I thought that I had a really good proposal for dealing with money market fund problems.  And it is good, far better than what the SEC is proposing.  My proposal is better because it treats money market funds like ETFs — they are pass-through vehicles, and as such, do not need capital buffers.

And, my proposal is better, because it recognizes that credit events should be rare but acceptable aspects of how money market funds work.  Think about it: particularly when short term interest rates are so low, there is no way for interest to cover even the slightest discrepancies versus NAV.

Under my way of doing things, let there be stable net asset values, freedom in investment guidelines, but the possibility of credit events.  The present set of restrictions in investing does no one any good, because the problem is not length of maturity or credit quality, but issuer concentration.

But let money market fundholders analyze the tradeoff between yield and risk.  Guess what?  Short-term bond fund holders have to do the same thing.

Though I would not do it for individuals, in the Stable Value world, there have been “in kind” distributions where when a fund winds up, it distributes assets pro-rata to clients.  With individuals, I would create a second fund that absorbs liquidity from the first fund as assets mature, where fundholders could withdraw assets, if desired.

But why are we going after money market funds?  When they fail, the cost is pennies on the dollar, and it rarely happens.  Why not go after banks?  They fail far more frequently, with much larger losses.  I say let money market funds fail, and do not increase regulations on them.  Rather, let them be like ETFs, and let them be constrained by the prudence of the free markets.  What? You can have investment without the possibility of loss?  Ridiculous.

Regulate the banks tightly, but let money market funds go free, but advertise that losses are more than possible.

One final note: in certain fixed income businesses, if there is an involuntary wind-up, two solutions for ending equitably are a pro-rata distribution of assets, or letting the portfolio mature, and sending cash with each maturity. With institutional money market funds the first option is possible: in a crisis, just divide the assets and let everyone work it out.  But with retail clients, the second option is also possible: send assets as the portfolio matures, with the complicating factor of what to do with a genuine default.  In such a case, collective action is usually preferable for winding up, so that might be the last few percent of liquidity that does not get distributed for some time.

Again, I will say, let money markets have the possibility of failure, rather than have extensive schemes to maintain them at par.  Unlike banks, money market failure are small and contained.  Tell the SEC and the banking regulators to focus on a real problem — bank insolvency.

Many investment ideas are promising so long as few do them.  Yes, there is an opportunity, but it is limited.  “Shh, don’t tell everyone about it.”

Thus, the concept of “risk parity.”  Lever every asset class up until it has the same volatility as common stocks. Under theoretical conditions, one could make extra money doing this, and with less risk than just a common stock portfolio.

That makes sense when few are doing it, but not when many are doing it.  When I worked for Hovde Capital Advisors, I highlighted to the group how hedge funds were forcing every asset class to the same level of riskiness.  A Grants Interest Rate Observer article on Leveraged Non-prime Commercial Paper is etched on my mind as emblematic of that era.

Risk parity can work so long as the total riskiness of the system does not get too high, as it did in 2007-8.  But if it does get too high, the assets that are levered face disadvantages versus volatile unlevered assets.  Failures of leverage feed on themselves, and lead to a real washout.  Failures of growth stocks don’t do that to the economy.

Risk parity turns managers into bankers, or worse yet, asset managers that specialize in non-AAA investment grade portions of structured securities deals.  Most asset managers are not used to thinking like bankers, largely because they think in terms of total return, and because they don’t have a balance sheet.  Their capital can run at will, unlike banks that have deposit stickiness, savings accounts, CDs, ability to borrow from the FHLBs, etc.  The banks can hold the assets to maturity, they have a buffer against losses in their capital, and don’t have to mark to market in an assiduous manner (though they *should* have to do so).

Think of the mortgage REITs in the most recent crisis — the ones that did the best were the least levered and had the longest terms for their repo lines.  In the short run, that costs more than the vain idea that one can roll over their repo lines every night, and that repo haircuts won’t rise.  Crises lead to a failure of both ideas, together with a set of forced sellers driving down the price of assets being repo-ed, which sometimes leads to a cascade where repo terms get progressively tighter, and only those that were the most conservative at the start of the crisis survive.

There is a Wall Street aphorism, “The fool does at the end of a bull market what the wise man does at its beginning.”  Risk parity falls into that bucket.  Early adopters of new asset classes and liability structures typically do well, but when they become mainstream, the dynamics can be ugly, as we learned in 2007-present.

So ignore the idea of risk parity.  Risk managers are not bankers, they don’t have the capacity to play leveraged spread games to maturity.  Risk parity if practiced on a large scale will produce wipeouts akin to the recent crisis.

Comments

• So they extend the period of accommodation by a little more than a year.  Sends financial markets flying, and especially TIPS prices, but will have little impact on the economy.  (Do they want the yield on 30 year TIPS to go negative?  Looks that way.)
• GDP growth is not improving much if at all, and the unemployment rate improvement comes more from discouraged workers.  Inflation has moderated, but whether it will stay that way is another question.
• In my opinion, I don’t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy finances itself.
• Also, the reinvestment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government, even with the recently announced refinancing changes.
• The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent increases in employment, or a US Dollar crisis.  Labor employment is the key metric.
• The Fed is out of good policy tools, so it will use bad policy tools instead, and for longer than before.

Questions for Dr. Bernanke:

• Why do think extending the period of accommodation by a little more than a year will have any significant effect on the economy, aside from stock and bond prices?
• Is it possible that you don’t really know what would have worked to solve the Great Depression, and you are just committing an entirely new error that will result in a larger problem for us later?
• Discouraged workers are a large factor in the falling unemployment rate. Why do you think the economy is doing so well at present?
• Why do you think that holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy finances itself?
• Why will reinvestment in Agency MBS help the economy significantly?  Doesn’t that only help solvent borrowers on the low end of housing, who don’t really need the help?
• Couldn’t increased unemployment be structural, after all, there is a lot more competition from labor in emerging markets?
• Isn’t stagflation a possibility here?  I mean, no one expected it in the ‘70s either.
• Could we end up with another debt bubble from keeping short rates so low?
• If the Fed ever does shrink its balance sheet, what effect will it have on the banks?

I appreciate Steve Randy Waldman, who writes the excellent blog Interfluidity.  Even before I started blogging, while I was at RealMoney, we interacted over CPDOs, along with Alea, and several others that were onto the scam.  That was a fun time, because aside from the Canadian rating agency Dominion, there was no one else questioning the idiocy of the AAA ratings aside from a few bloggers — we are the conscience of Wall Street, but that doesn’t mean that we get any pay as a result.  We write these things as a public service.

Recently, he wrote two  articles on financial intermediation.  Now I’d like to try my own thoughts on the topic.

Financial intermediation has two purposes: transactions and safety.  People want to buy and sell, but don’t want to have a currency where its value shifts radically day-to-day, which would complicate their decisions considerably.  They want a stable unit of account, and don’t want the possibility that they lose a lot of money as a result.  (Yes, during conditions of hyperinflation that boundary disappears, but that’s because they are already losing value already each day from holding the formerly “safe” transactional asset.  They get more careless on the intermediary, because of the risks of holding the safe asset.)

The second goal is safety/preservation/growth of purchasing power.  Can I park money or a short to long amount of time and be assured that when the term is up, I will:

• Receive receive back as much or more in purchasing power terms.
• Reduce my risks or the risks of those I care for from death and other calamities.

Financial intermediation leaves money on the table.  It does not seek the best investment outcome, but takes a lesser return, so that goals can be achieved with greater certainty.

Now, that provides an advantage to the financial intermediaries.  It means that they get cheap funding under most conditions.  Now, can they invest it over the likely lifetime of the funding and not lose money?  That’s a lot of what solvency regulation is about in banks and insurers.   Because financial promises made can’t be easily analyzed for quality by those that offer money, there are two responses by the government:

• Capital rules (which vary by liability and investments)
• Insurance, so that users don’t have to worry about loss.

And, for what it is worth, 12 years ago I played a large role in setting the rules for Maryland life insurers in place, both writing the law, and explaining to the legislators how it protected the public interest.  (Hey! Passed unanimously on the first try, and with the d-word! (Derivatives)  My bill allowed risk mitigation but not risk taking with derivatives.)  The then-governor dressed like a mafia don at the bill signing, for what it is worth… My boss and I and our external and internal legal counsels spent a lot of time on this, but I was the prime mover on getting it done.

As an aside, sitting around in hearings in Annapolis, not knowing when your bill will come up is a chore.  If you know me well, you know I brought work to do, and if that wore out, good books to read.  I was never sitting there with nothing, bored. In the process I learned that Johns Hopkins owns Maryland, but declines from making that public, except when they care. When they spoke up, the legislature rolls over and asks for a scratch on the tummy. Arf!

Sorry, got lost in reminiscing.  Can I say that it was weird?  (I will leave out my dealings with the Department of Insurance, which were surreal.)  I’m not political for the most part, but in the end, the Maryland life insurance investment code is one of the best of the 50 states.  Kind of sad that we don’t have more life insurers here.

The last three paragraphs were quite a detour.  Let me take a different tack.  Yes, intermediation is opaque; that is true by necessity.  Depositors and insureds do not know how their money is invested.  I am here to tell you that that is a feature and not a bug, because the regulators know you can’t analyze the safety of your deposited assets.

In most things, I am a libertarian, but in areas where average people can’t ascertain truth or or falsehood, I support some form of regulation.  Financial promises fall under that rubric, because they are hard to discern.

To close this off, my main point is this: people want financial intermediation, particularly during the bear phases of the financial cycle.  They want to be protected, and transact, and save.  It is reasonable that the government regulates this, because the ability to make future promises that people rely on is valuable to society as a whole.

Risk premiums should never be capitalized, they should only be taken into income as earned.

This may end up being another odd post of mine.  I’m going to start writing about bank regulation, but I will end up talking about monetary policy.

There are many people who hate the rating agencies. They hate them because they are a convenient target, and most people don’t understand what they do. Rating agencies provide opinions. Nothing more, nothing less.

Many people would like to get rid of the rating agencies. But it’s not that easy. Regulators outsource their credit rating function to the rating agencies because they don’t want to do that work.

There is a way to eliminate the rating agencies, and I have written about that before. But the idea is so radical, that the banks would rather have the rating agencies exist, than use my idea.

So what’s my idea? Simple. If you were setting up a portfolio, what would you assume would be the minimum that you could earn on the portfolio? My minimum would be buying Treasury bonds and earning interest on them.

So if I am looking at a portfolio of risky assets, I would split each asset into two. I would mirror the cash flow pattern of each asset, and construct an equivalent Treasury portfolio to mimic the cash flows. All of the cash flows above that amount from the risky asset are the risky cash flows. The amount of capital that banks hold as reserve against losses should be proportionate to the present value of risky cash flows.

Unlike my last piece on this, I am not saying that the whole present value of risky cash flows should be held as capital against losses. But the regulators should use this, if we are not using rating agencies, as a proxy for credit risk in bank asset portfolios.

Why is this a good measure of credit risk inside banks? The market for lending is fairly efficient. Debts that have more risk have higher interest rates.

This measure of risk benefits from the concept of simplicity. It can be applied everywhere. And, there is good theoretical justification for it. Any return that is upon the government bonds is subject to question.

But suppose we decided to use this as a major portion of our formula for regulating bank capital. What would happen to monetary policy?

Well, if the Fed tries to do something similar to “operation twist” it would require banks to hold more capital against their positions, because the safe interest rate falls, it causes the risky portion of each loan to rise. As such, any sort of “operation twist” would fail, because the rise in capital levels, would blunt any advantage from over Treasury interest rates.

From my vantage point, it would be a real plus to have monetary policy neutered in that way. The Fed, should it deserve to exist, should be concerned with the banking system and its solvency. It should not be concerned with the overall level of interest rates. If lowering interest rates lowers the judgment of solvency, then that would restrain the Fed from being too aggressive in lowering rates. And that would be good. The Fed has generally not succeeded with monetary policy. They have been too loose in the past, leading to the problems of the present.

And, as I have said before, we should not have unelected bureaucrats driving our economy, rather, we should have Congress do it because we can vote them out.

That’s all for now. Thanks for reading me. I appreciate all of my readers.

The world is a maze of debt.  Debts layered on debts.

The Earth and its productivity is roughly the same or better than prior years.  What is the problem with the economy then?

The problem is this: there are entities that made bad loans in the past that expect to be paid back in full.  They assumed the future would be far better than it turned out to be.  There is no way that the loans will be paid back in full.  The solution is paying back at a discount, whether through compromise or insolvency.

Wait. Many of the lenders are leveraged as well, and can’t take significant losses.  Paying back at a discount will bankrupt a number of banks, which will in turn bollix the economy.

So, we have to go slow?  Does this bring us back to the problem of how one eats an elephant?  “One bite at a time.”  That is the method of Japan, leaving an over-indebted government, and reasonably indebted private sector.  But it took two decades.

Whether it is in the Euro-zone, China, or America, it would be better to let entities fail, and deal with the mess.  Yes, GDP will drop a lot, but it will rocket out of the troubles 2-3 years out, the way that Eastern Europe did post-Warsaw Pact.

Ending  the economic malaise means ending the debt overhang.  Where is the government, or set of governments willing to attack this and reduce debts economy-wide?  I know it is a tough prescription, but economies don’t work well when they are overindebted.

I tried to think of a post where I would bring out the best of 2011 economically, but the best I could some up with was, “It could have been worse.” That doesn’t convey much fondness.

2011 was characterized by using debt to “solve” debt problems.  Avoid default, extend the loan.  Or, let a public entity refinance the loan.

2011 was a year of rebellion — more pointedly in the Arab world, late to Russia and China, and lazy in the US.  Lefter then most leftists, like Marx, they assume that a wimpy “protest” will produce change.  Sorry, you have to organize, produce leaders, and either influence existing parties or create a new one, or, fight (of which I am not in favor).  If “Occupy” can’t do that, it ain’t worth a warm bucket of spit.

And personally, I am disappointed in those that have come out in favor of Occupy, not because their many contradictory causes don’t have merit, but because Occupy is so singularly ineffectual.  “You say you want a revolution, weelll you know, we all would like to change the world.”  Talk is cheap.  Disorganized talk and effort is pollution, not cheap; we would pay to have it eliminated.  Either organize, or be gone.

As far as the stock market went, it was volatile, but went nowhere.  As for me, I had my worst relative performance calendar year in 12+ years being down 1% while the S&P 500 was up 2%, with dividends.

The US politics of 2011 was nothing abnormal — we have had other periods of delay and intransigence, but few where we ran such huge deficits, and for so little good.  (Congress has not declared war, after all.)  Personally, I am for Ron Paul, not because I like everything that he stands for, but because his delegates have the best odd of deadlocking the Republican Convention, and leading to the selection of another candidate far better than the midgets currently out there.  Personally, I think primaries are overrated, and think we might be better off with conventions where parties analyze/fight over who would be the best candidate.

Never have we had a world so indebted, where there are so many fixed claims asking to be paid out at par.  The future has ugly surprises awaiting creditors — you won’t get repaid in full, whether by inflation or compromise.  Overages of debt clamor to become equity, and only such a change will heal the global economy.

If you are a lender, analyze your portfolio and adjust it where you can to the strongest borrowers.

But goodybye 2011, it was not a good year for me, and for many.  May 2012 be far better, and may we see orthodox policies triumph, even if prosperity lags.

PS — and eliminate or curb the Fed, please.   If there is dirty work to be done, let Congress do it so we can vote them out.  Would that Ron Paul is our next President with a a compliant Congress that will rip out and eliminate our third failed central bank.  We would have some hard times for a number of years, but once they end, the growth would be strong.

There is little to no fanfare for the release of this report, (why do they release at such a distracted time of year, where people will ignore it?) which strips away a lot of the malarkey that the US Government delivers by providing data on an accrual basis, rather than on a cash basis, which is what the politicians argue about.  As a result, the politicians take actions that hurt the future in order to benefit the present.  If we viewed the national budget the way this report does, we would have had very different policies over the last 25 years.

As it is the report gives credit to Obamacare for lowering the costs of Medicare, as if a stroke of the law could reduce the medical needs of the elderly.  If it does decrease actual demands on Medicare, unlikely but good.  If not, we need to revise estimates up, as the alternative scenario on page 134 does. (PDF pg 156)  And perhaps more than that.

Here are the figures for the last three years:

The big shift was the passage of Obamacare, which was funded by a large cut to Medicare Parts A & B.  It’s not as if that law repealed the health care needs of the elderly, but only the rates at which doctors would be paid.  If the ultimate amounts to be paid by the government don’t shift, because we adjust the law & payments to meet undiminished need later, the 2011 Adjusted figures would be low by around $5 trillion.

The 2010 Adjusted figures attempt to strip out the distortions created by Obamacare.  The 2011 figures leave in the adjments from Obamacare, but reflect the Illustrative Alternative Scenario on page 133:

The Medicare Board of Trustees, in their annual report to Congress, references an alternative scenario to
illustrate the potential understatement of costs under current law. This alternative scenario assumes that the
productivity adjustments are gradually phased out over the 16 years starting in 2020 and that the physician fee
reductions are overridden. These examples were developed by management for illustrative purposes only; the
calculations have not been audited; and the examples do not attempt to portray likely or recommended future
outcomes. Thus, the illustrations are useful only as general indicators of the substantial impacts that could result from future legislation affecting the productivity adjustments and physician payments under Medicare and of the broad range of uncertainty associated with such impacts. The table below contains a comparison of the Medicare 75-year present values of income and expenditures under current law with those under the alternative scenario illustration.

Another factor in holding down the 2011 deficit was that measured inflation was low, there were no cost of living adjustments [COLAs], when assumptions expected 2.5% or so.  To the extent that COLAs remain low in future years, there will be further positive adjustments.

In closing, here are two graphs that display the net liabilities  of the US Government and the ratio of that to GDP:

next graph

To pay down liabilities like these would require the permanent allocation of an additional 8% of GDP.  Where would we find the will to do that?  I suspect as a result that we will see real decreases in Medicare benefits — things that won’t be eligible for payment.  Hospice care will be indicated at higher frequency when healing an old person would be costly.

So just be aware that something has to change, either taxes have to rise, or Medicare benefit levels have to fall.

I appreciate constructive criticism.  I particularly appreciate comments at this blog, regarding my long article on how return on equity changed during the financial crisis.

The reviewer said,

In a world in which I didn’t have only 20 minutes to read, analyze and write about this paper, I’d like to think through his model choices. I would feel much more comfortable on this point if he accepted the Russ Roberts Science challenge and have a section discussing the process by which he arrived at the process by which he arrived at his conclusions.

Look, I have a policy.  I don’t do specification searches.  If I don’t get reasonable results in the first two tries, I abandon the project.  As it was in this case, I only did one pass through the data.  I was testing for the idea that state or national governmental policy might affect book or market value returns, after adjusting for market sector.

He later commented,

I’d have two comments:

1. What’s the point of decomposing them, then?

2. Can’t you just attribute ALL variance of corporates to ‘historical accident’? Can there be no policy implications?

On point #2, I’d defend Merkel by saying that policy implications need a big enough sample that you can reasonably hold other factors constant. You’d need a dataset of every industry in every state over every conceivable macro-economic environment, then control for those other factors. Same applies for analyzing different countries.

The point of decomposing them is that you don’t know in advance what the result will be.  I only did one pass at the data (please ask academic economists what they do), in this case, it showed that after adjusting for sectors and general economics (time), the states one was in did not matter much, as those that did well did not move to seek lower tax environs.

The piece I did last year did not attribute everything to historical accident.  This year, I was surprised to find that few successful companies had not moved to lower tax/regulation jurisdictions.

I did not know what the decomposition would lead to — that was a major reason for doing it.  If there had been some indication that companies in the US sought lower tax or regulation states, I would have published that, but it was not so, in aggregate.  I does not matter that the result was ordinary.  Once I start the problem, if I come to any understandable result, consensus or non-consensus, I publish it.

Now in truth, I don’t think the paper was one of my best efforts.  I would like to have set error bounds, but I didn’t have access to good software.  I also would have liked to use a better database, like the CRSP database, but that was not available.  Given my lack of resources, it was the best I could do.  Anyway, anyone with more constructive criticisms, I welcome them.

When there is financial failure, it comes as a result of illiquidity.  Now, truly, these parties are insolvent, because they took the risk of not being able to pay cash when it was due.  Illiquidity and insolvency are really the same thing, though many obfuscate.

If you can’t pay cash, it doesn’t matter what your assets are worth in “normal” times.  Banks should have planned in advance to make sure liquidity was always adequate, rather than doing the usual borrow short, lend long, that they usually do.

But after reading through the Fed ‘s proposal on bank solvency, I conclude that they may not get the picture.  They spend time on liquidity and other issues.  With liquidity, it is uncertain how they will view repo markets.  To me, those should be view as short-term finance of long dated assets.

During times of crisis, repo markets seize up, with rising repo haircuts.  Maybe I’ve read the Fed’s proposal wrong, but it seems that it neglects repo funding, which had a large effect on the recent crisis.

If banks had to be able to size their activity to survive a rise in repo haircuts equal to half of the highest that we have seen, it would probably be enough to make the issue go away, because the haircuts would be less likely to rise as a result of that restraint.

Now, I appreciate the perspective of this article from Dealbreaker on the topic.  All of the assets of the bank support all of the liabilities. In one sense, there are no assets that are tagged “equity” and others tagged “liability.”

P&C Insurance works a little different.  In that, premium reserves are invested in high quality short-term debt.  Claim reserves are invested in high quality debt similar to the period that claims are expected to be paid out over.  The remainder (the equity) can be invested in risk assets in order to earn a decent return for shareholders.  The idea is this: match liabilities with high quality assets of the same length, and take risk with the remainder of assets, realizing that they might might needed for liquidity in the worst case scenarios.

But really, banks should not be viewed differently.  They should invest like P&C or life insurers.  Invest in high quality assets equal to the terms of their liabilities — deposits (estimate stickiness), savings accounts (same), CDs (the term is known).  After that, take risks with the remaining assets in ways that reflect their comparative advantage, realizing that they might might needed for liquidity in the worst case scenarios.  Illiquid investments (e.g. private equity)  should not be allowed for a majority of of those investments.

If banks don’t engage in asset/liability mismatches aka maturity transformation, most of the risks of bank runs will go away.  And that is what I propose.  Note that if that happens, average people will have to pay some fee each year to have a checking account.  Banks would be liquidity utilities.

This fits under my rubric that the insurance industry is much better regulated than the banking industry.  Were it in my power to do so, I would turn banking regulation over to the states, and leave to the Fed control of monetary policy only.  You would soon see intolerant banking regulation, much like we see in insurance, and defaults would decline.

What could be better?