ideologue, and I often fail. One bias of mine is that most macroeconomic policy actions of the government or central bank either don’t help, or merely shift the problem to another place.

Tonight’s issue is the wealth effect, which tends to be favored more by conservatives.  The wealth effect is the tendency to spend more as the market value of the assets of a person rises.  I don’t think the wealth effect is zero, but I don’t think can be very big, and tonight, I will explain why.

Now, imagine that you own some assets and the value of them has grown.  You’re feeling richer, and you would like to live richer as a consequence.  How are you going to do it?  You could:

  • Sell some of the assets.
  • Borrow against the assets.
  • If you control the assets, you could increase the stream of dividends, or pay yourself a higher salary.
  • Trade the assets for assets that pay a higher income.
  • Do more exotic things, like sell call options — but let’s ignore those possibilities for now.  Those are just contingent forms of selling.

Let’s take these in order:

Sell Assets

Selling appreciated assets in most cases means incurring a capital gain and paying taxes.  It can be an effective way of raising your purchasing power on a one-time basis.  It also means that someone like you, or, one of their representatives, is going to have to part with money so that you can receive cash for your money.  The net effect for the economy is not likely to be an increase of cash spent on consumption as a result.

As an aside, some people might be averse to selling assets in a big way because they don’t want to consume capital.  They may not believe that the remainder of their assets will continue to rise in value, and as such might not be willing to spend from realized capital gains.  That said, many older people *will* have to consume capital in old age, but they aren’t well-enough off to produce a wealth effect — they worry whether their assets will last.

Borrow Against Assets

I think this is dangerous if done in a big way, though I have seen some crackpots advocating that.  We should have learned from the financial crisis that if borrowing against stable assets like a home in order to spend can result in disaster, it does not make sense to do it against more volatile assets like stocks or a private business.  Your home is not an ATM.  That same logic should apply to a brokerage account.

If you do borrow against an appreciated asset in order to spend, that may increase your spending one time, but unless the value of your assets continually increases, you won’t be able to do it forever.  And, if asset values fall dramatically, you may find that if your debts are greater than your assets, that your spending may go down considerably as you pay back debt to hold onto your assets.

Now, if a lot of people are inverted in their borrowing, an increase in the overall price level of assets could make some people un-invert and breathe easier, and after a while, spend more from their incomes.  But the rise there will likely be offset by others whose savings aren’t worth as much being reticent to spend.

Pay Yourself a Greater Dividend or Salary

If you own all of a given asset, this becomes a question of taking income versus spending on capital expenditures to grow or maintain the business.  Greater personal spending is offset by lesser business spending.  Oh, and you have to pay tax on the income you receive.  If you own part of the business, but still control it, receiving a higher salary disproportionately helps you versus your minority shareholders.  You might be able to spend more, but it comes out of their pockets.

Trade Your Assets for Assets that Pay a Higher Income

You might want to look at two articles of mine:

First, it’s a simple trade.  You might have more income to spend, but someone else has less on average.  Beyond that, it makes more sense to pursue investments that give you the best returns regardless of how much income they pay.  You can decide on the income you need via dividends, selling bits of the investment, etc.

Income is not an inherent aspect of an asset.  Within bounds, it is arbitrary, as noted in the two articles to which I linked.  As a result, choosing a higher income set of assets may not give you more to spend over time.  Even if Congress passed a law tomorrow saying that all companies, public and private, have to pay a dividend equal to 3% of market value (or fair value, however determined), it might increase personal taxable income, but many would reinvest it while some would spend.  As for the corporations, they would have to spend less on capital expenditures, or borrow more to fund them.  A great increase in spending would be unlikely.

Summary

None of the ways I mentioned for getting more money for spending out of investments is likely to produce a lot of additional spending in aggregate across the economy.  As a result, I think that the Executive Branch, the Congress, and the Federal Reserve should be cautious of trying to make asset values rise, or encourage more borrowing against assets.  It will likely not have any significant effect to grow the economy over the intermediate -to-long term.

Photo Credit: Vinoth Chandar || Do you control the elephant, or does the elephant control you?

Photo Credit: Vinoth Chandar || Do you control the elephant, or does the elephant control you?

I’m currently reading a book about the life of Jesse Livermore.  Part of the book describes how Livermore made a fortune shorting stocks just before the panic of 1907 hit.  He had one key insight: the loans of lesser brokers were being funded by the large brokers, and the large brokers were losing confidence in the creditworthiness of the lesser brokers, and banks were now funding the borrowings by the lesser brokers.

What Livermore didn’t know was that the same set of affairs existed with the banks toward trust companies and smaller banks.  Most financial players were playing with tight balance sheets that did not have a lot of incremental borrowing power, even considering the lax lending standards of the day, and the high level of the stock market.  Remember, in those days, margin loans required only 10% initial equity, not the 50% required today.  A modest move down in the stock market could create a self-reinforcing panic.

All the same, he was in the right place at the right time, and repeated the performance in 1929 (I’m not that far in the book yet).  In both cases you had a mix of:

  • High leverage
  • Short lending terms with long-term assets (stocks) as collateral.
  • Chains of lending where party A lends to party B who lends to party C who lends to party D, etc., with each one trying to make some profit off the deal.
  • Inflated asset values on the stock collateral.
  • Inadequate loan underwriting standards at many trusts and banks
  • Inadequate solvency standards for regulated financials.
  • A culture of greed ruled the day.

Now, this is not much different than what happened to Japan in the late 1980s, the US in the mid-2000s, and China today.  The assets vary, and so does the degree and nature of the lending chains, but the overleverage, inflated assets, etc. were similar.

In all of these cases, you had some institutions that were leaders in the nuttiness that went belly-up, or had significant problems in advance of the crisis, but they were dismissed as one-time events, or mere liquidity and not solvency problems — not something that was indicative of the system as a whole.

Those were the warnings — from the recent financial crisis we had Bear Stearns, the failures in short-term lending (SIVs, auction rate preferreds, ABCP, etc.), Bank of America, Citigroup, credit problems at subprime lenders, etc.

I’m not suggesting a credit crisis now, but it is useful to keep a list of areas where caution is being thrown to the wind — I can think of a few areas: student loans, agricultural loans, energy loans, lending to certain weak governments with large liabilities and no independent monetary policy… there may be more — can you think of any?  Leave a comment.

Subprime lending is returning also, though not in housing yet…

Parting Thoughts

I’ve been toying with the idea that maybe there would be a way to create a crisis model off of the financial sector and its clients, working off of a “how much slack capital exists across the system” basis.  Since risky borrowers vary over time, and some lenders are more prudent than others, the model would have to reflect the different links, and dodgy borrowers in each era.  There would be some art to this.  A raw leverage ratio, or fixed charges ratio in the financial sector wouldn’t be a bad idea, but it probably wouldn’t be enough.  The constraint that bind varies over time as well — regulators, rating agencies, general prudence, etc…)

In a highly leveraged situation with chains of lending, confidence becomes crucial.  Indeed, at the time, you will hear the improvident squeal that they “don’t have a solvency crisis, but just a liquidity crisis! We just need to restore confidence!”  The truth is that they put themselves in an unstable situation where a small change in cash flows and collateral values will be the difference between life and death.  Confidence only deserves to exist among balance sheets that are conservative.

That’s all for now.  Again, if you can think of other areas where debt has grown too quickly, or lending standards are poor, please e-mail me, or leave a message in the comments. Thanks.

Dear Readers, I’m going to try a different format for this piece. If you think it is a really bad way to present matters, let me know.

Question: Why do pensions exist?

Answer: They exist as a means of incenting employees to work for a given entity.  It can be a very valuable benefit  to employees, because it is difficult to earn money in old age.

Q: How did we end up with retirement savings being predominantly associated with employment?

A: That’s mostly an accident of history.  First some innovative firms offered defined benefit [DB] plans [paying a fixed sum at retirement for life, often with benefits to surviving spouses, and pre-retirement death benefits] in order to attract employees.  After World War II, many unions insisted and won such benefits, and many non-union firms imitated them.

Q: Why didn’t many defined benefit plans persist to the present day?

A: In general, they were too expensive.

Q: If they were too expensive, why did they get created?

A: They weren’t expensive at first.  The post-WWII era was one of booming demand and excellent demographics — there was only a small cohort of oldsters to support, and a rapidly growing population of workers.  Also, the funding mechanisms allowed by the government allowed for low levels of initial funding to get them started, and they assumed that corporations would easily catch up at some later date.  Sadly, some of the funding was so low that there were some defaults in the 1960s, leaving pensioners bereft.

Q: Ouch.  What happened as a result?

A: Eventually, Congress passed the Employee Retirement Income Security Act in 1974.  That standardized pension funding methods and tightened them a little, but not enough for my taste.  It also created the Pension Benefit Guarantee Corporation to insure defined benefit plans.  It did many things to standardize and protect defined benefit pensions.  Protection comes at a cost, though, and costs went higher for DB plans.

Some firms began terminating their plans.  In the mid-1980s, some firms found that they could get a moderate profit out of terminating their plans.  That didn’t sit well with Congress, which passed legislation to inhibit the practice.  That indirectly inhibited starting plans — few people want to in the “in” door, when there is not “out” door.

Some firms began funding their plans very well, and the IRS didn’t like the loss of tax revenue, so regulations were created to stop overfunding of pension plans.  These regulations put sponsors in a box.  Given the extremely strong asset returns of the ’80s and ’90s, it would have made sense to salt a lot of assets away, but that was not to be.  Thanks, IRS.

Q: Were there any other factors aside from tax policy affecting DB plans?

A: Four factors that I can think of:

  • Falling interest rates raised the value of pension liabilities.
  • Demographics stopped being so favorable as people married less and had fewer kids.
  • Actuaries got pressured to be too aggressive on plan valuation assumptions, leading to lower contributions by corporations and municipalities to their plans.
  • By accident, the 401(k) was introduced, leading to an alternative pension plan design that was a lot cheaper.  Defined contribution plans were a lot cheaper, and easier for participants to understand.  The benefits were valued more than the technically superior DB plan benefits because you could see the balance grow over time — especially in the ’80s and ’90s!

Q: Why do you say that DB plan benefits were technically superior?

A: Seven reasons:

  • They were generally paid for entirely by the employer.
  • A lot more money was contributed by the employer.
  • It gave them a benefit that they could not outlive.
  • Average people aren’t good at investing.
  • Fees for investing were a lot lower for DB plans than for Defined Contribution [DC] plans.  (Employer provides a sum of money to each employee’s account.)
  • The institutional investors were better for DB plans than DC plans, because plan sponsors would go direct to money managers with talent, while plan participants demanded name-brand mutual funds that were famous.  (Famous means a lot of assets recently added, which means poor future performance.  Should you give your kids what they want, or what you know they need?)
  • If the companies could continue to afford the benefits, the benefits would be much larger in present value terms than the lump sum accumulated in their DC plans.

The last point is important, because the benefits promised were too large for the companies to fund.  Eventually, they will be too large for most states and municipalities to fund as well, but that’s another thing…

Q: So people preferred something that was easier to understand, rather than something superior, and companies used that to shed a more expensive pension system.  That’s how we got where we are today?

A: Yes, and add in the relative impermanence of most corporations and some industries.  You need a strong profit stream in order to fund DB plans.

Q: What are we supposed to do about this then?

A: Stay tuned for part two, which I will write next week.  Believe me, there are a lot of controversial ideas about this, and there are no easy solutions — after all, we got into this problem because most corporations and people did not want to save enough money for the retirement of employees and themselves, respectively.

Q: Till next time, then!

 

Too often in debates regarding the recent financial crisis, the event was regarded as a surprise that no one could have anticipated, conveniently forgetting those who pointed out sloppy banking, lending and borrowing practices in advance of the crisis.  There is a need for a well-developed model of how a financial crisis works, so that the wrong cures are not applied to the financial system.

All that said, any correct cure will bring about a predictable response from the banks and other lending institutions.  They will argue that borrower choice is reduced, and that the flow of credit and liquidity to the financial system is also reduced.  That is not a big problem in the boom phase of the financial cycle, because those same measures help to avoid a loss of liquidity and credit availability in the bust phase of the cycle.  Too much liquidity and credit is what fuels eventual financial crises.

To get to a place where we could have a decent model of the state of overall financial credit, we would have to have models that work like this:

  1. The models would have to have both a cash flow and a balance sheet component to them — it’s not enough to look at present measures of creditworthiness only, particularly if loans do not fully amortize debts at the current interest rate.  Regulatory solvency tests should not automatically assume that borrowers will always be able to refinance.
  2. The models should try to go loan-by-loan, and forecast the ability of each loan to service debts.  Where updated financial data is available on borrowers, that should be included.
  3. The models should try to forecast the fair market prices of assets/collateral, off of estimated future lending conditions, so that at the end of the loan, estimates can be made as to whether loans would be refinanced, extended, or default.
  4. As asset prices rise, there has to be a feedback effect into lowered ability to finance new loans, unless purchasing power is increasing as much or more than asset prices.  It should be assumed that if loans are made at lower underwriting standards than a given threshold, there will be increasing levels of default.
  5. A close eye would have to look for situations where if the property were rented out, it would not earn enough to pay for normalized interest, taxes and maintenance.  When asset prices are that high, the system is out of whack, and invites future defaults.  The margin of implied rents over normalized interest, taxes and maintenance would be the key measure, and the regulators would have to have a function that attributes future losses off of the margin of that calculation.
  6. The cash flows from the loans/mortgages would have to feed through the securitization vehicles, if any, and then to the regulated financial institutions, after which, how they would fund their future liabilities would have to be estimated.
  7. The models would have to include the repo markets, because when the prices of collateral get too high, runs on the repo market can happen.  The same applies to portfolio margining agreements for derivatives, futures, and other types of wholesale lending.
  8. There should be scenarios for ordinary recessions.  There should also be some way of increasing the Ds at that time: death, disability, divorce, disaster, dis-employment, etc.  They mysteriously tend to increase in bad economic times.

What a monster.  I’ve worked with stripped-down versions of this that analyze the Commercial Mortgage Backed Securities [CMBS] market, but the demands of a model like this would be considerable, and probably impossible.  Getting the data, scrubbing it, running the cash flows, calculating the asset price functions, implied margin on borrowing, etc., would be pretty tough for angels to do, much less mere men.

Thus if I were watching over the banks, I would probably rely on analyzing:

  • what areas of credit have grown the quickest.
  • where have collateral prices risen the fastest.
  • where are underwriting standards declining.
  • what assets are being financed that do not fully amortize, including all repo markets, margin agreements, etc.

The one semi-practical thing i would strip out of this model would be for regulators to score loans using a model like point 5 suggests.  Even that would be tough, but even getting that approximately right could highlight lending institutions that are taking undue chances with underwriting.

On a slightly different note, I would be skeptical of models that don’t try to at least mimic the approach of a cash flow based model with some adjustments for market-like pricing of collateral and loans.  The degree of financing long assets with short liabilities is the key aspect of how financial crises develop.  If models don’t reflect that, they aren’t realistic, and somehow, I expect that non-realistic models of lending risk will eventually be the rule, because it helps financial institutions make loans in the short run.  After all, it is virtually impossible to fight loosening financial standards piece-by-piece, because the changes seem immaterial, and everyone favors a boom in the short-run.  So it goes.

Photo Credit: Dana || They charge more for "Arrest me red" too!

Photo Credit: Dana || They charge more for “Arrest me red” too!

This should be a relatively quick note on personal lines insurance. I’m writing this after reading the piece in this month’s Consumer Reports on Auto Insurance.  I agree with most of it.  For those that are short on time, my basic advice is this: bid out your auto, home, umbrella and other personal lines property & casualty insurance policies once every three years, or after every significant event that changes your premium significantly.

Here are a few simple facts to consider:

  • Personal lines insurance — auto, home, umbrella, rental, etc. is a very competitive business, and the companies that offer it all want an underwriting formula that would give them the best estimate of expected losses from each person insured.
  • After that, they want to know how much “wiggle room” that they would have to build in some profit.  Where might the second place bid be?  How likely are consumers to shop around?
  • Most insurers use a mix of credit scores and claim history to calculate rates.  Together, they are effective at forecasting loss costs — more effective than either one separately.
  • Read my piece On Credit Scores.  They are very important, because they measure moral tendency.  People with low scores tend to have more claims than those with high scores on average.  People with high scores tend to be more careful in life.  This is a forward-looking aspect of a person’s underwriting profile.
  • It’s fair to use “credit scores” because they are positively and significantly correlated with loss costs.  The actuaries have tested this.  Note that it is legal in almost all states to use credit scores, or something like them, but not all of them.
  • As the Consumer Reports article points out, many insurance companies take advantage of insureds that stick with them year by year, because they don’t shop around.  Easy cure: bid out your policy every three years at minimum.  If enough people do this, the insurance companies that overcharge loyal customers will stop doing it.  (Note: when I was a buy side analyst analyzing insurance stocks, one company implicitly admitted to doing this, and I was insured by them.  Guess what I did next?  It was not to sell the stock, though eventually I did when I saw that their premium increases were no longer increasing profits.)
  • Also be willing to unbundle your home and auto policies — there may be a discount, or there may not as the Consumer Reports article states.  I’ve worked it both ways, and am unbundled at present.
  • If they have that much money for amusing advertising, it implies that the market isn’t that rational.  Bid it out.
  • But — it is important to realize that insurers don’t all have the same formulas for underwriting, and those formulas are not static over time.  Bidding out your insurance makes sure you benefit from changes that positively affect you.
  • Insurers tend to get more competitive as the surplus they have to deploy gets bigger, and vice-versa when it shrinks after a large disaster.  If your premium goes up after a disaster, bid the policies out.  If it drifts up slowly when there have been no significant disasters, or claims on your part, they are taking advantage of you.  Bid it out.

Bid it out.  Bid it out.  Bid it out.  What do you have to lose?  If loyalty means something to the insurer, they will likely win the bid.  If it doesn’t, they will likely lose.  Either way you will win.  If you have an agent, they will note that you are price-sensitive.  The agent will become more of an ally, even if it doesn’t seem that way.

I went through this several times.  Most people who have read me for a while know that I have a large family — I am going to start teaching number seven to drive now.  I bid it out when kids came onto my policy.  It produced a change.  When two of my kids had accidents in short succession, my premiums rose a lot.  They would not underwrite one kid.  I got most of it back when I bid it out.  Since that time, the two have been claim-free for 2.5 years.  Guess what I am going to do next March, when I am close to the renewal where premiums would shift?  You got it; I will bid it out.

There is one more reason to bid it out: it forces you to review your insurance needs.  You may need more or less coverage than you currently have. You might realize that you need an umbrella policy for additional protection.  You may decide to self-insure more by raising your deductibles.  The exercise is a good one.

You don’t need transparency, or more regulation.  You don’t get transparency in the pricing of many items.  You do need to bid out your business every now and then.  You are your own best defender in matters like this.  Take your opportunity and bid out your policies.

Make sure that you:

  • Choose a range of insurers — Large companies, smaller local companies, stock/mutual, and any that favor a group you belong to, if the group is known to be filled with good risks.
  • Give them a standardized request for insurance, giving all of the parameters for your coverage, and data on those insured.
  • Tell them they get one shot, so submit their best bid now… there will be no second looks.
  • Some companies argue more about paying claims.  (AIG once had a reputation that way.)  Limit your bidders to those with a reputation for fairness.  State insurance departments often keep lists of complaints for companies.  Take a look in your home state.  Talk with friends.  Google the company name with a few choice words (cheated, claim denied, etc.) to see complaints, realizing that complainers aren’t always right.
  • Limit yourself to the incumbent carrier and 4-6 others.  Seven is more than enough, given the work involved.

So, what are you waiting for?  Bid out your personal insurance business.

Full disclosure: long AIZ, ALL, BRK/B, TRV for myself and clients (I know the industry well)

Photo credit: jonesylife || Oh look, a dozen doves flying at the FOMC!

Photo credit: jonesylife || Oh look, a dozen doves flying at the FOMC!

June 2015July 2015Comments
Information received since the Federal Open Market Committee met in April suggests that economic activity has been expanding moderately after having changed little during the first quarter.Information received since the Federal Open Market Committee met in June indicates that economic activity has been expanding moderately in recent months.No real change.
Growth in household spending has been moderate and the housing sector has shown some improvement; however, business fixed investment and net exports stayed soft.Growth in household spending has been moderate and the housing sector has shown additional improvement; however, business fixed investment and net exports stayed soft.No real change. Swapped places with the following sentence.
The pace of job gains picked up while the unemployment rate remained steady. On balance, a range of labor market indicators suggests that underutilization of labor resources diminished somewhat.The labor market continued to improve, with solid job gains and declining unemployment. On balance, a range of labor market indicators suggests that underutilization of labor resources has diminished since early this year.No real change. Swapped places with the previous sentence.
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; energy prices appear to have stabilized.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.No real change.
Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.Market-based measures of inflation compensation remain low; survey‑based measures of longer-term inflation expectations have remained stable.No change.  TIPS are showing higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.10%, up 0.07% from April.
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 mandateNo real change.
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 earlier declines in energy and import prices 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 earlier declines in energy and import prices 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.
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 some 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 real change.

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. 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.No Change.

“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

  • This FOMC statement was another great big nothing. No significant changes.
  • Don’t expect tightening in September. People should conclude that the FOMC has 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.
  • 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.
  • Equities and long bonds rise. Commodity prices and the dollar are flat.
  • 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 continue to 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: jonesylife || Oh look, a dozen doves flying at the FOMC!

Photo credit: jonesylife || Oh look, a dozen doves flying at the FOMC!

 

April 2015June 2015Comments
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.Information received since the Federal Open Market Committee met in April suggests that economic activity has been expanding moderately after having changed little during the first quarter.Shades GDP up.  Why can’t the FOMC accept that the economy is structurally weak?
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.The pace of job gains picked up while the unemployment rate remained steady. On balance, a range of labor market indicators suggests that underutilization of labor resources diminished somewhat.Shades labor use up.
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.Growth in household spending has been moderate and the housing sector has shown some improvement; however, business fixed investment and net exports stayed soft.Shades up their view of household spending.  Drops a comment on consumer sentiment (that only lasted one month).
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.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; energy prices appear to have stabilized.Notes stable prices of energy, even though prices have risen over the last two months.
Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.No change.  TIPS are showing lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.03%, down 0.07% from April.
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.
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.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 real change.
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.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 earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.CPI is at -0.1% 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.
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.

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.No Change.

“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

  • This FOMC statement was a great big nothing. No significant changes.
  • People should conclude that the FOMC has 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 stronger view of GDP, energy prices and labor use.
  • 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.
  • Equities rise and long bonds are flat. 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 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 continue to 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: Bowen Chin || What's more Illiquid than Frozen Tundra?

Photo Credit: Bowen Chin || What’s more Illiquid than Frozen Tundra?

My last piece on this topic, On Bond Market Illiquidity (and more), drew a few good comments.  I would like to feature them and answer them.  Here’s the first one:

Hello David,

One issue you don’t address in your post, which is excellent as usual, is the impact of what I’ll call “vaulted” high quality bonds. The explosion and manufacturing of fixed income derivatives has continued to explode while the menu of collateral has been steady or declining. A lot of paper is locked down for collateral reasons.

That’s a good point.  When I was a bond manager, I often had to deal with bonds that were salted away in the vaults of insurance companies, which tend to be long-term holders of long-term bonds, as they should be.  They need them in order to properly fund the promises that they make, while minimizing cash flow risk.

Also, as you mention, some bonds can’t be sold for collateral reasons.  That can happen due to reinsurance treaties, collateralized debt obligations, accounting reasons (marked “held to maturity”), and some other reasons.

But if the bonds are technically available for sale, it takes a certain talent to get an insurance company to sell some of those bonds without offering a steamy price.  You can’t sound anxious, rushed, etc. My approach was, “I’d be interested in buying a million or two of XYZ (mention coupon rate and maturity) bonds in the right price context.  No hurry, just get back to me with any interest.”  I would entrust this to one mid-tier broker familiar with the deal, who had previously had some skill in prying bonds out of the accounts of long-term holders before.  I might have two or three brokers doing this at a time, but all working on separate issues.  No overlap allowed, or it looks like there is a lot of demand for what is likely a sleepy security.  No sense in driving up the price.

Because it is difficult to get the actual cash bonds, it is tempting for some managers to buy synthetic versions of those bonds, or synthetic collateralized debt obligations of them instead.  Aside from counterparty risk, the derivatives exist as “side bets” in the credit of the underlying securities, and don’t provide any additional liquidity to the market.

My point here would be that these conditions have existed before, and I think what we have here is a repeat of bull market conditions in bond credit.  This isn’t that unusual, and it will eventually change when the bull market ends.

Here’s the next comment:

Hi David,

I hope you’re doing well.  I’ve been reading your blog for about a year now and really appreciate your perspective and original content.  Just wanted to ask a quick question regarding your most recent post on bond market liquidity. 

Our investment committee often talk about the idea of bond liquidity (and discusses it with every bond manager who walks in our doors), and specifically how there are systematic issues now which limit liquidity and considerably push the burden onto money managers to make markets vs. the past, when banks themselves were free to make more of a market with their own balance sheets.

My (limited) understanding is that legislation since 2008 has changed the way that investment banks are permitted to trade on their own books, and this is a big part of the significantly decreased liquidity which has thus far been a relative non-issue but which could rear its head quickly in the face of a sharp correction in bonds.

Do you have any thoughts about this newer paradigm of limited market-making at the big banks?  You didn’t seem to mention it at all in your article and I’m wondering if my thoughts here are either inaccurate or not impactful to the bottom line of the liquidity conversation.

I’m sure you’re a busy guy so I won’t presume upon a direct response but it may be worthwhile to post an update if you think these questions are pertinent.

Another very good comment.  I thought about adding this to the first piece, but in my experience, the large investment banks only kept some of the highest liquidity corporates in inventory, and the dregs of mortgage- and asset-backed bonds that they could not otherwise sell.  The smaller investment banks would keep little-to-no-inventory.  Many salesmen might have liked the flexibility of their bank to hold positions overnight, or buying bonds to “reposition” them, but the experiences of their risk control desks put the kibosh on that.

As a result, I think that the willingness of investment banks to make a market rely on:

  • The natural liquidity of the securities (which comes from the size of the issue, market knowledge of the issue, and composition of the ownership base), and
  • How much capital the investment bank has to put against the position.

The second is a much smaller factor.  Insurance companies have to deal with variations in capital charges in the bonds that they hold, and that is not a decisive factor in whether they hold a bond or not.  It is a factor in who will hold a bond and what yield spread the bond will trade at.  Bonds tend to gravitate to the holders that:

  • Like the issuer
  • Like the cash flow profile
  • Have low costs for holding the bonds

Yes, the changed laws and regulations have raised the costs for investment banks to hold bonds in inventory.  They are not a preferred habitat for most bonds.  Therefore, if an investment bank buys a bond in order to sell it (or vice-versa) in the present environment, the bid-ask spread must be wider to compensate for the incremental costs, thus reducing liquidity.

To close this evening, one more letter on bonds from a reader:

First off, thank you for taking the time to share your knowledge via your blog.  It is much appreciated.

Now for a bond question from someone learning the fixed income ropes…

What is the advantage/reasoning behind a company co-issuing notes with a finance subsidiary?  Even with reading the prospectus/indenture I can’t understand why a finance sub (essentially just set up to be a co-issuer of debt) would be necessary especially since the company is an issuer anyway and they also may have other subs guarantee the debt also.  I’m probably missing something obvious.

The answer here can vary.  Some companies guarantee their finance subsidiaries, and some don’t.  Those that don’t are willing to pay more to borrow, while bondholders live with the risk that in a crisis, the company might step away from its lending subsidiary.  They would never let the subsidiary fail, right?

Well, that depends on how easy it is to get financing alternatives, and how easy it might be for the parent company to borrow, post-subsidiary default.

If things go well, perhaps the subsidiary could be spun off as a separate company, or sold to another finance company for a gain.  After all, it has had separate accounting done for a number of years.

Beyond that, it can be useful to manage lending separately from sales.  They are different businesses, and require different skills.  Granted, it could be done as two divisions in the same company, but doing it in separate companies would force separate accountability if done right.

There may be other reasons, but they aren’t coming to my mind right now.  If you think of one, please note it in the comments.

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.