Category: Public Policy

Ten Unsolved Problems in the Global Economy

Ten Unsolved Problems in the Global Economy

There are many celebrating the recovery as if it were already here.? This is a brief post to outline my main remaining concerns for recovery of the global economy.

1)? China is overstimulating its economy, and forcing its banks to make bad loans.? This pushes up commodity prices, and makes it look like China is growing, but little of the investments made are truly needed by the rest of the global economy.

2)? Western European banks have lent too much to Eastern European nations in Euros.? The Eastern Europeans can’t afford it, and widespread defaults are a possibility.

3)? The average maturity of bonds held by foreign investors in US Treasuries is falling.? Runs on currencies happen when countries can no longer roll over their debts easily, which is facilitated by having a lot of debt to refinance at once.

4)? On a mark-to-market basis, market values for commercial real estate have fallen dramatically.? Neither REIT stocks nor carrying values for loans on the books of banks reflect this yet.? Many banks are insolvent at market-clearing prices for commercial real estate.

5)? We still have yet to feel the effects from pay-option ARMs resetting and recasting.? Most of the pain in residential housing is done, but on the high end, there is still more pain to come, and the pay-option ARMs will reinforce that.

6)? The rally in corporate debt and loans was too early and fast.? Conditions are not back to normal for creditworthiness.? There should be a pullback in corporate credit.

7)? We had global overbuilding is cyclical sectors 2002-2007.? We overshot the demand for large boats as an example.? We overdeveloped energy supplies (that will be short-lived), metals, and other commodities.? It will take a while to grow into the extra capacity.

8 )? The US consumer is still over-levered.? It will be a while before he can resume his profligate ways, assuming a new frugality does not overcome the US.? (Not likely by historical standards.)

9)? The Federal Reserve will have a hard time removing their nonstandard policy accommodation.

10)? We still have the pensions/retiree healthcare crisis in front of us globally.

That’s all.? To my readers, if you can think of large unsolved problems in the global economy, forward them on to me here in the comments.? If I agree, I will incorporate them in future articles.

Twenty Notes on Current Risks in the Markets

Twenty Notes on Current Risks in the Markets

1)? A modest proposal: The government announces that they will refinance all debtors.? Not only that, but they will buy out existing debt at par, and allow people and firms to finance all obligations at the same rate that the government does for whatever term is necessary to assure profitability or the ability to make all payments.? The US Treasury/Fed will become “The Bank.”? No need for the lesser institutions, The Bank will eat them up and dissolve their losses, taking over and refinancing their obligations.? Hey, if we want a single-payer plan in healthcare, why not in finance?? Being healthy is no good if you can’t make your payments. 😉

This scenario extends the US Government’s behavior to its logical absurd.? The US Government would never be large enough to achieve this, but what they can’t do on the whole, they do in part for political favorites.? They should never have bailed out anyone, because of the favoritism/unfairness of it.? Better to have a crash and rebuild on firmer ground, than to muddle through in a Japan-style malaise.? That is where we are heading at present.? (That’s the optimistic scenario.)

2)? I have exited junk bonds, and even low investment-grade corporates.? Consider what Loomis Sayles is doing with junk.? Yield = Poison, to me right now, which echoes a very early post in this blog.? There are times when every avenue in bonds is overpriced — that is not quite now, because of senior CMBS, carefully chosen.? All the same, it makes me bearish on the US Dollar, and bullish on foreign bonds.? This is a time for capital preservation.

3) High real yields are driving the sales of US Government debt.? Is that a positive or a negative?? I can’t tell, but there is always a tradeoff for indebted governments, because they can usually reduce interest expense by financing short.? When their average debt maturity gets too short, they have a crisis rolling over the debt.? We are not there yet, but we are proceeding on that road.

4)? I have a bias in favor of buyside analysts, after all I was one.? But this research makes me question my bias.? Perhaps sellside analysts are less constrained than buyside analysts?

5) Debtor-in-possession lending is diminishing, reflecting the likelihood of loss.? In some cases that may mean more insolvencies go into liquidation.? Interesting to be seeing this in the midst of a junk bond rally.

6)? Short-selling isn’t dead yet.? Would that they would take my view that a “hard locate” is needed; one can’t short unless there is a hard commitment of shares to borrow.

7) Should we let managers compete free of the constraints imposed by manager consultants?? You bet, it would demonstrate the ability to add value clearly.? I face that? problem myself, in that I limit myself to anything traded on US equity exchanges.? As such, I have beaten most US equity managers (and the indexes) over the last nine years, but no one wants to consider me because I don’t fit the paradigms of most manager consultants.

8 )? Is there a fallacy in the “fallacy of composition?”? I think so.? Yes, if everyone does the same thing same time, the system will be unstable.? But if society adopts a new baseline for saving/spending, the system will adjust after a number of years, and there will be a new normal to work from.? That new normal might be higher savings and investment, in this case, leading to a better place eventually than the old normal.

9)? Anyway, as I have said before, stability of a capitalist system is not normal.? Instability is normal, and is one of the beauties of a capitalist system, because it adjusts to conditions better than anything else.

10)? Corporate treasurers are increasingly engaged in a negative arbitrage where they borrow long and hold cash so that the company will be secure.? How will this work out?? Will this turn into buybacks when things are safe?? Or will it just be a drag on earnings, waiting for an eventual debt buyback?

11)? Does debt doom the recovery?? Maybe.? I depends on where the debt is held, and how is affects consumption spending.? Personally, I think that consumers and small businesses are under a lot of stress now, and it won’t lift easily.

12)? So things are looking better with junk bond defaults.? Perhaps it was an overestimate, or that it would not all come in 2009.? We will see.

13)? Junk bonds do well; junk stocks do better.? In a junk rally, everything flies.? All the more to hope that this isn’t a bear market rally; if so, the correction will be vicious.

14)? Eddy, pal.? Guys who criticize data-mining are near and dear to me.? Now the paper in question has a funny definition of exact.? I don’t know how to describe it, except that it seems to mean progressively more accurate.? I didn’t think the paper was serious at first, but given the relaxed meaning of “exact,” it data-mines for demographic influences on the stock market.? Hint: if you have lots of friends when you are nine, ask for stock as a birthday present.

15)? I’m increaisngly skeptical about China, and this doesn’t help.? I sense that the global recession is intesifying, amid the current positive signs in the US.

16)? Do firms with female board members do worse than companies with only male board members?? No, but they get lower valuations, according to this study.? I started a study on female CEOs in the US, and I got the same result, but it is imcomplete at present — perhaps new data will invalidate my earlier findings.? Why does this happen, if true?? Men seem to be better at managing single investments, while women are better at managing portfolios.

17)? Do we have more pain coming from the banks?? I think so.? Residential real estate problems have not reconciled, and Commercial real estate problems are just beginning.? If we mark loans to market, many large banks are insolvent, and this is not an issue that will easily be healed with time.

18)? As a nation, I like Japan, and would like to visit it someday.? What I don’t want is for the US to imitate its economic stagnation, but maybe that could be the best of all possible worlds for the US.

19)? I am de-risking my equity and bond portfolios at present.? I do not think that the present market levels fairly reflect the risks involved.? I am reducing risk in bonds, and looking for strong sustainable equity yields in equities.

20)? Echoing point 17, we face real problems on bank balance sheets from commercial real estate lending.? There is more pain to come.? The time to de-risk is now.

Living with Excluded Views

Living with Excluded Views

1)? As I’ve said before, I don’t care whether Bernanke is reappointed or not, because who will be appointed that has a materially different theory of central banking than Bernanke?? I don’t see Ron Paul getting appointed.

But to reappoint Bernanke because a bunch of economists think it is a good idea is dumb.? The neoclassical economists were blind going into this crisis, and only a few outside the mainstream saw the debt building up, and said this would not work out well.

And, if I were in Bernanke’s shoes, I would not want endorsements from economists.? Oh wait, he is one.? Alas, I am one too, though rogue. Outside of economists, are politicians the only ones who trust economists?? Yet, the politicians use the economists as a useful shield.? “We only did what the economists suggested would bring prosperity.? We cannot be blamed if the experts are dunces.”

I think Bernanke will be reappointed.? I only hope he is there long enough to see him either struggle with stagflation, or with a Japan-style malaise, or both.? As I have said since 2004 at RealMoney, “This will not work out well.”

2)? Barack Obama is a bright guy.? He may be the brightest president since… um, I’m not sure, he might be the brightest of them all.? That does not mean that I agree with his ideas, because a bright man starting from bad postulates ends up in a bad place quicker.? That said, there seems to be some restraint on his part, as noted in this WSJ article:

In early July, the president ordered a briefing on derivatives — financial contracts that track the return on stocks, bonds, currencies or other benchmarks. Critics had been raising questions about administration proposals to regulate certain derivatives, such as credit-default swaps, which many blame in part for the financial crisis. With advisers gathered round on the Oval Office’s twin sofas, Mr. Obama said he was concerned that the administration hadn’t struck the right balance.

Its proposal called for standard derivatives to be traded on an exchange, bringing them into the open. Critics were calling the proposal too timid because it also would allow “customized” derivatives to continue trading privately. “What is to assure that this won’t drive all derivatives off the exchange?” the president asked, according to Mr. Emanuel.

He says Mr. Obama was frustrated his team wasn’t offering up a full range of views on how to approach derivatives regulation. “Get me some other people’s opinions on this,” Mr. Emanuel recalls the president as saying. “I want more than what’s in this room.”

In the end, the administration tweaked its position on derivatives. In legislative language drafted this week, it is seeking to require financial firms that offer customized derivatives to maintain higher capital cushions.

And so goes the proposed legislation.? It only tweaks at the edges the existing derivative setup, and does not question the troubles that the financial markets wreak on the cash markets when they are allowed to become gambling markets, where speculators trade with speculators, and the tail begins to wag the dog.? Synthetic markets must be smaller than the real markets, if we want to have longer-term stability.? Hedgers must lead the markets, not speculators.

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That’s all for now.? I don’t have much hope in the legislation on derivatives, or who leads the Fed.? Given where the terms of debate are, the debate excludes my views.

Beyond Co-ops: National Healthcare Mutual

Beyond Co-ops: National Healthcare Mutual

I’m not a healthcare actuary; I am a life & investment actuary.? I did pass my health exam on the actuarial syllabus with a high score, but that was almost 20 years ago.? So, take what I say not as expert opinion, but as reasonably well-informed opinion (I hope).

I general, I believe the US needs to move away from insurance with respect to healthcare.? Let people pay directly for healthcare services, and if they must have insurance, let it be with a high deductible, like $5000/year.? If the government then wants to help the poor, let them pay on the deductible.

Wait.? That’s a non-starter.? First-dollar coverage is the holy grail.? Expensive as anything, but that is the perverted goal.

Rationing takes place in any economic/political system, it is merely a question of how the goods and services get rationed.? Price?? Time?? Need (however defined)?

So, the politicians look to cover everyone, and yet control costs in the medical system.? Covering everyone is very expensive, because for the most part, the worst risks aren’t insured.? Those that would pay the highest premiums on a actuarially fair basis don’t buy/get insurance.

Controlling costs means reducing access, limiting doctor freedom, limiting choices, delaying treatment, etc.? Preventive care is a nice concept, but the gains are negligible.

I say let people be free, and get the government out of the picture.? No corporate deduction for healthcare costs.? No HSAs or other tax-preferred benefits (I have one of those).? Scale back Medicare; it is way too expensive relative to the GDP of the US.? Finally, inculcate a culture that recognizes that we are all going to die, and that certain care for the elderly will not be available unless they can pay for it privately.? We don’t want to prolong an expensive death at taxpayer expense.

An Idea

But with all that, let me propose one idea that might help.? I once proposed a program to improve the banking system of the US through the creation of mutual banks.? I thought, why not try the same idea with health insurers?

So, I started reading the news on the healthcare proposals, and I was surprised to find the idea of co-ops being discussed (also).? Some co-ops have been successful in managing costs and access, others not, as many co-ops have failed.

My thought was this: mutual banks could work versus the big? banks, because scale is not much of an advantage in banking.? Big banks have expense advantages, but they take dumb risks.? With healthcare there is a real advantage to size.? Small co-ops can’t compete against major health insurers.? But maybe a big mutual entity could do so.

Instead of a bunch of medical co-ops, better to sponsor/seed one mutual health insurance company that can cover the whole USA, and challenge the big private insurers.? The new entity would be charged with the tasks of reducing the uninsured, and lowering healthcare costs.? Much better than the co-ops idea.

But, nothing is perfect; we haven’t reached Solla Sollew yet.? If the mutual insurer is supposed to subsidize care, how should they do it?? Many of those that are uninsured are bad risks.? Others who might want to use the mutual company might look for policyholder dividends, particularly if they did not use the healthcare system much.

In the life insurance industry, the best mutuals imitate stock insurers, but adopt a longer-term view of their business.? I would assume that it would be true of a mutual health insurer as well.? So, what benefit would come from a large mutual health insurer?

  • Competition against the large managed care providers, lowering prices, kind of like what Southwest Airlines does…
  • Skimming the cream of those who are basically healthy, but can’t easily find insurance.
  • Congress would gain insight into how difficult it is to lower medical expenses, and how difficult it is to cover the uninsured.

The main reason that Congress is having large problems with this issue is that they are trying to do too much.? They are aiming for costless solutions to a costly problem.? They are looking to restrain access to healthcare to a culture that wants its problems solved now.

This is all a fool’s bargain to me, so let Congress charter National Healthcare Mutual, and see how much good it can do, before it returns to them hat in hand.

Ten Notes on the Current Markets

Ten Notes on the Current Markets

1)? Great minds think alike.? Fools seldom differ.? Remember my post on AIG’s subsidiaries?? Well, now in the New York Times, much of the same.

2)? Fed Independence! (spit, spit)? Come on, Bernanke, you argue against the Fed being audited because it might compromise Fed independence, and yet you regularly have lunch with leaders of the Executive branch.? You compromise the independence of the Fed more than any audit could by acting cooperatively with the Treasury.? If you were really independent, you would do what is best for your explicit mandate — fighting inflation and unemployment, rather than tinkering with non-bank credit markets, and rescuing companies.

3) Manus manum lavat. One hand washes the other.? Banks that have been bailed out are buying more Treasuries.? Some of that is lower spreads — lack of lending opportunities.? The rest is implicitly paying back the government.

4) The government may be increasing its sales of TIPS.?? I’ve been less bullish on TIPS of late, and this does not encourage me to change.? Further, farmland values may be falling.? Given growth in demand for food in the world, that should not be so, but maybe that is wrong.? Maybe depressionary conditions are that strong.? I also offer up the piece from UBS, via FT Alphaville, that suggests that deflation is more likely to minimize the total cost of debt to the US government.

All of this depends on the current length of US government debt.? If all of it were nominal (not inflation-indexed) 30-year debt, the US Government would gladly inflate.? Their financing is locked in.? But if it were all short-dated, the US government would have to manage the powder keg.? After all that was Mexico in 1994 — the government was financed in the short-term interest rate markets.

Thus, governments that have not been prudent, and have financed short-term can face a run on the currency.? The US government finances to an average of 4-5 years, so it is not apparent whether they could face a run or not.

The more TIPS that are issued as a fraction of the total debt, the less valuable the inflation guarantee becomes.? If China, or any other creditor thinks that TIPS are the solution to loss of value on US debt claims, let them realize this:

  • Yes, if the US inflates its currency, there will be protection.
  • No, if the US defaults on its obligations, you won’t be materially better off.
  • If the US decided to selectively default on foreigners, paying them back in a different US dollar than the domestic one, TIPS won’t help you much.

5)? Bye, bye, Fannie and Freddie?? Sending them into runoff was my proposed solution when the crisis hit.? Now that the reality of the humongous losses from mortgage lending and guarantees has become apparent, the government faces reality, and may wind them down.? As it is now, we know that F&F are unlikely to pay back their aid from the government in full.? In my opinion, better that the government would have let the companies go into Chapter 11 without interference. Instead, the taxpayers bail out much of the capital structure that did not deserve a bailout.

6)? Should Ben Bernanke be reappointed as Fed Chairman?? It doesn’t matter.? There is no significant variation in ideas among likely candidates that would make a significant difference in how the Fed behaves.? I don’t think Ben should be reappointed, but I don’t see any worthy replacements.? Ron Paul is out of the question, sadly.

These articles argue that Ben Bernanke should not be reappointed, and they make some good arguments:

All that said, what is the option?? Is there someone stunningly good standing in the wings, with a materially different view of monetary policy from Bernanke, who would be acceptable to the activist Obama administration?? I don’t see one available, so perhaps the devil you know is better than the devil you don’t.

7)? The corporate bond market has been on fire of late, with higher prices, tightening spreads and greater issuance.? We had several episodes like that in 2002, before facing reversals.? The first time is not the charm, and I would expect more of a backup in prices because corporate loss rates have not peaked yet.

8)? Let me just point out that “cash for clunkers” is another version of the “broken window fallacy.”

9)? As for AIG, I don’t expect the government to be paid back in full.? Sales of AIG subsidiaries have gone at cheap prices, and only the simple subsidiaries have been able to be sold.? Investment banks will make money on the deal, though.

10)? Even if GDP shrinkage is slowing due to government spending, that still means that the private sector is weak.? GDP ex-government growth will be a statistic to watch in the future.

Avoiding the Tail Wagging the Dog

Avoiding the Tail Wagging the Dog

I’ve written a number of pieces where I have discussed limits on derivatives.? These have seemingly been among my least popular pieces, partly because I seem to argue against the free market.? I’m not arguing against the free market, per se, but arguing that there are some types of contracts that should not be valid on a public policy basis.? This piece is meant to integrate my thoughts on:

  • Having a hard locate with shorting — (shares that have not been previously lent are located and confirmed to be borrowed).
  • Insurable interest with respect to credit default swaps [CDS].? Only hedgers can initiate transactions, and if the hedger sells, he must first collapse the CDS transaction.
  • Insurable interest should apply across all derivative markets, and should become a regular part of insuring systemic stability.? Regulators of the various exchanges would require hedgers to divulge the assets or liabilities in question that they are hedging.? The hedgers would then be allowed to buy and sell contracts up the hedging need, and no more.? Speculators would bid for the right to trade with the hedgers, but could not trade with other speculators.? Every transaction must have a hedger.

One of my core reasons for this is to shrink derivative activity so that it is smaller than the underlying markets.? This will keep “the tail from wagging the dog.”? After all, if you need to do a transaction, why not buy/sell the underlying, on a forward basis if necessary?? Also, let the regulators understand their clients more closely, so that they can better prevent insolvencies.

My second core reason is that speculators dealing with speculators is gambling, and should be regulated that way, because there is no transactional tie to the real economy.? Now, some will say,”Doesn’t all investment involve gambling?”? My answer is no.? All investment involves risk-taking, but there is a difference between risk-taking and gambling.

Every business/businessman takes risks.? Many of those risks get externalized in public security markets because the equity and debt of the company trade on secondary markets.? The prices of the shares and bonds reflect marginal perceived risk of the business.? That risk is necessary risk.? Unnecessary risk is two unrelated parties with no economic interest betting on whether the company can survive or not; such a bet should be regulated as gambling.

Most people buying/shorting a stock have some reason why they think they will make money.? Even if they are wrong, they don’t think their actions are as uncertain as a coin flip.? Few pick tickers randomly, and decide positions (buy/short) randomly.

My third core reason is to reduce regulatory and taxation arbitrage.? Many derivative transactions are done to escape regulations and taxation existing in the underlying markets.? Let these parties abide by the rules of their regulators, and let them pay the taxes that they owe.

There are legitimate reasons for wanting to lay off short-term risk, without selling a long term asset.? But on the whole, speculative markets should not exceed the demand for hedging.? Similarly, markets for shorting should not exceed the amount of underlying available to be borrowed.

That’s my position.? Separate investment and gambling through a requirement of hedging in synthetic transactions.? If some want to gamble on companies, let them go to Vegas; the margin requirments will be tighter.

I know this article won’t be popular, but I do want financial markets to have real legitimacy over the long term.? Gambling, even if legal,? never has moral legitimacy.? Better to have smaller markets that are viewed by most to be legitimate, than to have large markets that have the legitimacy of a casino.

Book Review: Mr. Market Miscalculates

Book Review: Mr. Market Miscalculates

Since the first time I read him, I have been a fan of James Grant.? He helped to sharpen my focus on how money and credit work in the long run, and how they affect the economy as a whole.? Reading one of his early books, Minding Mr. Market: Ten Years on Wall Street With Grant’s Interest Rate Observer, I gained perspective on the increasingly complex financial world that we were moving into.

But not all have shared the opinion of Mr. Grant’s wisdom.? When I worked for Provident Mutual, the Chief Portfolio Manager (at that time new to me, but eventually a dear colleague) said to me, “feel free to borrow any of the publications we receive.”? For a guy who likes to read, and learn about investments, I was jazzed. But, when I came back and asked whether we subscribed to Grant’s Interest Rate Observer, I got the look that said, “You poor fool; what next, conspiracy theories?” while she said, “Uh, noooo. We don’t have any interest in that.”

Now the next two firms I worked for did subscribe, and I enjoyed reading it from 1998 to 2007. But now the question: why buy a book that repeats articles written over the last fifteen years?

I once reviewed the book Just What I Said: Bloomberg Economics Columnist Takes on Bonds, Banks, Budgets, and Bubbles, by another acquaintance of mine, the equally bright (compared to James Grant) Caroline Baum.? This book followed the same format, reprinting the best of old columns, with modest commentary.? In my review, I cited Grant’s earlier book as a comparison, Minding Mr. Market.

As an investor, why read books that will not give an immediate idea of where to invest now?? Isn’t that a waste of time? That depends.? Are we looking to become discoverers of investment/economic ideas, or recipients of those ideas?? Books like those of Grant and Baum will help you learn to think, which is more valuable than a hot tip.

Here are topics that the book will help one to understand:

  • How does monetary policy affect the financial economy?
  • Why throwing liquidity at every financial crisis eventually creates a bigger crisis.
  • Why do value (and other) investors need to be extra careful when investing in leveraged firms?
  • What is risk?? Variation of total return or likelihood of loss and its severity?
  • Why financial systems eventually fail at compounding returns at rates of growth significantly above the growth rate of GDP.
  • Why great technologies may make lousy investments.
  • Why does neoclassical economics fail us when trying to understand the financial economy?
  • How does one recognize a speculative mania?
  • And more…

The largest criticism that can be leveled at James Grant was that he saw that he would happen in this crisis far sooner than most others.? Being too early means you eventually get disregarded.? The error that the “earlies” made, and I knew quite a few of them, was not recognizing how much debt could be crammed into the financial economy in order to juice returns on fixed income assets with yields lower than likely default losses.? That’s a mouthful, but the financial economy had not enough good loans to make relative to the amount of loans needed to maintain the earnings growth expectations of the shareholders of financial companies. Thus, the credit bubble, facilitated by the Fed and the banking regulators.? You can read all about it in its many facets in James Grant’s book.

You can buy the book here: Mr. Market Miscalculates: The Bubble Years and Beyond.

Who would benefit from the book?

  • Those that have assumed that neoclassical economics adequately explains the way our economy works.
  • Those that want to understand how monetary policy really works, or doesn’t.
  • Those that want to learn about equity or fixed income value investing from a quirky but accurate viewpoint.
  • Those that want to be entertained by intelligent commentary that proved right in the past.

As with other James Grant books, this does not so much deal with current problems, as much as educate us on how to view the problems that face us, through the prism of how past problems developed.

Full disclosure: If you buy anything through the links to Amazon at my blog, I get a small commission,? but your costs don’t go up.?? Also, thanks to Axios Press for the free review copy.? I read the whole thing, and enjoyed it all.

Seven Notes on the Current Market Mess

Seven Notes on the Current Market Mess

1)? Avoid short-cycle data.? When writing at RealMoney, I encouraged people to ignore short-term media, and trust those that gave long-term advice.? After all, it is better to learn how to invest rather than get a few hot stock picks.

In general, I read writers in proportion to their long-term perspective.? I don’t have a TV.? I rarely listen to radio, but when I do listen to financial radio, I usually feel sick.

I do read a lot, and learn from longer-cycle commentary.? There is less of that around in this short-term environment.

When I hear of carping from the mainstream media regarding blogging, I shake my head.? Why?

  • Most bloggers are not anonymous, like me.
  • Many of us are experts in our? specialty areas.
  • Having been practical investors, we know far more about the markets than almost all journalists, who generally don’t invest, or, are passive investors.

Don’t get me wrong, I see a partnership between bloggers and journalists, producing a better product together.? They are better writers, and we need to get technical messages out in non-technical terms.

We need more long-term thinking in the markets.? The print media is better at that than television or radio — bloggers can go either way.? For example, I write pieces that have permanent validity, and others that just react to the crisis “du jour.” Investors, if you are focusing on the current news flow, I will tell you that you are losing, becuase you are behind the news flow.? It is better to consider longer-term trends, and use those to shape decisions.? There are too many trying to arb the short run.? The short run is crowded, very crowded.

So look to value investing, and lengthen your holding period.? Don’t trade so much, and let Ben Graham’s weighing machine work for you, ignoring the votes that go on day-to-day.

2)? Mark-to-Market accounting could not be suppressed for long in an are where asset and liability values are more volatile.? Give FASB some credit — they are bringing the issue back.? My view is when financial statement entities are as volatile as equities, they should be valued as equities in the accounting.

3)? Very, very, weird.? I cannot think of a man that I am more likely to disagree with than Barney Frank.? But I agree with the direction of his proposal on CDS.? My view is this: hedging is legitimate, and speculation is valid to the degree that it facilitates hedging.? Thus, hedgers can initiate transactions, wtih speculators able to bid to cover the hedge.? What is not legitimate is speculators trading with speculators — we have a word for that — gambling, and that should be prohibited in the US.? Every legitimate derivative trade has a hedger leading the transaction.

4)? I should have put this higher in my piece, but this post by Brad Setser illustrates a point that I have made before.? It is not only the level of debt that matters, but how quickly the debt reprices.? Financing with short-term dbet is almost always more risky than financing with short-term debt.

Over the last six years, I have called attention to the way that the US government has been shortening the maturity structure of its debt.? The shorter the maturity structure, the more likely a currency panic.

5)? Look, I can’t name names here for business reasons, but it is foolish to take more risk in defined benefit pension plans now in order to try to make up? the shortfall of liabilities over assets.? This is a time for playing it safe, and looking for options that will do well as asset values deflate.

6)? Junk bonds have rallied to a high degree; at this point I say, underweight them — the default losses are coming, and the yields on the indexes don’t reflect that.

7) Peak Finance — cute term, one reflecting a bubble in lending/investing.? Simon Johnson distinguishes between three types of bubbles — I’m less certain there.? Also, I would call his third type of bubble a “cultural bubble,” rather than a “political bubble,” because the really big bubbles involve all aspects of society, not just the political process.? It can work both ways — the broader culture can draw the political process into the bubble, or vice-versa.

The political process can set up the contours for the bubble.? The many ways that the US Government force-fed residential housing into the US economy — The GSEs, the mortgage interest deduction, loose regulation of banks, loose monetary policy, etc., created conditions for the wider bubble — subprime, Alt-A, pay-option ARMs, investor activity, flipping, overbuilding, etc.? In the process, the the federal government becomes co-dependent on the tax revenues provided.

I still stand by the idea that bubbles are predominantly phenomena of financing.? Without debt, it is hard to get a big bubble going.? Without cheap short-term financing, it is difficult to get a stupendous boom/bust, such as we are having.? That’s just the worry behind my point 4 above.? The US as a nation may be “Too Big To Fail,” to the rest of the world, but if the composition of external financing for the US is becoming more-and-more short-term, that may be a sign that the endgame is coming.

And, on that bright note, enjoy this busy week in the markets.?? Last week was a tough one for me personally; let’s see if this week goes better.

Duh.

Duh.

Duh.? I don’t like saying “Duh.”? There’s something dumb-sounding about it.? The only thing worse is saying “Duuuuh,” or “Duuuuuuhh.”

Yet, when I read Dr. Bernanke’s Op-Ed in the Wall Street Journal today, my initial response was “Duh, of course, in order to exit all ya gots to do is do the opposite of what ya did to enter.? It will be cheap and simple.”

Why should the Fed think that doing the opposite will be easy?? Take the Fed’s forelorn policy tool, the Fed funds rate.? When has it been easy to raise the rate?? Only very bold central bankers would act before it was clearly needed.

Wait, Give Dr. Bernanke a chance.? What did he say?

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury?s account at the Federal Reserve rises and reserve balances decline.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury?s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Third, using the authority Congress gave us to pay interest on banks? balances at the Fed, we can offer term deposits to banks?analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

What is his first method?? Suck cash out of the system temporarily, and hold fixed-income assets while waiting.

The second method is to let the Treasury suck cash out of the system temporarily, perhaps compromising Fed independence somewhat.

Third?? Make a good offer to the banks so that they lend to the Fed and not to customers, slightly longer-term.

Finally, the Fed could suck in cash by selling the Treasury, Agency, and Mortgage bonds they have acquired, perhaps raising longer-term interest rates in the process.

It all sounds easy.? But tightening the Fed funds rate is not easy, particularly toward the end of the cycle.? What of these new policy tools?? Will they face similar difficulties?

Yes, and maybe more.? The Fed lacks experience with these tools.? As I have said before, policy accommodation is like a drug: easy to receive and hard to withdraw.

As the withdrawal occurs, there will be pain, and more so as the withdrawal continues.? Can you imagine what happens to the bond markets when they realize the Fed is selling?? It will be ugly.? Welcome to the asymmetry of the markets, Dr. Bernanke.

One thing that was neglected were all of the specialized lending programs.? How do they get unwound?? I’m not sure, but I believe the same pain thresholds apply, only that special interests will complain privately.

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Making the markets happy is a fool’s bargain, Dr. Bernanke.? Doing that leads into a liquidity trap, as your acquaintance Dr. Greenspan left you with.? The markets need to be jolted every now and then to know that you aren’t their slave.? Without that, the markets grow complacent, realizing that the Fed exists for their aid and comfort.

In the short-run, Dr. Bernanke, it is always easier to please that fickle mistress, the markets.? Dr. Greenspan learned that all too well.? The markets will eat until they are obese — even beyond that, until they are regurgitating breakfast.? In a macroeconomic sense the markets are not efficient — they will take whatever the government gives, and beg for more, until it kills them, like a drug overdose.

In that sense, the long term is not the sum of short terms.? Rather the seemingly optimal short terms can lead away from what would be optimal long term.

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With that, I end this piece.? On the off-chance that you are reading this, Dr. Bernanke, Ben, I would simply say that removing policy accommodation is easier said than done.? There are always tensions, regardless of the method, and political and economic pain to boot.? Embrace the pain, and let elected officials deal with the consequences.? You’re a brave man, but it is their responsibility — let Congress deal with the crisis.

China, the Wild Card — Seven Notes

China, the Wild Card — Seven Notes

1) Is China really growing or not?? Wait, is that a stupid question, or what?? Of course China is growing, and pulling the global economy out of the ditch as well.? Read this report from Time.? Uh, maybe not.? What if it is all a lending bubble?

What seems to be happening is that the powers that be in China are encouraging banks to lend aggressively.? Firms in China aren’t finding a lot of opportunities in export markets, so they build up inventories “that they know they will need eventually.”? Financial counterparties and individuals speculate on financial assets like real estate and stocks as they find cheap financing available.? (Example)

That’s my view of China at present.? I think those that are arguing for a resurgence in China at present are missing the similarities to the late 1980s with Japan where large amounts of productive capacity were built up with no markets large enough to sell the incremental production to.

I could be wrong, but this is leading me to lighten up on cyclicals.? Maybe some utilities…

2) With all of the noise of those looking for a replacement for the US Dollar as the world’s global reserve currency, I have two questions:

  • Are the surplus nations looking to reduce their surpluses, and thus suck in fewer foreign assets?
  • Is there a new deficit nation that is politically stable, militarily strong, etc., that is capable of running current account deficits for some time?? Surplus nations need a safe place to invest.

3) In the meantime, the US tries to assure trading partners that their purchasing power is safe.? We remember the laughable assertion of Tim Geithner trying to assure the Chinese that they did not have to worry about devaluation of the dollar.? Well, now he is saying the same things to the Saudis.? At least with the Saudis, we are doing their bidding in the Middle East, by bottling up Iran,? so perhaps he does not have to worry so much there.

4) Back to point 2.? Are the current account surplus nations willing to consume from the rest of the world and flip around to deficit conditions, letting their currencies appreciate, and killing their politically powerful export industries?? That’s what it will take to replace the US Dollar.? I don’t care who is arguing against the US as a reserve currency.? The reserve currency must by nature offer high quality securities on net to the surplus nations to invest in.? It must run current account deficits on average.

That’s why China can’t be the world’s reserve currency.? China isn’t willing to stop export promotion, or encourage domestic consumption.? India and Russia may kvetch as much as they like, but both are in the same boat as China, but to a lesser degree.

Oddly, the best policy for most of the complainers would be to allow/encourage imports, and stop export promotion.? Freed from these distortions, the global economy would start to normalize.? Cross-border capital flows would decline because exports would not need to be balanced out.

5) The US has no interest in selling Yuan-denominated debt yet.? China eagerly buys Treasuries today.

6)? Does the one child policy fuel excess savings in China?? Maybe, but I doubt it is a big factor.? Dowries are unlikely to eclipse the actions of the central bank and government.

7) A final note from Andy Xie — there is a lot of momentum in China, but little underlying change in the fundamentals.

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My summary is this:? To the degree that the recent upturn is driven by expectations that China pull the global economy out of the ditch, the move is mistaken.? As my friend Cody Willard asked me three years ago, what happens if Chinese growth proves to be a sham?? Can you trust their statistics?

My answer was that I wasn’t certain, but that things would get more clear if that were the case — and I think things are clearer now.? My policy implication is to move assets out of export-driven sectors, and those driven by China demand.? Utilities, here I come. 😉

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