Category: Public Policy

The Trill is Gone

The Trill is Gone

Posted on by David Merkel

This should be my last post on Trills.? Let me begin it by suggesting that we sell all of our national parks (and other land owned by the US Government) to the Saudis in exchange for forgiveness of our debts.? Wait, we could do better.? Disney could create theme parks, even on the national mall, making being American far more fun than the stuffy Smithsonian.

What’s that you say?? We are selling our patrimony?? How dare we sell our precious resources to exploiters/foreigners?? Uh, times are tough, and much as we make paper promises, eventually something hard and enduring has to back them up.

I feel the same way about Trills.? If the US Government ever were to sell trills, it would be the same as selling away a share in the take from the IRS in perpetuity.? Selling shares in the IRS, ridiculous, right?? Well, that is what a trill is — selling a share of the IRS.

Imagine that the US Government taxes at 20% of GDP, and then they sell Trills equal to 1% of GDP.? Initially, the US? Government would get a flood of cash, but would have given up 5% of their income stream.? If we had angels running our government, focusing on long-term projects, I would not object so much, but we spend in the present and neglect the future.

A government that issues Trills reduces its flexibility.? Initially not so, they get a lot of cash in, and don’t have to put a lot out.? The US government at present has explicitly issued debt with a market value around 75% of GDP.?? Implicitly, the funding shortfall when you add in the excess liabilities from the entitlements is 400% of GDP.

To keep things simple, let’s assume that the initial yield of Shiller’s trill is correct (1%), not only for small amounts of issuance, but large amounts.? That is probably a bad assumption in this case, after all, the proportion of Treasury issues out past 20 years is a small minority of Treasury issuance, and even with existing demand, the yield curve is quite steep.? Trills, being perpetual bonds with a growing coupon, are longer than any fixed income instrument that I have ever seen, so if they were issued in large amounts, who knows what the initial yields would be?

(Note to potential investors: if trills ever see the light of day, they could be an interesting buy, but I would let the first few auctions pass until the curve gets satiated and the initial coupon rises to a higher level, i.e., the price falls for all trills. You might even wait for the government to announce the last trills auction to buy.? One thing about trills — every issuance will raise additional doubts about ever being paid back.? They would be more valuable when the government says it won’t create any more of them.)

So, back to the application, imagine the US government auctioning off $11 Trillion (yes, with a “Tr”, not a “B”) of trills to retire the explicit debt.? Assume that the 1% initial coupon holds — we have now walled off 0.75% of GDP as a permanent expense in the Federal budget — keeping the numbers simple, that would be 3.75% of all Federal revenues in perpetuity.? Doesn’t sound like much, but we replace the existing debt with a exponentially growing stream where debt service is initially $110 billion.? That could help balance the budget at present, but at a cost to all future generations, until the US shall be no more.

Now, the 1% initial coupon would not hold for such large issuance.? Say the coupon ends up being 2%.? Now 7.5% of Federal revenues are dedicated to debt service in perpetuity, and 1.5% of GDP.

This would become addictive to the US Government — trills raise a lot of money relative to their initial cashflows, and they have no rollover risk.? Now imagine the US issuing a present value of $70 Trillion in trills (5x current GDP) over the next 30 years to roll over existing debt, take care of all the unfunded liabilities, and cover all of the structural deficit for the next 10 years.? At my assumed coupon of 2%, that would wall off 10% of GDP in perpetuity, or half of Federal revenues to pay for the sins of the past.? The bad human proverb recorded in the Bible might return to common parlance, “The fathers have eaten sour grapes, and the children’s teeth are set on edge.”? (Note: at/near the exile of Judah, some complained they were being punished for the sins their forbears committed, and not their own sins.? God corrects the proverb, saying that people are punished for their own sins.)

Potentially, trills are a heavy burden to place on all future generations for the fiscal profligacy of the last 80 years.? I would rather not see trills see the light of day as a result.? It would postpone the eventual day of reckoning where the US Government would have to slim down dramatically, and live within its budget.? Trills would make the US government more reckless, not more cost conscious.

But, if trills are to be issued, let some more desperate entity issue them first, like Greece or California, and then let the rest of us watch the consequences.? They would provide help in the short run, at a likely cost of a bigger failure later, with more damage to creditors, and the general economy.

This should be my last piece on this, though one final thought tugs at me — the derivatives market that would grow up around trills would be a hoot.? GDP futures and options, stripping coupons to create discount trills and income trusts.? The investment bankers would have a field day, with the cheap cost of burdening all future generations, who I am sure will remember Dr. Shiller warmly.

Fourteen Comments on the Financial Economy

Fourteen Comments on the Financial Economy

Posted on by David Merkel

1) Yield-seeking — it is alive and well.? Check out this article on pay-in-kind bonds.? With PIKs, one can be concerned with the return on the money, and the return of the money at the same time.? The history of returns on PIK bonds are such that you are usually better off putting the money under a mattress.

2) More yield-seeking — spreads on mortgage bonds over Treasuries are at a 17-year low, and as I measure it, and all-time low.? Investors have gone maniac for GSE insured mortgage bonds.

3) I am as close to neutral on PIMCO as anyone I know.? I have written articles explaining how they make money, which is different from the public pronouncements of Gross and McCulley.? The current missive of Gross impresses me as fair, recognizing the limits of the Federal Government and the Fed.? PIMCO is taking less risk, selling US and UK debt, and buying German debt.? This is conservative; they are giving up yield.

4) Bruce Krasting notes that the Social Security system paid out more in 2009 than it took in.? That event was not supposed to happen until 2016 or so.? Aside from that, he notes the negative COLA adjustment.? As for me, I look at this and say, “Whether it comes slower or faster, it will come.? Medicare and Social Security will destroy the Federal budget eventually, or will be scaled back to where those that were taxed complain about it.

5) If you want to consider a technical reason for rates being so low, consider all of the mutual fund buyers.? They have favored bonds.? This is a contrary sign for interest rates — they are headed higher.

6) Bernanke blames bank regulation so that he can absolve monetary policy.? Typical.? Blame what you control less, to absolve what you control directly.? A better and brighter economist (in my opinion), John Taylor disagrees.? He views the mid-decade low rate policies as contributing to the lending frenzy.? Don’t get me wrong.? Bank regulation was lousy, but monetary policy was lousier, helping to create the boom that now gives us the bust that normalizes things.

7) How amazing was the junk bond market?? Better, how amazing was the distressed debt market?? Oh my, though junk bonds paced equities, distressed debt did far better.? Such is the case when a turn happens; this one was forced by the US Government.

8) If you want to understand how finance reform gets blocked, read this article.? Better than most, it explains the intricacies of why the Democrats have a hard time passing the legislation that the radicals would like.

9) I am not a Buffett-lover or hater.? When I read his opposition to Kraft raising its bid, I said to myself, “Of course.? Don’t overpay.? Most deals are best avoided.”? Which is true — M&A is in general a value destroyer.

10) Personal bankruptcies are rising in the US.? It is a messy time.

11) Let the Chicago School of Economics die.? I have already argued for their demise.

12) The CMBS market is experiencing delinquencies that have not been seen before.? This is just another example of the difficulties many commercial mortgage loans are in.

13) Strip malls have high vacancy rates.

14) I appreciate Tyler Cowen’s article, suggesting that things are pretty good.? We should be glad that other places in the world did well, even if we did not do so well.

Trillusions

Trillusions

Posted on by David Merkel

My article on Dr. Shiller’s idea of Trills was warmly received in some quarters, and not in others.? Though I think Trills are a very bad idea for financing the US Government (though I think the US Government is not creative enough in its financing plans), there is one thing that I do agree with Dr. Shiller on — the price of Trills.? He says they would trade near $1400 — a 1% initial yield.? My view of a 1.06% initial yield largely agrees — the bond math is the bond math; we can argue about assumptions, but given the assumptions, there is only one answer.? Comments about risk premium miss the point.? Yes, we don’t know the future growth of the economy, but pricing assumes a growth path.? Also, these are US Treasury securities — default risk is nonexistent in dollar terms, right? 😉

Why are Trills a bad idea?? First, they seem cheap because of the low initial yield, but they aren’t cheap because the interest rate grows exponentially.? Assuming 3.4% average nominal GDP growth, the coupon doubles every 21 years, forever.? Suppose we issue a Trill in 2010, and we get a 1% coupon like Schiller suggests.? What will future coupons be?

  • 2031 — 2%
  • 2052 — 4%
  • 2073 — 8%
  • 2094 — 16%
  • 2115 — 32%
  • 2136 — 64%
  • 2157 — 128%

And so on.? Unlike ordinary bonds, the price for calling the issue grows along with the coupon, so there is no escape.? The best that can be said is that Trills would guarantee the default of the US Government if issued widely enough.

But now for the illusion of Trills.? Because they pay one one-trillionth of GDP each year, some deem them to be the equivalent of owning one one-trillionth of the US economy.? Oh no, they are far more valuable than that.

The US economy is subject to all manner of risks, risks that are higher than that of the US Government paying on its debts.? Whether thinking of all the producers in aggregate, or all of the consumers in aggregate, the average cost of capital is a lot higher than what the US Government could borrow at in perpetuity.? Rather than evaluate the Trills at the rate of the US Government at 4.4%, I think the proper rate is more like 7%, give or take a percent.? You might think 7% is too high, but there are significant risks to growth in any economy from government intervention, plague, war, famine, etc.? At 7%, the value of a trill drops from $1400 to $400.? The difference is the guarantee of payment by the US government, rather than the economy as a whole, so long as the US Government is solvent.

And, that is another significant difference.? If the US government is ever credit impaired, Trills will cease to be a share of one one-trillionth of the US economy.

I have suggested before that Dr. Shiller is more creative than the markets will allow.? Derivative instruments are facile creatures — we can dream up anything, but what derivatives the cash markets will support is another matter.? Shiller’s housing ETFs have gone away.

Trills are government bonds, should they ever be created.? They are not shares in the US economy.? That distinction is significant to the value of the securities, and the effect on the republic of the United States.

Five Comments and Notes

Five Comments and Notes

Posted on by David Merkel

1) There is a new blog that I recommend: Macroeconomic Resilience.? I have commented there recently, and I think that he understands the complexity of markets in ways that most Ph. D. economists don’t.? Here is a recent post, and my comment.

http://www.macroresilience.com/2010/01/01/moral-hazard-a-wide-definition/comment-page-1/#comment-6

One job ago, at a hedge fund that was bearish on financials, we would talk about this all the time.? Regulators could have stopped the crisis in the early 2000s had they simply enforced lending standards.? The banks would have screamed and ROEs would have gone into the single digits, but the crisis could have been prevented.

But, regulators are to a degree subject to politicians.? Politicians, in the absence of any moral compass aside from re-election, are mainly beholden to those that fund their campaigns, when the electorate is without education, or a moral compass as well.? Thus, regulations were neutered.

After that, how many businessmen would watch out for the companies they served, instead of what would maximize their pay?? There were some bankers that did so and got shown the door.? There were other banks owned privately, were conservative, and missed the crisis.? It could be done, but the management team or owners had to deliberately sacrifice the short run in favor of missing an uncertain crisis.

Chuck Prince said something to the effect of “When the music is playing, you gotta get up and dance.” to justify doing business in the face of bad credit metrics.? Well, yes, in a place where no one cares for the long-run health of the firms, or of society as a whole.

Someone has to care for the long run.? Better it be free individuals rather than the government.? But if free individuals will not do it, eventually the government will.

2) I have been a fan of Michael Pettis for many years, from his publication of his book, The Volatility Machine.? Here is a comment that I posted at his blog, which I highly recommend:

http://mpettis.com/2010/01/china-new-year-and-one-more-vote-for-gdp-adjusted-bonds/

Michael, I ordinarily agree with you on almost everything economic, but I can?t agree on the trills. I believe in asset-liability matching, even at the government level. Try to match term risk and liquidity risk to what is being funded.

I have argued that the debt structure of the US government has been getting too short, and recommended that the US Treasury lengthen its funding policies ? I even said that to the Treasury officials that I met with in November.

http://alephblog.com/2008/11/25/issuing-debt-for-as-long-as-our-republic-will-last/
http://alephblog.com/2009/11/04/my-visit-to-the-us-treasury-part-2/ (2 of 7)

But trills have exceedingly long duration ? the remind me of some structured settlements that I have had to model, but these are perpetuities ? even longer for the coupon to grow. Duration looks like it would be north of 40 ? it depends on the assumptions used.

A perpetuity growing at GDP rates saddles our posterity with debts that they cannot bear. Cheap debt up front ? really costly on the back end.

http://alephblog.com/2009/12/27/not-so-cheap-trills/

But, thanks ever so much for your blogging. I learn so much from you. Keep it up.

3)? Insurance for those dropping out of school?? Sounds really dumb:

http://blogs.wsj.com/economics/2009/12/31/would-insurance-for-college-failure-keep-more-students-enrolled/

This sounds like a product that only dumb insurers would write. Never write insurance where the insured has better knowledge and more control than the insurance company.

4) Many are crying over auction rate preferred securities.? But most of the assets that were harmed were owned by corporations, who had investment professionals that chose auction rate preferred securities because they yielded significantly more than money market funds, but with seemingly little risk, and the system worked for around 20 years.

They took above average risks, and now they expect to be bailed out?? I have read through many ARPS prospectuses.? For those that read them, the risks were clearly disclosed.? I do not have a lot of sympathy for those that did not do their job.

5) From the “bitter taste” zone, we learn that foreign investors in US debt lost the most versus investing in the debt of other developed nations in 2009.? Should that surprise us when demands for loans accelerated dramatically in 2009?? I don’t think so, and most reasonable analysts would agree.

Yield = Poison (2)

Yield = Poison (2)

Posted on by David Merkel

My first real post at the blog was Yield = Poison.? In late February 2007, prior to the blowup in the Shanghai market, I felt frustrated and wanted to simply say that every fixed income class seemed overvalued.? Short and safe seemed best.

It reminded me of a discussion that I had with a colleague two jobs ago, where in mid-2002, the theme was “yield is poison.”? I did the largest credit upgrade trade that I could in the second quarter of 2002, prior to the blowup of Worldcom.? Moved the whole portfolio up three notches in four months.? Give away yield; preserve capital for another day.

I feel much the same, but not as intensely in the present environment.? Spreads could come in further if the government keeps providing low cost liquidity to those who make money on the spread they earn on financial assets.? But most fixed income assets do not reflect likely default costs.? Perhaps the long end of the Treasury curve is worth a little allocation of assets here, if only as a deflation hedge, but if the Fed is going to start lightening up on their QE, and the Treasury will be having high issuance, I might want to stand back for a while? while supply will be high, and try to buy near the end of the quarterly refunding.

There is another sense in which I say “yield = poison,” though.? When rates for safe assets are low, retail and professional investors are both tempted to stretch for yield.?? Wall Street is more than happy to deliver on your desire for yield.? It is their top illusion, in my opinion.

Two examples from my bond trading days: the first was some local brokers asking to buy a small amount relatively highly-rated junk bonds from us.? They were offering a full dollar over the usual market price.? They called me, since I ran the office, but I handed them over to the high yield manager, who said, “Jamming retail, are we?”? [DM: placing overpriced bonds in customer accounts.]? After a lame reply which amounted to,”Look, don’t ask us about what we are doing, we’re offering you a good deal, do you want to sell your bonds or not?”? the high yield manager sold them a small amount of the bonds, and we didn’t hear from them again.

The second example was when a bulge bracket firm called me and asked me if I owned a certain very long duration bond.? I said yes, and he made me an offer several dollars above what I thought they were worth.? With a bid that desperate, I said I could offer a few there, and more a little back, but for the block he would have to pay more still.? He offered something close to the “more still” price, and I sold the block to him there.

As we were settling the trade, I asked him, “Why the great bid?”? He said, “We need the bonds for retail trusts.? They get an above average yield, but if rates fall, after five years, we buy them out at par, and keep the bonds.? If rates rise, they take the loss.”

Even on Wall Street, if you have a good relationship, you get an honest answer.? That said, it made me sorry that I sold the bonds, even though it was the best thing for my client.

There are many ways to frame the yield question at present, here are two:

  • You are on a fixed income, and you are having a hard time making ends meet.? Should you lend longer to earn more, go for lower rated credits, or do nothing?
  • You are earning almost nothing on your money market fund.? You need liquidity, but where else could you invest it?

I would be inclined to buy a mix of foreign-denominated bonds, but most people can’t deal with that.? So, I would advise them to build a “bond ladder” where they have high quality issues maturing every year for the next 10 years.? As each bond matures, I would use the proceeds to buy bonds ten years out, re-establishing the 10-year ladder.

But don’t reach for yield.? Odds are, you will get capital losses great than the excess yield you hoped to receive.? And remember this, don’t buy products someone else wants to sell you.? Specifically, don’t buy high yielding investment products that Wall Street sells to enhance your income.? They prey upon those who want more money, and are weak in their knowledge of how the markets work.

To professionals: don’t reach for yield now; long-run, you are not getting paid for the risks.? You have seen how illiquid structured products can be in the face of credit uncertainty, and impaired balance sheets of holders and likely purchasers.? You have seen how spreads can blow out (bond prices fall), and roar back in (prices rise again) in the absence of safe places to invest money.

I’ll give the Treasury and the Fed this: they have created an environment where savers are punished, and have to take significant risks to get yield.? They have created a situation where the markets are dependent on subsidized credit, and speculation dominates over lending to the real economy.? They are pushing us deeper into a liquidity trap, as low-to-negative return investments in autos, homes, and banks get supported by cheap public credit, rather than getting reconciled in bankruptcy, so that capital can be redeployed to higher returning projects.

Anyway, enough for now — more later.

Happy New Year

Happy New Year

Posted on by David Merkel

Happy New Year.? I would like to begin by thanking my readers for supporting me in 2009.? Let us hope and pray that 2010 will be even better.

That said, the investment grade corporate bond market, the junk bond market, and the bank loan markets can’t have a better year in 2010.? Rates would have to go below Treasuries, perhaps even to zero.? Also, it will be tough, but not impossible for stocks to manage a gain better than 26.5% gain in 2010.? But it would require stellar corporate earnings amid continued low financing rates, with no significant continuation of corporate defaults at a high level.

I don’t hold this view with a ton of confidence, but today’s selloff was supposedly due to the Fed deciding to consider selling some of the bonds that they have bought over the last six months or so.? I’ve said before a number of times that it is a lot easier to begin an easing program than end one.

The quantitative easing was a way of buying bonds expensively, which would hold down rates in the process.? The bond market ran in front of the Fed, pushing up bond prices, figuring (correctly) that the Fed was a forced buyer.? As the end of the process drew near, bond investors sold as the Fed began buying their remaining bonds.? Now the Fed thinks of selling.? Well, even with the yield curve near record levels of steepness, it could get steeper (though probably not by much, I get the weird feeling that something will break, but I don’t know what).? Once it becomes evident that the Fed has shifted from buy to sell mode, some bond investors will start shorting the market.? Given the record financing schedule that the Treasury will be doing, there will be a lot of supply hitting the market.? The yield curve steepness anticipates much of this, but there will be a very negative tone if the Fed and Treasury are selling bonds at the same time.

This makes the recent actions with Fannie & Freddie more understandable.? Fannie and Freddie can take losses on mortgages, and the losses get passed on to the US Government, eventually.? Losses on bad housing debt gets turned into additional government debt.? (Wonderful, not.) The US Government can use Fannie and Freddie to try to reflate the housing market, at least the lower end of it.

The trouble with all of this is that we are bailing out less productive assets, and taxing more productive assets to do so.? We don’t need more housing, banks, or autos.? We have too much capacity in those areas.? Bailing them out is a recipe for stagnation, a la Japan.? Handing over investment decisions to the government is an utter and total waste of resources.? The role of government in the economy should be to punish theft and fraud, and prevent them where they can.? Assuring prosperity is not possible, so don’t try to promise it, much less attempt it.

I think the Treasury and Fed are trapped.? They will have a really hard time removing the stimulus, because they don’t want to raise interest rates.? Banks have become more reliant on low rates since quantitative easing started.

Then there is China.? Because they own so much of our debt, they are the prisoner of the US.? If the US were to default, their financial system would likely fail.? China is running a bubble policy of its own, and real estate prices are rising, though the ability to service debt is rising more slowly.? As with the Fed, forcing rates down can work for a while.? But only for a while.? Some of that bubble extends to the US, sucking in our debt to keep their currency cheap.? Dumb as a rock, but hey, we get cheap goods, and they get expensive debt.

There is an endgame here, but I do not know the what or the when.? The US Government could default only on external debt.? Hey, if Argentina can do it, so can we, and don’t think that the US Treasury isn’t drawing up contingency plans for that even now.? What could be more a more fitting end to being the world’s reserve currency than to default in the end, but protect their own citizens, and send a large portion of the global banking system into insolvency, aside from that in the US?? Truly perverse, after the way the US has gamed the system so far.? Who knows, after such a crisis, the new US Dollar might seem to be the best possible global reserve currency, but I doubt that would happen when wounds are fresh.

Anyway, here is to a great 2010.? May all of your debtors pay you full value.

Nine Notes and Comments

Nine Notes and Comments

Posted on by David Merkel

As I roll through the day, i often make comments on the blogs and websites of others.? I suppose I could gang them up, and post them here only.? I don’t do that.? Other sites deserve good comments.? Today, though, I reprint them here, with a little more commentary.

1) First, I want to thank a commenter at my own blog, Ryan, who brought this article to my attention.? I’ve written about all of the issues he has, but he has integrated them better.? It is a long read at 74 pages, but in my opinion, if you have 90 minutes to burn, worth it.? I will be commenting on the ideas of this article in the future.

2) My commentary on Dr. Shiller’s idea on Trills drew positive attention, but the best part was being quoted at The Economist’s blog.

3) Tom Petruno at the LA Times Money & Company blog is underappreciated.? He writes well.? But when he wrote Fannie and Freddie shares soar, but for no good reason.? I wrote the following:

From my comments to my report on financials yesterday ?Federal Home Loan Mortgage Corp [FRE] and Federal National Mortgage Assn [FNM] Rise as U.S. Removes Caps on Assistance ? this gives the GSE stocks more time, and hence optionality. I still think they will be zeroes in the end, but there will be a lot of kicking and screaming to get there. The government is engaged in a failing strategy to reflate the housing bubble, and they aren?t dead yet.

I write a daily piece on financials for my company’s clients.? The stock of the GSEs rose because the odds of them digging out of the hole increased.? You can’t dig out of the hole if you are dead, so when you are near that boundary, even small changes in the distance from death can affect sensitive variables lke the stock price.? Plus, the odds rise that the US will do something really dumb, like convert theor preferred shares to common.

4) Kid Dynamite put up a good post on CDOs, I commented:

KD, maybe we should play chess sometime. Spotting a queen and rook is huge. I have beaten Experts, though not Masters on occasion (except in multiple exhibitions), and I can’t imagine losing to anyone who has spotted me a rook and queen.

All that said, I never gamble, and as an actuary, I know the odds of most games that I play.

Now, all of that said, I never cease to be amazed at all of the dross I receive in terms of ideas that look good initially, but are lousy after one digs deep.

Good post. Makes me wonder how I would have done in the same interview. Quants need to have a greater consideration of qualitative data. When I was younger, I didn’t get that.

5) Then again, Yves Smith comments on a similar issue at her blog.? My comment:

I?m sorry, but I think jck is right. The risk factors were clearly disclosed. Buyers should have known that they were taking the opposite side of the trade from Goldman.

As I sometimes say to my kids, ?You can win often if you get to choose your competition,? and, ?Winning in investing comes from avoiding mistakes, not making amazing wins.?

As a bond manager, I was offered all manner of amazing derivative instruments. I turned most of them down. Most people/managers don?t read the prospectus, but only the term sheet. Not reading the prospectus is not doing due diligence.

Since we are on the topic of Goldman Sachs, in 1994, an actuary from Goldman came to meet me at the mutual life insurer where I worked. I wanted to write floating rate GICs which were in hot demand, and all of my methods for doing it were too risky for me and the firm.

Goldman offered a derivative instrument that would allow me to not take too risky of an investment strategy, and credit an acceptable rate on the GIC. So, as I read through the terms at our meeting, a thought occurred to me, and so I asked, ?What happens to this if the yield curve inverts??

He answered forthrightly, ?It blows up. That?s the worst environment for these instruments.? Now, if you read the docs, it was there, and when asked, he told the truth. The information was not up front and volunteered orally.

But that?s true of almost all financial disclosures. You have to read the fine print.

As for the derivative instruments, in early 2005, many large financial institutions took billion dollar writedowns. All of my potential competitors in the floating rate GIC market left the market. I went back to buyers, and offered the idea that I could sell them the GICs at a lower spread, which would give them a decent return, but with adequate safety for my firm. All refused. They basically said that they would wait for the day when the willingness to take risk would return.

And it did, until the next blowup in 1998 around LTCM.

My lesson: the craze for yield drives many derivative trades. What cannot be achieved with normal leverage and credit risk gets attempted, and blows up during hard times.

Structure risks are significant; the give up in liquidity is significant. The big guys who play in these waters traded away liquidity too cheaply, and now they are paying for it.

=-=-=-=-=–=-==-=-Whoops, where I said 2005, I meant 1995. That loss I avoided for the firm was one of my best moves there, but we don?t get rewarded for avoiding losses.


6) Then we have CFO.com.? The editor there said they want to publish my comment in their next magazine.? Nice!? Here is the article.? Here is my comment:


Time Horizon is Critical
Yes, Wheeler did a good job, as did MetLife, including their bright Chief Investment Officer.

What I would like to add is the the insurance industry generally did a good job regarding the financial crisis, excluding AIG, the financial guarantors, and the mortgage insurers.

Why did the insurance industry do well? 1) They avoided complex investments with embedded credit leverage. They did not trust the concept that a securitized or guaranteed AAA was the same as a native AAA. Even a native AAA like GE Capital many insurers knew to avoid, because the materially higher spread indicated high risk.

2) They focused on the long term. The housing bubble was easy to see with long-term perception — where one does stress tests, and looks at the long term likelihood of loss, rather than risk measures that derive from short-term price changes. Actuarial risk analysis beats financial risk analysis in the long run.

3) The state insurance regulators did a better job than the Federal banking regulators — the state regulators did not get captured by those that they regulated, and were more natively risk averse, which is the way regulators should be.

4) Having long term funding, rather than short term funding is critical to surviving crises. The banks were only prepared to maximize ROE during fair weather.

I know of some banks that prepared for the crisis, but they were an extreme minority, and regarded by their peers as curmudgeonly. I write this to give credit to the insurance industry that I used to for, and still analyze. By and large, you all did a good job maneuvering through the crisis so far. Keep it up.

7) Then we have Evan Newmark, who is a real piece of work, and I mean that mostly positively.? His article😕 My comment:

Good job, Evan. I don?t do predictions, except at extremes, but what you have written seems likely to happen ? at least it fits with the recent past.

But S&P 1300? 15% up? Wow, hope it is not all due to inflation. 😉

8 ) Felix Salmon.? Bright guy.? Prolific.? His article on residential mortgage servicers.? My response:

Hi Felix, here?s my two cents:

I think the servicers are incompetent, not evil, though some of the actions of their employees are evil. Why?

RMBS servicing was designed to fail in an environment like this. They were paid a low percentage on the assets, adequate to service payments, but not payments and defaults above a 0.10% threshold.

Contrast CMBS servicing, in which the servicer kicks dud loans over to the special servicer who gets a much higher charge (over 1%/yr) on the loans that he works out. He can be directed by the junior certificateholder (usually one of the originators) on whether to modify or foreclose, but generally, these parties are expert at workouts, and tend to conserve value. The higher cost of this arrangement comes out of the interest paid to the junior certificateholder. Pretty equitable.

Here?s my easy solution to the RMBS problem, then. Mimic the CMBS structure for special servicing. An RMBS special servicer would have to be paid a higher percentage on assets than a CMBS special servicer, because he would deal with a lot of small loans. The pain of an arrangement like this would get delivered where it deserves to go: to those who took too much risk, and bought the riskiest currently surviving portions of the RMBS deal.

The underfunded RMBS servicers may be doing the best they can. They certainly aren?t making a bundle off this. As a former mortgage bond manager, I always found the RMBS structures to be weaker than the CMBS structures, and wondered what would happen if a crisis ever hit. Now we know.

9) But then Felix again through the back door of Bronte Capital.? My comments:

I don?t short. Short selling is socially productive though. Here is how:

1) Sniffs out bad management teams.

2) Sniffs out bad accounting.

3) Adds liquidity.

4) Defrays the costs of the margin account for retail investors. Institutional longs get a rebate. Securities lending programs provide real money to long term investors, with additional fun because when you want to sell, you can move the securities to the cash account if the borrow is tight, have a short squeeze, and sell even higher.

5) Provides useful data for longs who don?t short. (High short interest ratio is a yellow flag in the long run, leaving aside short squeeze games.)

6) Allows for paired trades.

7) Useful in deal arbitrage for those who want to take and eliminate risk.

8) Other market neutral trading is enabled.

9) Lowers implied volatility on put options. (and call options)

10) And more, see:

http://alephblog.com/2008/09/19/governme nt-policy-created-too-hastily/Short selling is a good thing, and useful to society, as long as a hard locate is enforced.

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That is what my commentary elsewhere is like.? I haven’t published it here in the past, and am not likely to do it in the future, but I write a lot.? Amid the chaos and economic destruction of the present, the actions are certainly amazing, but consistent with the greed that is ordinary to man.

One Dozen or so Books on Economics

One Dozen or so Books on Economics

Posted on by David Merkel

One reader asked me:? David do you have a Top 10 book list on Economic Theory for beginners? Just finished “The Myth of the Rational Market” and loved it. But I don’t know what to read next. Or let me ask the question another way, should I start with reading books on Austrian economics? Hayek? Misses? Fisher?

I do want to give a list of economics books that I have read that I have found useful.? I am an odd duck here, because I have been schooled in the neoclassical theories, and I have largely rejected them.? Men, and the institutions of men are more complex than that.

Here’s my dirty secret.? Yes, read the Austrian economists, but I have not read any of them.? I have come to their conclusions on my own, but my views have also been influenced by Minsky and the Santa Fe Institute.? I view economics as ecology.

All that said, here is a list of economics books that I think are valuable, that I have read:

1) Manias, Panics and Crashes, by Kindleberger. Kindleberger explains how crises come into existence in a systematic way.

2) Devil Take the Hindmost, by Chancellor.? Chancellor describes the history of crises, and gives significant background data regarding economic crises.

3) The Alchemy of Finance, by Soros.? Explains why men are not rational as the neoclassical economists think.? Explains nonlinear dynamics — reflexivity, as he calls it.

4) A History of Interest Rates, by Homer. ? Detailed studies of how interest has played a role in our world again and again, even as idealists attempt to limit or eliminate it.

5) The Volatility Machine, by Pettis.? Explains how smaller nations get whipped around by the economics of larger nations.? The author is an important read in my opinion at his blog.

6) The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else, by de Soto.? Puts forth the idea that laws protecting property rights help create wealth.

7) Against the Dead Hand: The Uncertain Struggle for Global Capitalism, by Lindsey. Promotes global trade as a means of increasing wealth.? On the same topic, How Nations Grow Rich: The Case for Free Trade, by Krauss.

8 ) The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor — Puts forth why culture matters.? Some cultures by nature will be poor and others rich.

9) The House of Rothschild: Volume 1: Money’s Prophets: 1798-1848 and The House of Rothschild: Volume 2: The World’s Banker: 1849-1999, by Ferguson.? Records tumultous years, and how some of the most clever capitalists ever known survived it.? Also notes that they never expanded to America when it would have counted.

10) The Birth of Plenty : How the Prosperity of the Modern World was Created, by Bernstein. Explains how the Western world grew into the present lack of scarcity that it now has.

11) The Elusive Quest for Growth: Economists’ Adventures and Misadventures in the Tropics, by Easterly. Development economics is at its best when there are few subsidies — economics in the developing world is the same as it is here, only more so.

12) The Nature of Economies, by Jacobs.? In story form, she explains the nonlinearities of economics.

My view is that governments should provide a few basic simple rules regarding the economy, and let the courts fill in the details.? Economies grow best when they are free, and where the culture concludes that growth is valuable.? That is not true everywhere.

Full disclosure: all of the books that I mention here I own, and I bought with my own money.? If you enter Amazon through my site and buy anything, I get a small commission, but your prices are he same regardless.

Update: These are books on macroeconomics.? I may have a similar post on microeconomics coming.? Also, I forgot one book that I recently reviewed: This Time is Different, by Reinhart and Rogoff.? They cover why crises happen, but unlike Manias, Panics, and Crashes or Devil Take the Hindmost, they quantify it.

Not so Cheap Trills

Not so Cheap Trills

Posted on by David Merkel

What would you pay for a bond that offered to pay you $1/year, but would increase its payment by 3.4% each year?? Assume that bonds that offer no increase in payment, but offer $1/year currently yield 4.4%, for a price of $22.73.? Assuming there is no doubt about the creditworthiness of the issuer, one should be willing to pay $94.48 for the bond increasing its payment at 3.4% per year, accepting an initial current yield of 1.06%.

That is part of the idea behind bonds that Dr. Schiller is proposing.? These bonds called trills would:

  • Pay one trillionth of GDP as interest each year.
  • Would be full faith and credit bonds of the US Government.
  • Would be consols — perpetual bonds that never pay the principal back.

The key here is how fast GDP grows in nominal terms.? TIPS increase at the rate of the CPI-U.? If there is growth over the inflation rate, a trill would? be more valuable than TIPS, and at equivalent interest rates, people would pay more for trills.

My interest rate models indicate that if the US were to issue a consol, a perpetual bond, it would have a yield near 4.4%.? Here’s the question: what do you think nominal GDP growth will be on average? forever?? If it is above 4.4%, one should be willing to pay an infinite amount to buy it.? At lower rates of nominal GDP growth, the security will have a finite value that declines rapidly with lower nominal GDP growth.

Trills would be volatile securities.? The prices would fall hard during periods where long term interest rates are rising, but where GDP is not expected to be growing as rapidly.? Conversely, they would rise rapidly when long term interest rates are falling, but where GDP is not expected to be shrinking as rapidly.

I would not want the US Government to issue trills.? Why?? They suck a lot of money in, and do not consider what it will do to the government in future years.? I can say with confidence that a large issuance of trills would lead to the demise of the US Government.? There is no way that the government could keep up with the payments, because most finance today relies on the idea that the economy can grow out of the debt burden.? With trills, that is not possible.

Trills sound like a nifty idea, an to indebted governments, they offer very cheap finance in the short run, but the eventual end is the insolvency of the government that cant keep up with the increase in interest payments.

Governments want to keep the option of inflating away their debts if they can.? Don’t tell governments in the EU about this though.? They sold that option too cheaply.

In summary, trills are a bad idea.? They are just another way for the government to suck in a lot of money in the short run, while paying out far more forever.

My TIPS, Treasuries, and Inflation Model

My TIPS, Treasuries, and Inflation Model

Posted on by David Merkel

I finished the first phase of a project today.? But first let me tell you a story.? It was 1990, and the Society of Actuaries Investment Section was holding a conference.? It was a great conference; I still have the binder from it.? There are few meetings from twenty years ago that still have relevance for me.

One of the presentations was by Stanley Diller, a managing director of Bear Stearns, who insulted all of the actuaries at the conference by telling them the the insurance industry was dead wrong for talking about yields and spreads.? Everything was duration and convexity, and those that did not understand that would lose.

He ended his presentation suddenly, did not take questions, and stormed out of the room.? I’m not sure why, but I had a seat in the back, and intercepted him.? I said, “You can’t just say this and not give any justification for your views, how do you back it up?”? He thrust a business card into my hand and said, “Call my secretary, she will send you the info.”? He stormed away.

The next day I called the secretary, and she told me she would send the information.? Two days later, I had it, and a few days later, I had replicated it in my own model.

Since then, I have used the model profitably many times.? Today I use it to describe the yields in Treasury Notes and TIPS.? I have used it to produce an estimate of future inflation expectations.

Using closing prices, here is my estimate of the coupon-paying yield curve:

And here is the spot curve (estimating where zero coupon bonds would price):

And finally, the forward curve, which estimates the expectations of future short-term rates, inflation, and real rates:

Pretty neat, huh?? Let me tell you a little about the model:

  • Values are as of the close 12/22/2009, but the model can be run in real time.
  • It is estimated from the full coupon-paying Treasury Note and Bond markets — over 200 bonds in the model.
  • The model estimates a nominal spot curve, fitting prices with 4 parameters, over 99% R-Squared.
  • The model estimates a forward inflation curve, fitting TIPS prices with 4 parameters, over 99% R-Squared.
  • The two models are estimated jointly, through nonlinear optimization.
  • The model has one constraint — nominal spot yields must be positive after 4 months.
  • Every other curve is derived from those two curves.

What are the useful things that we learn from the model?

  • There are mispricings in the Treasury and TIPS curves, but they are typically small, and would be hard to make money off of.? That’s? demonstrated by the high R-Squareds.
  • The Fed has achieved its goal of making real rates negative in the short term.
  • And, has made made nominal rates negative for some very short instruments inside 6 months of maturity.
  • Inflation expectations start low, and peak around 2022, then tail off.
  • Long term inflation expectations are still under 3.5% — ignore the portion of the inflation and real curves after 23 years, they are extrapolations.
  • Implied short-term real yields go positive in 2011, peak in 2024 and tail off thereafter.
  • The nominal forward curve is steep as a mountain on both sides.? Though there is a lot of fear over what will happen over the next 12-14 years, those fears have not been built into the prices of longer-dated Treasury securities.
  • The nominal spot curve peaks after 22 years — in my experience, that is normal, and is a reason why longer nominal note yields decline.? US Treasury — take note.
  • Inspecting the differences between coupon-paying yields on Treasuries and TIPS makes inflation expectations look more tame than they really are.? Federal Reserve — take note.
  • 30-year TIPS would likely fund cheaper than 20-year TIPS — US Treasury, take note.? The scarcity value would help as well.

This is just the beginning.? I’m not planning on writing about this every day, but I should be able give you some updates every now and then.? Hopefully the firm I work for should be able to benefit through research that this enables me to create for institutional clients.

Full disclosure: I own shares in Vanguard’s TIPS fund.? And truth, we all own Treasuries somewhere if we look deep enough. 😉

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