Category: Public Policy

Problems with Constant Compound Interest (3)

Problems with Constant Compound Interest (3)

Posted on by David Merkel

This post should end the series, at least for now.? Tonight I want to talk about the limits to compounding growth.? Drawing from an old article of mine freely available at TSCM, I quote? the following regarding talking to management teams:

What single constraint on the profitable growth of your enterprise would you eliminate if you could?

Companies tend to grow very rapidly until they run into something that constrains their growth. Common constraints are:

  • insufficient demand at current prices
  • insufficient talent for some critical labor resource at current prices
  • insufficient supply from some critical resource supplier at current prices (the “commodity” in question could be iron ore, unionized labor contracts, etc.)
  • insufficient fixed capital (e.g., “We would refine more oil if we could, but our refineries are already running at 102% of rated capacity. We would build another refinery if we could, but we’re just not sure we could get the permits. Even if we could get the permits, we wonder if long-term pricing would make it profitable.”)
  • insufficient financial capital (e.g., “We’re opening new stores as fast as we can, but we don’t feel that it is prudent to borrow more at present, and raising equity would dilute current shareholders.”)

There are more, but you get the idea.

Again, the intelligent analyst has a reasonable idea of the answer before he asks the question. Part of the exercise is testing how businesslike management is, with the opportunity to learn something new in terms of the difficulties that a management team faces in raising profits.

As with biological processes, when there are unlimited resources, and no predators, growth of populations is exponential.? But there are limits to business and investment profits because of competition for customers or suppliers, and good untried ideas are scarce.? Once a company has saturated its markets, it needs a new highly successful product to keep the growth up. Perhaps international expansion will work, or maybe not?? Are there new marketing channels, alternative uses, etc?

Trying to maintain a consistently high return on equity [ROE] over a long period of time is a fools bargain and I’ll use an anecdote from a company I know well, AIG.? I was pricing a new annuity product for AIG, and I noticed the pattern for the ROE of the product was not linear — it fell through the surrender charge period, and then jumped to a high level after the surrender charge period was over.

I scratched my head, and said “How can I make a decision off of that?”? I decided to create a new measure called constant return on equity [CROE], where I adjusted for capital employed, and calculated the internal rate of return of the free cash flows.? I.e., what were we earning on capital, on average over the life of the product.

I took it to my higher-ups, hoping they would be pleased, and one said, “You don’t get it!? You don’t argue with Moses!? The commandment around here is a 15% return on average equity after-tax!? I don’t care about your new measure!? Does it give us a 15% return on average equity or not?!”

This person did not care for nuances, but I tried to explain the ROE pattern, and how this measure averaged it out.? It did not fly.? As many have commented, AIG was not a place that prized actuaries, particularly ones with principles.

As it was AIG found ways to keep its ROE high:

  • Exotic markets.
  • Be in every country.
  • Be in every market in the US.
  • Play sharp with reinsurers.
  • Increase leverage
  • Press the accounting hard, including finite reinsurance and other distortions of accounting.
  • Treat credit default swap premiums as “found money.”
  • Take on additional credit risk, like subprime lending inside the life companies through securities lending.

In the end, it was a mess, and destroyed what could have been a really good company.? Now, it won’t pay back the government in full, much less provide anything to its shareholders, common and preferred.

Even a company that is clever about acquisitions, like Assurant, where they do little tuck-in acquisitions and grow them organically, will eventually fall prey to the limits of their own growth.? That won’t happen for a while there, but for any company, it is something to watch.? Consistently high growth requires consistently increasing innovation, and that is really hard to do as the assets grow.

If True of Companies, More True of Governments

This is not only true of companies, but even nations.? After a long boom period, state and federal governments stopped treating growth in asset values as a birthright, granting them a seemingly unlimited stream of taxes from capital gains, property, and transfer taxes.? They took it a step further, borrowing in the present because they knew they would have more taxes later.? The states, most of which had to run a balanced budget, cheated in a different way — they didn’t lay aside enough cash for their pension and retiree healthcare promises.? The Federal government did both — borrowing and underfunding, because tomorrow will always be better than today.

Over a long enough period of time, things will be better in the future, absent plague, famine, rampant socialism, or war on your home soil.? But when a government makes long-dated promises, the future has to be better by a certain amount, and if not, there will be trouble. That’s why an economic downturn is so costly now, the dogs are behind the rabbit already, running backwards while the rabbit moves forwards makes it that much harder to catch up.

I’ve often said that observed economic relationships stop working when people start relying on them, or, start borrowing against them.? The system shifts in order to eliminate the “free lunch” that many thought was available.

A Final Note

Hedge funds and other aggressive investment vehicles should take note.? Just as it is impossible for corporations to compound their high profits for many decades, it is impossible to do the same as an investor.? Size catches up with you.? It’s a lot easier to manage a smaller amount — there are only so many opportunities and inefficiencies, and even fewer when you have to do so in size, like Mr. Buffett has to do.

“No tree grows to the sky.”? Wise words worth taking to heart.? Investment, Corporate, and Economic systems have limits in the intermediate-term.? Wise investors respect those limits, and look for growth in medium-sized and smaller institutions, not the growth heroes of the past, which are behemoths now.

As for governments, be skeptical of the ability of governments to “do it all,” being a savior for every problem.? Their resources are more limited than most would think. Also, look at the retreat in housing prices, because the retreat there is a display of what is happening? to tax revenues… the dearth will last as long.

Full disclosure: long AIZ

Ten Points — Mainly About the Debt Markets

Ten Points — Mainly About the Debt Markets

Posted on by David Merkel

1) Why have long interest rates been rising?

  1. Increased supply.
  2. Mortgage bond/supply hedging. (also one, two)
  3. Belief in a strengthening economy.
  4. Long-term inflation expectations have been rising.
  5. Some foreign investors are selling.
  6. Flight to trash.

Number 1 is incontrovertible.? Number 2 is close.? Number three is true, though the economy is not strengthening that much in inflation adjusted terms.? As for 4, yes, TIPS inflation breakevens have been steadily rising, both short- and long-term.

The last one is the most interesting.? It is the analogue to the equity investors that are buying financials.? Since the financials have been hot, equity managers lagging in performance have encouraged the purchase of hot financials.? Same for junk bonds among broad mandate bond managers.? Many managers are buying long financial corporates for speculative gains, while selling long Treasuries to fund the purchases.

With a few exceptions, it has paid recently for bond managers to play on the riskier areas of their mandates, with the exception of high quality long duration bonds, which were the big winners last year, and the big losers this year so far.

So when you look at the rise in high-quality long rates (prices down), and the rally in junk (prices up), etc., realize that these are part of a larger phenomenon.?? There is not one simple reason for the recent moves, there are many, and they are loosely related.

2)? That’s not to say that the Fed publicly understands this (one, two, three) .? When they announced their plan to buy long Treasuries, Agencies, and Mortgage bonds, there was some hope that they could keep mortgage rates down and stimulate the economy by making cheaper to finance homes.? That dream is in tatters now (one, two, three, four, contrary opinion from Paul Kasriel, who I generally respect).? The six forces listed above are bigger than the Fed’s ability to control.

3)? Will the Fed start tightening rates in 2009?? Yes or no?? When you phrase the question that way, most thoughtful observers will answer no, saying that the Fed would never start acting when a recovery is barely underway, if it is underway at all.

But maybe that’s the wrong question.? Ignoring the Fed funds futures market for a moment, ask this question instead:? Subjectively, have the odds risen recently that they might tighten sooner, and maybe even in 2009?? Certainly.? There have been other times when the Fed has acted, tightening when conditions were less than optimal.? I’ll give you two of them:

  • After the dollar tanked in 1986, with inflation still pretty benign, starting in December of 1986, the Fed began to raise rates, primarily to defend the dollar.? Not realizing all of the second order effects that would take place, the tightenings led to a bear market in bonds, and eventually the crash later that year as bonds became compelling compared to stocks.
  • From 1973 to 1982, the Fed often raised rates when the economy was less than strong.? Inflation was out of control, and it didn’t much matter whether industrial capacity or labor capacity were fully used — there was still inflation, and thus, stagflation.

It’s possible we may run into the same thing here, though if the only thing we experience is commodity price inflation because the dollar is weak, that doesn’t feed back into consumer prices that much,? because raw commodity prices play a small role in consumer prices.? Labor costs are much more important.? Would it be possible to get rising wages when unemployment is high?? Yes, look at the ’70s.

4)? But maybe the Fed can tighten without tightening.? They can begin lightening up on their credit easing programs.? Might work.? Maybe they could reverse their trade in long Treasuries, Agencies, and Mortgage bonds.? Uh, yeah, unlikely, but maybe they slow down a little.? In a case like this, moving the Fed Funds rate might be the least painful option.

So maybe a move in the Fed funds rate isn’t impossible in 2009.? The difficult part here is forecasting:

  • What conditions will be in the real economy will be like
  • How well the global economy turns
  • Whether the large amount of incremental Treasury debt and guarantees will be readily digested on favorable terms
  • Whether the financial economy won’t hit a few more roadblocks from commercial mortgages, corporate and personal insolvencies, unemployment, etc.
  • Whether there is some “bolt from the blue” like a new war, weakness in the Chinese economy, etc.

What isn’t hard is looking at the overall debt levels relative to GDP, and realizing that we have only rationalized a part of them.

5) Residential Housing is still weak, and getting weaker, but the pace of the decline has slowed.? The market still has issues in front of it:

As I said in an old CC post:


 David Merkel
Hear Cody on Housing
8/24/2007 1:25 PM EDT

Much, but not all of the upset in the lending markets (which, if you look at swap spreads, the current manifestation of the crisis seems to be passing — down 4 basis points today), is from deflating values in housing. My estimate for how much further real estate has to decline on average in the US is 10-20%. We need to find owners for about 4% of the US housing stock that is vacant. The pain that has been felt in subprime and Alt-A loans will get felt in prime loans, and possibly conforming loans as well. Fannie and Freddie won’t get killed, but they will take credit losses.

So, listen to Cody. Residential real estate markets do not clear as rapidly as a futures exchange. The illiquidity and variations in lending standards tends to lead to markets that adjust slowly, and autocorrelatedly. I.e., if it went up last period, odds are it will go up next period, and vice-versa.

It will take a while for the residential real estate market to clear. When the inventory gets down to 3% it will be time to start speculating on homebuilders and mortgage lenders again, but real estate prices won’t start rising in aggregate until the inventory of unsold homes gets below 1.5-2.0%.

Position: none

In hindsight, I was way too optimistic, but I could never bring myself to write that things could be much worse, because then you get labeled a “perma-bear,” and then you get ignored.? So, if you want pessimism, here it is from T2 partners.? We may be near fair value now, but given that our housing stock is misfinanced (too much debt, terms that are too short), we will definitely go below fair value.? The only question is how much we go below fair value.

6)? Regarding the US Dollar fixed income, who is right?? The Russians, who are selling?? The Chinese, who are kvetching, but still buying??? Or the Japanese, who possess unshakable trust in US bonds??? Only time will tell.? Transitions from one currency regime to another can be messy in the absence of an anchor like gold.? There is some point where if the US keeps borrowing, and there seems to be no end in sight, that foreign creditors will finally write off their losses, and move on to some new arrangement.

In the short run, it is not in the interests of China or Japan to ditch the Dollar.? It would take something notable to get them to change, and I can’t see what that would be.? It certainly won’t be Yuan-denominated bonds from the US.

7)? Buy Corporate Bonds Now.? Aren’t we a bit late here?? The time to buy was back in the end of 2008.? Investment Grade Corporates are at fair value now, and I would reduce holdings of BBB corporates to below benchmarket levels. High yield is still a little cheap, so I would reduceallocations to high yield now to benchmark levels.? We still have significant financial stress ahead of us, and there is a lot of room for lower-rated credits to underperform.

8 ) As another example of this, consider how many junk-rated senior loans will need to be refinanced over the next five years.? Perhaps the bid from CLOs will come back, or the the banks will heal and bring it onto their balance sheets.? But absent that, there will be upward pressures on yields when refinancing senior loans.

9) I knew that I wrote something with respect to the Fed and Treasury using force to make banks take TARP funds.? I finally found it.? So, this isn’t hot news that the banks were forced to take TARP funds, (and here) but it’s nice to see that I guess right every now and then.? Barry was quite possibly right that the TARP was a ruse to protect Citi, but the bigger surprise would be how much Bank of America and Wells Fargo would need it.

10) Final note: if banks are opaque, regulators are more so.? Glad to see Matthew Goldstein continuing to put out good work on financials.? He was great at TSCM, and I’m sure will be great at Reuters.

Loss Severity Leverage

Loss Severity Leverage

Posted on by David Merkel

I’ve been analyzing on some surplus notes from a mutual life insurer which is part of a group of mutual insurers.? Mutual insurers are opaque, because there are no large private interests external to the company with a concentrated interest in the well-being of the company.? This company lost significant money in 2008 and the first quarter of 2009.? Most of it was writedowns on non-GSE (not Fannie, nor Freddie) residential mortgage bonds, where they bought mezzanine or subordinated bonds.

Wait.? Some definitions:

Senior bonds: those rated AAA, representing the group that gets paid first in a securitization.? In a securitization where the loss experience is so bad that the senior bonds take losses, typically all of the senior bonds get paid pro-rata.

Subordinate bonds: Bonds that receive high yields in a securitzation (rated BBB and below), but take losses first as losses emerge.? High risk, high return (maybe).

Mezzanine bonds: If the subordinate bonds get wiped out, the Mezzanine bonds (rated AA and A) are next.? Not much extra yield, but less chance of loss.

When a securitization goes bad, the juniormost bonds get losses allocated to them until they wiped out, then it goes to the next most junior class.? This highlights a difference between the loss severities of corporate bonds and structured bonds.? With corporate bonds, there is some recovery of principal — not all of the principal, of course, but 40% on average.? With structured bonds, typically you get all of your principal paid, or none of your principal paid (excluding early amortization).

I realized this for the first time when I analyzed the Criimi Mae Securitizations back in 1999.? The securitization trusts contained mostly junk-rated CMBS tranches, and junk-rated securitizations of other CMBS deals, and they sold off investment grade participations in the securitizations.? This was the messiest set of deals that I ever analyzed.? It reinforced one idea to me, that if you are not senior in a deal, you may lose it all.? With structured finance, there is loss severity leverage in mezzanine and subordinate bonds.

Going back to the firm I was analyzing, When I looked at their performance last year, I thought, “Stable company.? Bread and butter life company.? As my old boss said, ‘It takes more than incompetence to kill a mutual life insurer, it takes malice.’ ”

Today I am not so sure.? I once was a mortgage bond manager, and I bought senior securities because the yield spreads on the lower-rated securities were so small.? This company, like Principal Financial, bought mezzanine and subordinate bonds in significant measure, though they did slow down after 2005.

I have estimated the likely losses on the bonds that the company owns, and it is unlikely but not impossible that the company dies in the next few years.? The parent mutual company has ponied up money recently, and will probably do so in the future.? Who can tell?

My estimates of loss are less than those that the bond market is estimating.? If we marked the assets of the company to market, it would be significantly insolvent.? Insurance policies are high credit quality obligations, they don’t vary as much as bonds that are risky.? Now, if I had the Actuarial Opinion and Memorandum, perhaps I could know the truth.? That group of documents analyzes the long-term ability of a life insurance company to survive.? That document is sadly not public.? If it suggested that the company in question needed additional capital, that would be reflected in the public filings, and there is no such reference for the company in question.

Can You Afford To Lose It All?

Anytime one buys a mezzanine or subordinated security, or buys a surplus note, or trust-preferred security, or other bit of junior debt or preferred stock, one must ask, “Can I afford to lose it all?”? When there are senior investors, investors that are more junior can get whacked.? Senior investors ordinarily must be paid in full before junior investors get paid.

This applies even to AA and A-rated structured securities.? They aren’t senior, so they can lose all their principal.? And that’s what this life insurance company bought a lot of, picking up a princely few extra tenths of a percent in interest over the AAA bonds for a lot more risk.

How Did These Securities Get Such High Ratings?

Uh, seemed like a good idea at the time?? ;)?? As I’ve said before, it is impossible to set regulatory capital levels or subordination levels for assets that have not been through a failure cycle.? New asset classes have no track record of failure, and as such, estimating the likely expected present value of losses, and how variable losses could be is just an educated guess.? Sometimes they would apply models of related asset classes and tweak them.? That’s still a guess, though.

Also, using statistics for assets held on balance sheets, and applying them to securitizations, where the originator has little skin in the game, made the assumptions made for losses on residential mortgage lending too low.

The rating agencies did have competitive pressures to get business, but my view is that they did not have sufficient relevant loss experience to guide them.

What Should Have Been Done?

Regulators abdicated their duties by merely relying on the rating agencies. Ratings are fine in theory, and someone has to make judgments of relative risk, but the macro decision of what classes of investments are permitted, and what capital level to hold against them belongs to the regulators.? The regulators haven’t done well in setting up rating agencies of their own, so let the rating agencies continue on, but let the regulators be smarter in how they set the capital levels (higher for structured products than for corporates and munis, because of loss severity leverage), and what they allow regulated entities to invest in.

My view is that any new asset class has to go through a failure cycle before regulators allow regulated entities to invest in them.? Investments in such new assets? should be treated as a deduction from equity.

Wait, We Need to Invest in Those Assets to Stay Competitive!

That scream came the regulated entities.? Sorry guys, the risks of untried asset classes belongs to unregulated entities that don’t have deposit insurance, state guarantee funds, etc., where there is no systemic risk.? If they go under, no one in the public domain should care.

In principle, it shouldn’t matter within a group of regulated companies what the rules are, so long as they are enforced similarly by the regulators.

Anything else?

One final note — there is one medium-sized mutual insurer flying under the radar that I think its state regulator is unaware of the risks that it faces, and the rating agencies as well… it carries high ratings from all the main insurance raters.? Given the project that I am currently working on, I can’t reveal the name, but the guaranty funds would be more than capable of handling the failure.

Book Review: Bailout Nation

Book Review: Bailout Nation

Posted on by David Merkel

I liked Financial Shock.? But it was kind of like listening to the news on the radio, versus watching it on television, in comparison to Bailout Nation.? What can I say, Barry writes ably and amusingly, without losing erudition.? With help from Aaron Task, the book sings.? Having written for RealMoney, I have experienced the superb editing by editors that understand finance.? (I always enjoyed interacting with Aaron in the CC.)

Also, the writing is simple to understand, but you don’t get a simplistic view of who was to blame, similar to my Blame Game series.? There are a lot of culprits who took advantage of the boom times, leaving themselves and all of us more vulnerable in the eventual bust.

Barry begins the book by describing the normal temptation of nations to bail out large private interests when things go south.? The US resisted these temptations until the creation of the Federal Reserve, an quasi-public entity that I like to say was created so that the Treasury Department could take actions that would otherwise be unconstitutional.

He then describes early bailouts (Lockheed, Chrysler) that set the pattern for what will come later.? But the greater factor that Barry describes are the implicit bailouts where Greenspan threw liquidity at every crisis, which avoided the reconciliation of bad lending decisions.? Great examples include: commercial mortgages in the early ’90s, Mexico and mortgages in 94, Russia/Asia/LTCM in 98, and the Nasdaq in 2000-2.

Liquidity was never absent in the Greenspan era, and debts built up, realizing that since the Fed would protect them, why not take more risk?

The idea backfired on the Fed.? Investors took more risk because they thought the Fed would protect them, and so they leveraged up on investments at narrow spreads over risk-free investments in order to meet return targets.

Any policy that reduces risk-consciousness is a bad one.? Ditto for those that say follow the crowd.

As I have said before, if a country has fiat money, it must also regulate credit.? Conditions in the banking sector deteriorated through the Bush Jr., administration, leading to the credit crises we are seeing today.? Conservative, it is not.

Barry also details the crisis in 2008 as it unfolded, and questions the motives of parties involved, or, why they didn’t act earlier.

Personal Notes

  • The 1996 Greenspan comment on “irrational exuberance” is treated well by Barry.? Greenspan was long on words but short on deeds.
  • Barry could have done more with the Banking crisis 1989-93, which prompted the aggressive Fed policy which is similar to today’s policy.
  • Big as the Federal Reserve is, they certainly did not do their regulatory job with respect to lending terms.
  • Barry agrees with me that the CPI is understated.
  • On AIG, I would note that AIG Financial Products was not the only problem, though it was the biggest.? The domestic life companies had real issues.
  • I was gratified to see how many experts that Barry cited favored increased immigration to the US of those that are wealthy.
  • Finally, on the second to last page, he quotes an obscure economist with a weirdly-named blog.? Hey Felix, yes, he quoted few bloggers, but you missed this one.

All in all, a great book.? If there is a better one to describe the crisis, I will be very surprised.

If you want to buy it you can buy it here:?? Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy

For one final note, I love the cover of the book where they morph the Wall Street Bull into a pig.? It symbolizes the era we are in in.

Monetary Policy is Loose — The Yield Curve is Steep

Monetary Policy is Loose — The Yield Curve is Steep

Posted on by David Merkel

With a headline like that, you might be inclined to say, “Duh! Next you’re going to tell me that the sky is blue.”? Guilty, I am, but I won’t mention the azure sky; it’s raining here. ;)? I got here through analyzing the swap curve and asking the question, “When has the swap curve been shaped like this in the past?”

Swap curve.? Time for explanations.? The interest rate swap market is big — very big.? It allows parties to exchange a fixed yield over a period, for a floating rate, 3-month LIBOR [London Interbank Offered Rate], or vice-versa.? The fixed rates at different tenors/maturities define the swap curve. Typically, these swaps are done with AA-rated banks, so credit spreads versus Treasuries are low.

Personally, I find swap rates more comparable across countries than sovereign obligations.? Why?? The maturities are more similar, as is the credit quality.? Anyway here is my graph of comparable swap curves.? I would post it as a picture, but my browser keeps crashing on me.

Broadly, the shape of the current swap curve if very similar to the curves in October 1992 (no 30-year swap data), February 2002, and May 2004.? What was the state of economic policy at each of those times?

  • October 1992 — FOMC policy had just reached its most generous level for that cycle, where it would stay at 3% until the speculative pressure built up from overly cheap money would rapidly change in 2004.? There was considerable doubt as to whether monetary policy would be effective, and commercial real estate was still in the tank.? The great concern should have been getting monetary policy out of boom/bust mode — letting a recession take its course, and not trying to artificially make them shorter or more shallow than they need to be to clear away bad debts.? As it was, the great monetary ease was the prelude to the bond market’s annus horribilis in 1994, together with the collapse of the negative convexity trade, and the speculation in Mexican cetes, all of which required easy money.
  • February 2002 — nearing the effective end of the loosening cycle, and panic is considerable.? Many worries over technology and industrial companies.? The stock market was going down almost every day.? European financials, overloaded with equity-linked and other risk assets, were getting crushed.? Bright spot: US banks were in good shape, as was the housing market.
  • May 2004 — the easing cycle was just about to end, and about 18 months too late, with at least 1% more easing than was needed.? The US residential housing markets are in a feeding frenzy, and clearly, the recession is long since past.? The curve was steep only because Fed policy had not budged, and the market anticipated a considerable adjustment.

Three very different situations, and different than what we face today.? The one commonality is the loose monetary policy.? Some will say monetary policy doesn’t feel loose today.? That is because the Fed funds rate is down at the zero bound, and monetary policy is being conducted through “credit easing” — using the Fed’s balance sheet to benefit troubled lending markets, rather than the economy as a whole.

The present rise in long rates is partially a repudiation of the Fed’s ability to control the long end of the curve in Treasuries, Agencies, and Mortgage rates.? The Fed is too small to achieve such a task, so once the emotional shock of their buying program wore off, the curve steepened, pushed by hedging in the residential mortgage market, once the move became great enough.

We’re in uncharted waters here, so in whatever role you play in investing, be careful.? Unusual situations beget more unusual situations.? More on this in future posts.

PS — Other posts worth perusing:

Problems with Constant Compound Interest

Problems with Constant Compound Interest

Posted on by David Merkel

This piece is an experiment.? I’m not exactly sure how this will turn out by the time I am done, so if at the end you think I blew it, please break it to me gently.

People in general don’t get compound interest, or exponential processes generally.? It is not as if they are pessimistic, they are not numerate? enough to apply the rule of 72.? (Rule of 72: For interest rates between 3 and 24%, the time it takes to double the money is approximately 72 divided by the interest rate, expressed as a whole number.)

But there is a greater problem, and it applies to the bright as well as the dull.? People don’t understand the limitations of compound interest.

Let me begin with a story: I started my career at Pacific Standard Life, a little life insurer based in Davis, California.? The universal life policieswere crediting 11-12% interest, and annuities were in the 9-10% region.? It was fueled by junk bonds.? One of my first projects was to set the factors that would give us GAAP reserves for the universal life products.? To do this, I was told to project UL account values ahead at 11-12% interest for the life of the policies.

That rate of interest doubles policy account values every six or so years.? What economic environment would it imply to sustain such a rate of interest?

  • High inflation, or
  • High opportunities, because there is little competition.

The former was a possibility, the latter not.? As it was, inflation was receding, and 1986 was the nadir for the 80s.

People buying policies would see these tremendous returns illustrated, and would buy, because they saw an easy retirement in sight.? Alas, constant compound growth rarely happens in economics.? Policyholders ended up very disappointed; Pacific Standard went insolvent in 1989, and the rump was sold off to The Hartford.

Where do we often see constant compound growth modeled in finance?

  • Asset allocation models, including simple illustrations done by financial planners
  • Life insurance sales and accounting
  • Defined benefit pension accounting
  • Long-dated debt obligations
  • Simple stock price models, like the Gordon Model, and all of its dividend discount model cousins.
  • Social finance systems, like public pensions and healthcare.

There are likely many more.? Whenever we talk about long-dated financial obligations, whether assets or liabilities, we need something simple to aid us in decision-making, because the more variables that we toss in, the harder it is for us to make reasonable comparisons.? We need to reduce calculations to single variables of yield, present values, or future retirement incomes.? Our frail minds need simple answers to aid us.

I’m not being a pure critic here, because I need simple answers also.? Knowing the yield of a long debt obligation has some value, though if that yield is high, one should ask what the is likelihood of realizing the value of? the debt.? Similarly, it would be useful to know how likely it is that one would receive a certain income in retirement.

I’m going to hit the publish button now, and pick this up in a day or so.? Until then.

“Just Gimme the Answer, Will Ya?”

“Just Gimme the Answer, Will Ya?”

Posted on by David Merkel

Half of my career, I have worked for bosses who were actuaries, and half not.? Half of my career, I worked for bosses that were intellectually curious, and half not.? There was a strong, but not perfect correlation between the two — most actuaries are intellectually curious, but there are a few that aren’t.

Those that know me well, know that I am a pragmatic idealist.? I have strong beliefs, but I also have a strong desire to solve the problem.? Where I run into difficulty is where the problem is ill-constructed, and does not admit a good answer.? Any answer would be subject to numerous qualifications and explanations.? Perhaps I can give some examples:

“What’s my illiquid structured finance bond worth?”

Oh my.? Whether residential mortgage, commercial mortgage, or asset-backed, that depends a lot upon future loss activity across the whole financial sector.? Typically I only get this question when the bond is worth little, but the entity thinks it is worth a lot, but can’t get a bid anywhere near that.? Often they have been misled by third-party pricing services doing a facile job in exchange for a fee.

“How will this equity portfolio behave versus the market?”

Ugh. Beta is unstable, and estimates often lead to erroneous conclusions.? More detailed modeling can come up with a reasonable answer, but also state that the correct beta is a weak tendency, and is swamped by other effects.

“This investment will eventually come back, right?”

No.? Most will, but not all will.? Some do go to zero, or something really close.? Mean-reversion exists in the markets, and over long time periods it is strong on average, but in specific over short horizons it does not work.

“What’s the interest rate sensitivity of this illiquid structured finance bond?”

Often there is not a good model of prepayment/extension risk.? Or, the model exists, but the security in question is dominated by credit risk.? Will that tranche pay off or not?? In such a situation, the wrong question is being asked, because interest rate risk is not the main risk.

“What’s the right spread to Treasuries for this illiquid bond?”

Sorry, but the answer will be regime-dependent, and will vary by the liquidity of the era.? During times of high liquidity, it will trade near liquid bonds of similar risk.? In times of low liquidity, it will trade far behind its liquid cousins.

What’s the right yield tradeoff between bonds of different credit quality classes?

Again, it varies.? Even across a whole cycle, there is no right answer.? Personally, I would try to estimate the likelihood, subjectively, that we would enter the other side of the cycle within the life of the asset in question.? There are boom valuations, and bust valuations, and scarce little time in-between.

“Just Gimme the Answer, Will Ya?!? I need an Answer!”

Yeah, I got it.? I’m a practical man also, but I try to understand where I can go wrong.? Process is as important as the result.? For many investors, institutional as well as retail, they don’t understand the broader environment that we are in, and they think there are these long term averages that don’t vary that much.? Just invest, and you will make good money over a 2-5 year period.

Sorry, but life is more variable than that.? Investment processes are a function of human processes.? Where humans play a game of follow-the-leader for a long time, with positive results, the cycle will be long, and the unwind severe.? Truth is, the real economy grows at a 1-3%/year rate in inflation adjusted terms, with a lot of noise, absent rampant socialism, or war on our home soil.? The result over the long term should not be much more than 2% more than bond returns, with moderate risk.

You mean there are no answers?

No, there are answers, but there are confidence bands around the answers, and the answers are subject to the overall well-being of the financial economy.? We are playing a complex game here, because the boom-bust cycle is less than predictable on average.? Thus the advantage goes to those that play with excess margin, particularly when things are running hot, and they? pull back.? It is a tough discipline to maintain, but it yields results over the long term.

I will say it this way: focus on where we are in the risk cycle, and? it will aid you in where to invest.?? As Buffett says, “Be greedy when others are fearful, and fearful when others are greedy.”

I encourage caution.? Ask what can go wrong.? Consider what a prolonged downturn in the economy would do.? If the answer is “little,” then be a man and take real risks.

Be skeptical, but don’t be paralyzed in decision-making.? Look to the long-run as a weak tendency, and realize that over many years and with moderate certainty, the trend will revert on average, buit not necessarily for individual investments.

So what should I do?

  • Keep a reserve fund of safe assets.
  • Be skeptical of short, intermediate, and long-term results, but for different reasons.
  • Resist trends during normal times, but during times of extreme movement, let it run.
  • Always consider what could go wrong.? WHat is the upside and the downside, and the likelihood of each.

There is no single formula or answer for all investment problems, but a conservative attitude, and a reasonable analysis of where we are in the risk cycle will help.

The Bump at the end of the Cycle

The Bump at the end of the Cycle

Posted on by David Merkel

I haven’t done it recently, but I begin with a bunch of my old CC posts from five years ago:


 David Merkel
Are There Buyers out There for Long Treasuries?
5/14/04 8:28 AM?ET
I have been arguing for a while that despite a record short interest in Treasury futures, liquidation of the banks leveraged long positions is a bigger factor in the market. The gentle and slow movements of this market have had an upward bias in yield, lower in price. This can be temporarily self-reinforcing, as a rise in rates causes new players to say that they can’t take the pain, and they liquidate long positions.That said, we should begin to see some relief here; the yield curve has only been this steep twice before in the last 22 years, and this is within 5 basis points of the record-wides over that period (the other times were in 1992 and 2003). I would expect buying interest to materialize below 5.00% on the 10-year Treasury note.The yield curve has already built in 125 basis points of tightening, though when it happens is up for grabs. The ultimate amount of tightening will depend on several factors, notably the level of inflation and the occurence of any macroeconomic catastrophes precipitated by the tightening. (Think of the stock market in 1987, solvency of U.S. banks in 1989, Mexico in 1994, LTCM in 1998 and the Nasdaq in 2001… U.S. housing in 2005?)Unless interrupted by a crisis, the ultimate level of tightening will require the short rate (yield on 90-day T-bills) to be at least 100 basis points less in yield than the long rate (the yield on the current long bond). The yield on the long rate will depend more on the anticipated level of inflation. The short rate chases a moving target.Final note: U.S. dollar-denominated liquidity is getting scarcer. One month ago, the yield on three-month LIBOR broke its 200-day moving average. Typically, this doesn’t bode well for financial equities in the short run. Don’t fight the Fed, at least for the first few tightenings.

No stocks mentioned

and…


 David Merkel
Gradualism means… flexibility?!
5/20/04 4:14 PM?ET
In Ben Bernanke’s speech, which is going on as I write, he gave three reasons for the Fed to move gradually:1. The Fed does not possess perfect information, so caution is warranted. The Fed learns from the reactions of the real economy and the asset markets, and adjusts its actions.
2. Gradualism gives the Fed greater control over long-term interest rates, and asset prices.
3. Gradualism reduces stress to the financial system.

I disagree with his last two points. The Fed does not have much impact on the long end of the yield curve in anything more than the short run. Long rates are affected primarily by the rate of nominal GDP growth in the intermediate term. The Fed reacts to long-term interest rates, and sets the fed funds rate relative to the long rate. Steep curves speed nominal economic activity, and flat curves slow nominal economic activity.

As to stress in the financial system, comparisons to the chinese water torture come to mind. While gradualism might be better than drastic moves, gradualism did not prevent the following blowups: bond market (early 87), stock market (late 87), real estate (89-90), Residential MBS and Mexico (94), LTCM and Asia (98), and the Nasdaq (2001-2).

Call me a skeptic, but the Fed likes to maximize its own flexibility in applying policy, and gradualism fits that bill. Crises would be better prevented if the Fed stopped trying to fine-tune the economy though over-providing liquidity.

Okay, I’m getting off my soap box now…

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Aaron Task
Soap Box
5/20/04 4:36 PM?ET
David, re. this list: bond market (early 87), stock market (late 87), real estate (89-90), Residential MBS and Mexico (94), LTCM and Asia (98), and the Nasdaq (2001-2).Save for the first 2, the rest occurred on Greenspan’s watch. The chairman is often credited for “navigating” us through such crises, but few seem to stop and think about his responsibility (direct or indirect) for their occurrence.Currently, he’s now overseeing a *possible* housing bubble (and corresponding crash in MBS markets). I can’t wait to see how he “navigates” through that.

NOT reassured by his reappointment

David Merkel
More on the Bernanke Speech
5/20/04 4:50 PM?ET
First, a quote from his speech:First, I do agree that the flare-up in inflation in the first quarter is a matter for concern, and that the inflation data bear close watching. Should the rise in inflation show signs of persisting, I am confident that the Federal Open Market Committee will adjust policy as necessary to preserve price stability. As the qualified and probabilistic language of the FOMC’s statement makes clear, the likelihood that the pace of rate normalization will be “measured” represents a forecast about the future evolution of policy, not an unconditional commitment on the part of the Committee. Although I expect policy to follow the usual gradualist pattern, the pace of tightening will of necessity respond to evolving economic conditions, particularly the strength of the ongoing recovery in the labor market and developments on the inflation front.Measured may not be as gradual as one might expect. The fed wants to keep its options open. Though Mr. Bernanke says that he wants Fed policy to be transparent to the markets, the flexibility needed to respond to changing conditions makes the predictability of Fed actions difficult over anything longer than a few months.Bernanke did give us a peek at the neutral Fed funds rate. He believes that it is 2.7% over inflation. If the Fed has an inflation target of 1-2%, that gives a neutral fed funds rate of 3.7-4.7%. He added that the neutral fed funds rate changes with economic conditions, which was another argument for gradualism.

If the Fed is eventually aiming at a 4% fed funds rate, and they do 50 basis points each time they tighten (aggressive assumption) that would augur for six tightenings, assuming that a crisis doesn’t interrupt their activities. Who is ready for six tightening moves out to the end of 2005? I think most market participants are expecting less.

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David Merkel
At Least the Price of Soap Boxes isn’t Going Up
5/20/04 5:05 PM?ET
Aaron, I agree with you. In some ways, I think Greenspan was shaped by his initial reaction to the stock market crash in 1987. He threw liquidity at the problem and it went away, or so it seemed. The banks became flush with money to lend, and they lent badly on real estate, which helped to drive the next crisis.Greenspan, having moved far from his earlier Ayn Rand-leanings, and his early devotion to the gold standard, became an inveterate policy tinkerer once in power. Do I blame him? A little; many of us do less well than we would have expected when more power comes into our hands. Greenspan is no exception there.But creating and responding to crises is not unique to Alan Greenspan. At the tight points of monetary policy, crises pop out. Here are a few more from Volcker’s term: Continental Illinois (1984), and third world debt (early 80s). There were other crises correlated with monetary policy before that, but the leverage wasn’t as high, unless you go back to the 1920s. By its very nature, tight monetary policy reveals the places in the economy that have insufficient financial flexibility. The question I have, is where that inflexibility exists today.

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Well, here we are on the other side of the interest rate cycle.? Rates are not being tightened, but rather, they have been loosened to the point where they are irrelevant.? “Credit Easing” monopolizes liquidity for the favored markets that the Fed wants to heal, while other credit markets go begging.

Monetary policy is loose, and as I have stated before, loose monetary policy typically ends in some excess, whether that excess is goods price inflation, or asset inflation, or perhaps a currency panic, where foreign creditors conclude that they will not get paid back in anything near the terms that they expected when they originally lent.

So, what might be the end of this cycle?? Here are some possibilities:

  • A slow rise of interest rates in the US, as smaller foreign central banks decide that they have better opportunities elsewhere, and stop buying additional US dollar-denominated liabilities.
  • A major global war interrupts everything, disrupting global trade and capital flows, and forcing the US to largely self-fund its obligations, all the while spending more on defense.
  • Goods inflation runs, starting with commodity prices, as the rest of the world, excluding the US and Europe, heals faster.

There are many more variations on the scenarios here, but these give an idea of the forces that may undermine the current quietude.

Thirteen Aspects to our Current Economic Situation

Thirteen Aspects to our Current Economic Situation

Posted on by David Merkel

1) Last night I started out with the concept of a “housing mismatch.”? Today, with a hat tip to Calculated Risk, I can make my case better.? The low end of the market is humming, as new buyers come in.? Makes sense.? Who get the capital together for a downpayment?? New homebuyers for homes on the lower end.? But homeowners that want to upgrade are stuck, because the buying power of the equity of their current home has deflated.? Thus few upgrading buyers, and they are typically a large part of the housing scene.? Good article — helps point out why this cycle in residential real estate may have prices drop below equilibrium levels.? We are close to equilibrium now, but nowhere near reversing.

2) How should bank solvency be regulated?? If sticking with the existing model, the bank examiners must be more rigorous, and they should consider some stressful scenarios, such as we are experiencing now, or worse.? Perhaps a market-based solution would help, such as that which former Fed Governor Poole has proposed.

His objective is the toobig to fail institutions, but he says that all banks would have to issue subordinated debt.? This would be difficult to implement for small banks. Small issue sizes in the debt market are tough to place, and rolling over 1% each year makes the sizes smaller still. The sub debt would have to be at the operating bank subsidiaries, which are smaller than the holding companies.

I like the idea, though. Maybe a market would develop for small bank sub debt? maybe even funds specializing in it. The yields could be significant, and even protected to some degree, given the need to roll it over to stay operating.

That said, loss incidence might be infrequent, but loss severity and correlation would be high. That?s true of losses on unsecured financial debt generally, but it would be worse with sub debt.

This idea is not new, but it is worth a try. The financial analysis of banks by regulators who have little economic incentive to be right, and hampered by politics has not worked well. It would be replaced by profit-seeking analysts who do have an incentive in the health of the bank in question.

3) Given the fall in global trade, export-driven nations are getting hit hard.? Maybe that can help explain why Treasuries are selling off on the long end — aside from excess supply due to the humongous deficit, there is less need to recycle excess dollars by buying Treasuries.

4) Okay, I was wrong about the Indiana Pension System winning in the short run regarding secured Chrysler debt.? Given the time pressures, the suit was rejected.? Maybe they will win on appeal, but how that works out after the deal is done is messy.

5) GM bondholders have rejected a settlement, and so the company will likely go through chapter 11.? I do not get the large amount of financing that the US government is putting up.? What? Do they want to repeat the losses they will experience through AIG?

6) With the shrinkage in market capitalizations, the number of sell side analysts declines.? No surprise here.? The number of sell side analysts is proportional to the money that can be made by investment banks off of underwriting and trading.? As market capitalizations fall, so do revenues for investment banks.

7) Yesterday, I said that if California defaulted, we would face a constitutional crisis.? I still think that is true.? I ran across Felix’s thoughts on the matter today, though they are one month dated.? The upshot to me is that there are no ways of enforcing payment if a state won’t pay on their municipal debts.? This is a hole in the system, and one that could pinch many in the US, not just Californians.

8 ) Federal Reserve Transparency act of 2009?? Bring it on.? Yea, Ron Paul, one of the few economically literate memebers of Congress.? The Fed gets away with a lot because they aren’t purely private or public.? They use their dual status to hide — when it is more useful to be a government institution, they are that.? Vice versa, when being private allows the avoidance of FOIAs.

9) This is one long article.? How sunk are we regarding peak oil/hydrocarbons?? I have revised my estimates of oil production downward, and will buy more energy related stocks at my next rebalancing.

10) Though I am not a dollar bull, there is no easy replacement for the US Dollar on the global scene.? Euro, too experimental.? Yen, too small.? I have not advocated that the Chinese currency could replace the Dollar (as some have), because their economy would have to become far more open.? They aren’t willing to do that.

11) It’s tough being a corporate director. 😉 No, it’s altogether too easy, which leads to complacency.? Consider the situation at the banks, or at the FHLBs.? Years of leverage expansion, where the livin’ was easy, made them lazy, and unwilling to challenge their managements.? No surprise that their reasons for existence are being chalenged now.

12) Though Samuelson misses the point that trust fund exhaustion is not the trouble point, his article is a welcome addition to the discussion.? Time is not on the side of the social insurance programs of the US Government, but as I have stated, that trouble comes when revenues are less than expenses, because the trust funds, invested in Treasuries, are a farce.? The only way the US government can pay off on those is through taxation, borrowing, or inflation.

13) What are implied breakeven levels of inflation implying from TIPS?? That many people fear that inflation will run out of control, given the reckless actions of the Fed and the US Government.

Fifteen Notes on our Current Economic Situation

Fifteen Notes on our Current Economic Situation

Posted on by David Merkel

1) I don’t think that residential real estate prices are turning in general.? But even if residential housing recovers, and demand returns, there will be a “housing mismatch.”? There will be too many high end homes relative to buyers.? Financing for high end homes is sparse, and too many expensive homes were built during the boom years.

2) Inflation.? What a debate.? In the short-run, deflationary pressures are favored, but what can you expect when so many dollar claims are being created by the Fed?? The output gap may indicate inflation is impossible, but stagflation is possible when monetary policy exceeds the need for dollar claims amid a collapsing economy, as in the 70s.

3) At the time, I suggested that the banks forced to take TARP funds had been coerced because the regulations could be lightly or tightly enforced.? Looks like that was true.? Why does this matter?? The TARP was supposed to be stigma-free because all major banks were taking it.? Coercion should make the government more lenient on payback terms.

4) I never did all that much with the cramdown that the Obama administration did with Chrysler secured creditors.? All that said:

5) Can global trade patterns be changed to avoid the dollar?? Some are trying.? In the long run, if the US is only a capital importer, the US Dollar will lose its reserve status, and weaken considerably.

6) Union jobs are magic.? They provide these incredible benefits, but with one small problem: they kill the companies that are forced into them.? GM may be sold to the government, but unless the burden of total compensation being above productivity is lifted, there will be no substantive change.

7) Dilution.? I was never a fan of McClatchy, but this seals the story on the newspapers.? Sell equity interests cheaply, so that you can survive.? The same is happening with many banks, and it is forcing the share prices of the industry lower.

8 ) Commercial real esate is the final shoe to drop in our credit bust.? Prices are 20% below the peak.? Refinancing will prove tough.? There are no sectors in commercial real estate that are not overbuilt.

9) The PBGC is taking its share? of losses at present.? This is no surprise here, given all I wrote about the PBGC at RealMoney.? The losses on a market value basis are even greater, because firms with underfunded pensions are more likely to default.

10) Residential real estate has not stabilized yet.? The bottom will come after the resets on Alt-A lending.

11) Are there difficulties with lending in the farm belt?? To a greater degree than I expected, yes.

12) Will California survive?? We can only hope.? Given that there is no bankruptcy code for states, California could prompt a Constitutional crisis if it defaults.

13) Should the Fed regulate systemic risk?? Perhaps when it stops creating it.? My position was, and continues to be that the Fed has been incompetent with monetary policy, bringing us to where we are today.? We need to eliminate the Fed and its bureaucracy, which produces little value for the US.? Monetary policy could be conducted with a far smaller staff; it might even be better.? Remember, bureaucries hit economies of scale rather rapidly.? Small is beautiful with bureaucracies.

14) In the recent slowdown, there has been inventory decumulation.? Those at the end of the supply chain have been hit the hardest.? Welcome to the cyclical world when it has to slow down.? The tail always gets it the worst in a game of “crack-the-whip.”

15) Ending with inflation, John Hussmann makes the case that the current economic policy must result in inflation.? If you are reading this, John, given that we live in the same city, perhaps we could have lunch someday?

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