Here are two articles to read on risk parity:

Pro: Pick Your Poison

Con: The Hidden Risks of Risk Parity Portfolios

I’m on the “con” side of this argument, because I am a risk manager, and have traded a large portfolio of complex bonds.  For additional support consider my article Risks, Not Risk.  Or read the second half of my article, “The Education of a Corporate Bond Manager, Part X.” There is no generic risk in the markets.  There are many risks.  Interest rate risk and credit risk are different topics.   There are bonds that have interest rate risk but not credit risk — long Treasuries.  There are bonds that have credit risk but not interest rate risk — corporate floating rate notes, my favorite example being floating rate bank trust preferred securities.

It is not raw price volatility that drives investment results as much as the underlying drivers of the volatility.  For fixed income, I described those in the two articles linked in the last paragraph.  During non-credit-stressed times, a bank’s 30-year floating rate trust preferred security is roughly as volatile as a five-year noncallable bond that it issues.  But during times of credit stress, the first security becomes volatile, whereas the second one doesn’t.  The first moves in line with 30-year swap yields, LIBOR, and long junior bank spreads.  The second moves in line with 5-year Treasury yields, and short senior bank spreads.  The underlying drivers have little in common, and when things are calm, their volatilities are similar, because the drivers aren’t moving.  But when the drivers move, which in this case is one correlated driver, credit stress (30-year swap & junior bank spreads go a lot higher), the volatilities are very different, the first one being high and the second one low.

Thus equating volatilities across a bunch of asset subclasses, investing less in the volatile, and levering up the non-volatile, is hard to do.  History embeds all the curiosities of the study period, and calls them normal, and that past is prologue.

From the Pick Your Poison article above, what I think is the (lose) money quote:

Gundlach insists most money managers misunderstand junk bonds, comparing them to 5-year Treasurys to determine how rich their yields are, when the correct comparison should be to 30-year Treasurys.

How can Gundlach compare junk bonds, which do better when the economy heats up, with long-term Treasurys, which get killed when the economy revs up and the Fed raises interest rates?

That’s irrelevant, he responds. The thing to look at is volatility, because that tells you the odds you will have to sell at a loss when you need to raise cash in an emergency. On that basis, junk bonds that were trading at a seemingly reasonable spread of 5 percentage points, or 500 basis points, to 5-year Treasurys in mid-2011 were actually trading at an intolerably low 250-basis-point spread to the proper bond. (By then DoubleLine had cut its junk bond allocation from 10% to 1%.) Sure enough, junk fell 12% as the year went on, and the spread to 30-year Treasurys has doubled since mid-2011.

“It’s called risk parity,” Gundlach says. “There’s only two investors who seem to understand it—me and Ray Dalio,” the highly successful manager of $122 billion (assets) Bridgewater Associates.

Personally, I don’t think Gundlach makes his money that way for his funds, but in case he does, how should a good bond manager view junk bonds?

First, ignore Treasuries — they aren’t relevant to the price performance of junk bonds.  I’ve run the regression of Treasuries vs junk bond index yields many times.  It’s barely significant for BBs, and insignificant thereafter.  Second, look at stock market indexes of industries that lever up and issue junk debt.  Junk corporate debt is a milder version of junk stocks, i.e., the stocks that issue junk debt.

Third, a corollary of my first reason, realize that risks with junk aren’t driven by spreads, but yields.  With highly levered, or very junior debt, it does not trade on a spread basis, but on a price basis.  Anyone looking at spreads will see too much volatility versus yields and prices.

But mere volatility won’t tell you the riskiness.  Indeed, when economic times are good, junk will do well, and long Treasuries do poorly.  Now, maybe that makes for a very noisy hedge, but I wouldn’t rely on it.

And, volatility is a symmetric measure, which as bond yields get closer to zero, the symmetry disappears.  Most asset classes display negative skew and fat tails, which also makes volatility problematic as a risk measure.

Going back to my first piece on the topic, if I were applying risk parity to a bond portfolio, it would mean that I would have to buy considerably more of shorter and higher quality instruments, and lever them up to my target volatility level, somehow with spreads large enough that they overcome my financing costs.  Now, maybe I could do that with mispriced mortgage securities, but with the problem that those aren’t the most liquid beasties, particularly not in a crisis if real estate is weak.

I guess my main misgiving is that levered portfolios are path-dependent, as pointed out in the GMO piece above.  You can’t be certain that you will be able to ride through the storm.  The ability to finance short-term disappears at the time it is most needed.

Now, if you can get leverage after the bust, and invest in beaten-up asset classes, you can be a hero.  But that’s a time when only the most solvent can get leverage, so plan ahead, if that’s the strategy.  If an investor could consistently time the liquidity/credit cycle, he could make a lot of money.

As the GMO piece concludes, the only benchmark that everyone could hold would be a proportionate slice of all of the assets in the world, which implicitly, would strip out all of the leverage, because one would own both the shares of the company, and the debt it owes, and in the right proportion.

So I don’t see risk parity as a silver bullet for asset allocation.  I think it will become more problematic, as all strategies do, as more people show up and use it, which is happening now.   First in the hands of the master, last in the hands of a sorcerer’s apprentice.  Be careful.

PS — I have respect for the skills of Gundlach and Dalio.  I’m just skeptical about what happens to risk parity when too many use it, and use it without understanding its limitations.  And, here is a nice little piece about Bridgewater and its strategies.

Comments

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

Questions for Dr. Bernanke:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My main industry model is illustrated in the graphic.  Green industries are cold.  Red industries are hot.  If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”  Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.  Yes, things are bad, but are they all that bad?  Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

If you use any of this, choose what you use off of your own trading style.  If you trade frequently, stay in the red zone.  Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?  Why change if things are working well?  I’m not saying to change if things are working well.  I’m saying don’t change if things are working badly.  Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.  Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.  This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.  It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology names here, some energy some healthcare-related names, P&C Insurance and Reinsurance, particularly those that are strongly capitalized.  I’m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

A word on banks and REITs: the credit cycle has not been repealed, and there are still issues unresolved from the last cycle — I am not interested there even at present levels.  The modest unwind currently happening in the credit markets, if it expands, would imply significant issues for banks and their “regulators.”

I’m looking for undervalued and stable industries.  I’m not saying that there is always a bull market out there, and I will find it for you.  But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.  I don’t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.  The red zone is pretty cyclical at present.  I will be very happy hanging out in dull stocks for a while.

P&C Insurers and Reinsurers Look Cheap

After the heavy disaster year of 2011, P&C insurers and reinsurers look cheap.  Many trade below tangible book, and at single-digit P/Es, which has always been a strong area for me, if the companies are well-capitalized, which they are.

I already own a spread of well-run, inexpensive P&C insurers & reinsurers.  Would I increase the overweight here?  Yes, I might, because I view the group as absolutely cheap; it could make me money even in a down market.  Now, I would do my series of analyses such that I would be happy with the reserving and the investing policies of each insurer, but after that, I would be willing to add to my holdings.

Do your own due diligence on this, because I am often wrong.  One more note, I am still not tempted by banks or real estate related stocks.  I am beginning to wonder when the right time to buy them as a sector is.  As for that, I am open to advice.

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

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

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

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

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

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

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

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

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

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

What could be better?

What I write here will not be rigorous.  We’ve heard about “peak oil.”  We’ve heard about other resources, and how production will decline over time.

But what of credit? It isn’t that hard to create, but it is hard to create well, particularly when debt levels are high, as in this environment.

It’s not just the US, debtor-friendly as it has been for most of its existence.  Most of the rest of the world has debt problems.

China has indebted municipalities and banks, and debts to many projects from Party members that will not pay off.  The EU is  overly indebted everywhere, not just the PIIGS, and finds its overall borrowing rates rising as lenders wonder what a Euro will be worth if the Eurozone dies.

In the US, government debt rises more than corporate and consumer debt falls.  We’ll pay the government debt off later.  Don’t worry.

The simple solution to every problem is to say the it is a liquidity problem, not a solvency problem.  How do does one solve a liquidity problem?  Get a loan.  If the assets are really worth more than the liabilities, there should be some unencumbered assets that you can secure a loan with, and pay off the liquidity squeeze.  But absent that, it’s insolvency, regardless of what notional price one places on the assets.

But what if the problem is really a solvency problem?  Will a loan help cure that? No.  You can’t solve a debt problem with debt.

There are generally few liquidity problems relative to solvency problems.  As an example, most corporate bonds don’t default on principal payments, but on interest payments.  For individuals, balloon payments on loans might be relatively more of a problem, but since most people finance their homes, etc., on relatively thin ratios of income to debt service, interruptions of income lead to insolvency more often than balloon payments.

Consider for a moment that every liability is the asset of someone else, but not vice-versa, because some assets are owned free and clear.  Now pretend that we take everything in the world (the same could be applied to a nation), and put it on a single balance sheet, but we don’t net out the liabilities that would cancel out.

Which system would be more stable?  One where the liabilities are roughly equal to the net worth, or one where they are roughly five times the net worth?  The former, of course.  Now, not all liabilities are the same — long-dated claims like pensions only claim a little bit of the assets of the world at a time, whereas a large number of short-dated liabilities would make the system less stable, or perhaps lead to inflation.  Many dollars chasing few goods, or assets, or both.

I’m not sure exactly where the boundary line is for “peak credit.”  It would depend on the structure of the liabilities in question.  But once the fuzzy limits get exceeded:

• Growth can slow.  (Think of the book, “It’s Different This Time.”)
• Debt deflation may arrive. (Extend, Compromise, Default)
• Inflation may arrive for assets, goods, or both, depending on the propensity to save versus consume.
• And, if the debt gets high enough, and immediate enough, any entity may hit the “tipping point” where the market concludes that it is no longer possible for the entity to pay off its debts.  Short-term rates skyrocket, and the prices on long debt discount expected recovery levels.  For countries with their own currency, it may involve a lot of inflation, though a negotiation with creditors might be simpler.

In general, if we were starting over again, there are a lot of things that we should have done differently:

• Dividends would be deductible, and not interest.
• This would apply to all personal and corporate interest, including mortgages.
• We would eliminate the GSEs, and all government lending programs.
• We would run balanced budgets as a nation, and live with the modest volatility that induces.  We would not engage in fiscal stimulus.
• We would eliminate or constrain the Fed, such that it could never let the difference between ten and two year Treasury yields exceed 1.5%, or be less than -0.5%.  We would let recessions do their work of eliminating bad investments, because if you don’t, you end up with the debt deflation we are facing now.
• Or, go back to a gold standard, after analyzing what the proper value for the dollar would be, so as to avoid inflation or deflation.
• We would constrain banks to match assets and liabilities, and not engage in maturity transformation.

Banks would be a lot less profitable under such an arrangement, but it would prevent debt bubbles.  Besides, the banks would make up for it by charging for deposit/checking accounts.

Summary

We may be near “peak credit” at present, and that is true of much of the world.  Better we should have had a smaller financial sector, and avoided the financialization of the economy.  As it is, we face many years of slower growth ahead as we bleed debt out of the economy, or a number of years of inflation ahead, as we inflate away debts.  I suspect the former, but I can’t ignore the latter.

Comments

• The more I read the Fed statements, the more I think that they are paid to be Pollyannas.  The rose-colored glasses are glued to their faces.  There is never any criticism of their actions; blame always goes elsewhere.  They are similar to modern teenagers that lack talent, but have incredible self-esteem.
• GDP growth is not improving much if at all, and the unemployment rate improvement comes more from discouraged workers.  Inflation has not moderated significantly, either.
• They point to the risks coming from global financial markets.  The Fed is the lead regulator in the US of banks and SIFIs; if trouble abroad leads to trouble here, they have no one to blame but themselves.
• In my opinion, I don’t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located.
• Also, the reinvestment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government, even with the recently announced refinancing changes.
• The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent increases in employment, or a US Dollar crisis.  Labor employment is the key metric.
• The Fed is out of good policy tools, so it will use bad policy tools instead.

Questions for Dr. Bernanke:

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

I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My main industry model is illustrated in the graphic.  Green industries are cold.  Red industries are hot.  If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”  Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.  Yes, things are bad, but are they all that bad?  Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

If you use any of this, choose what you use off of your own trading style.  If you trade frequently, stay in the red zone.  Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?  Why change if things are working well?  I’m not saying to change if things are working well.  I’m saying don’t change if things are working badly.  Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.  Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.  This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.  It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology names here, some energy some healthcare-related names, P&C Insurance and to a lesser extent Reinsurance, particularly those that are strongly capitalized.  I’m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

A word on banks and REITs: the credit cycle has not been repealed, and there are still issues unresolved from the last cycle — I am not interested there even at present levels.  The modest unwind currently happening in the credit markets, if it expands, would imply significant issues for banks and their “regulators.”

I’m looking for undervalued and stable industries.  I’m not saying that there is always a bull market out there, and I will find it for you.  But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.  I don’t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.  The red zone is pretty cyclical at present.  I will be very happy hanging out in dull stocks for a while.

P&C Insurers Look Cheap

After the heavy disaster year of 2011, P&C insurers and reinsurers look cheap.  Many trade below tangible book, and at single-digit P/Es, which has always been a strong area for me, if the companies are well-capitalized, which they are.

I already own a spread of well-run, inexpensive P&C insurers & reinsurers.  Would I increase the overweight here?  Yes, I might, because I view the group as absolutely cheap; it could make me money even in a down market.  Now, I would do my series of analyses such that I would be happy with the reserving and the investing policies of each insurer, but after that, I would be willing to add to my holdings.

Do your own due diligence on this, because I am often wrong.  One more note, I am still not tempted by banks or real estate related stocks.  I am beginning to wonder when the right time to buy them as a sector is.  As for that, I am open to advice.

There is a benefit to reading books on marketing for those that will never be marketers: it will immunize you to sales pitches.  Think of it as studying the strategies of the enemy.  When you talk to salesmen, you can flip their words back at them, or tell them “no,” to the questions that have a guaranteed “yes” attached to them.  Better, if you want, you can tell them, “Stop. I know your tactics.  Cease the sales language and answer these questions I have…” Maybe they will cease.  If not, leave.  There are many places to buy, and some people that will listen to you elsewhere.

Some weeks ago, I was traveling, and heard an ad for a “financial seminar.”  This one sounded better than most, and featured the teachings of a well-known writer.  For fun, I signed up for the free seminar, just to see what would happen.

In reading what little I had before the seminar, I concluded that the only way of doing what they claimed was private ownership of high cash flow properties or businesses.  When I went to the seminar, I was not disappointed — that was the main idea.  Secondarily, they said you could get non-recourse financing easily, or equity limited partnerships to finance you.  (Money grows on trees…)

The first problem is this: mispriced properties are few and far between, and there is competition to buy them, generally.  Second, financing for property investment is scarce, especially for anything where the lender has no recourse to the borrower.

Passive Income

Passive income is an idol in these shows.  It seems like free money, but in practice it is difficult for investors to buy properties cheaply, finance them, and get rents that are far higher.

If it were that easy, they would create a REIT and do it themselves.  I asked the presenter at the end of the presentation: “If there are that many high cash flow properties available, why doesn’t a REIT buy them?  After all, they can finance more cheaply than you.”  Response: “What’s a REIT?”

That’s more than the wrong answer; it means you don’t know what you are doing.

Tactics

There was a lot of framing going on.  The package was worth $5000, but we have a special offer for $600.  Today for you?  $200.  After some people leave — “Yes, $200, but your spouse can some too.”  Oh and if you buy today, we’ll throw in these extras…

I suspect there were shills in the audience, who went back to buy.  I looked back several times, and estimated that 50-60 out of 200 went back to buy.  At the end, only 30 remained to hear the ending advice.

Regardless, the gross revenue of the day was around $6000, which supposedly covered only the cost of the presenter and the hotel room.  I have my doubts.

Other  Notes

Twice the presenter mentioned that the company that the author worked with was publicly traded.  Well, sort of, it deregistered in Spring 2011, and the company is worth less than $10 million today as it trades on the pinks.  What can you say for a company with a negative net worth, normally negative income, and very low trading volume?  (Leave aside the lawsuits…)

The presenter appealed to Buffett on not diversifying, but Buffett tells average investor that they are best invested in mutual funds.  Being undiversified carries with it the idea hat one is incredibly smart, and able to do far better then the averages.

The reason that they put forth a private market strategy is that it can’t be falsified.  That is the great thing about selling people on investing in real estate.  There is no way to put forth an audited track record.  You can tell anecdotes, and people buy your educational materials.

Summary

Be skeptical.  Nothing good is easy.  Anything advertised in investing can’t be that good.  I knew this, and my experience proved it as I reviewed the charlatans.

I wrote about the thoughts of others Wednesday as I took notes on their talks.  I don’t type that fast, so my notes gives synopses of the talks given.

Now for my own thoughts.  I have a sympathy for anyone that wants to take monetary policy out of the hands of the government, because they don’t do it well.  Some sort of hard money standard is necessary, whether gold, silver, or a commodity basket.

Ideals

I have one major ideal here, and I don’t care as much how it is accomplished: get the government out of the monetary policy business.  My secondary ideal is regulating banks properly.

A gold standard could do the job, but I am not wedded to the idea.  Gold standards can be inflationary or deflationary.  It depends on the price at which you link the currency to gold.  Post-WWI, Britain pegged it too high, and got deflation.  France pegged it too low and got inflation. Getting the right level would be important.  Fortunately, we know where it trades now relative to the dollar, and that would be pretty close to the right level, if the stated gold levels of the Fed and the Treasury are accurate.

Practical

A full audit of the Fed is a minimum, as is an audit of the gold at Fort Knox.  Do it once, so that all doubts can be dispelled.

I think that bank regulation for leverage and asset-liability management is more critical than monetary policy itself. Banking crises stem from inadequate asset-liability management.  As James Grant pointed out from the historical example that he gave, deposits should back only self-liquidating assets.  Longer term assets must be backed by matching funding, or equity.

Unseasoned asset classes (i.e., asset classes for which we have no real loss statistics because they have never had failure as a group) should be disallowed as investments for banks except against surplus.  After that, risk based capital should be based off of strict actuarial studies, with a significant provision against adverse deviation, and no credit for diversification.  And, don’t allow banks to score their own riskiness, a la Basel.  That is ridiculous; the fox guards the henhouse.  If a bank has superior risk control, they will earn the results over time; they should not as a result lever up more.

Now, I really don’t care if it makes banks unprofitable, or earn less than their cost of capital.  In that case, we will get fewer banks, the margins of the remainder will rise, and you end up with a genuinely stable system with occasional bank failures that don’t threaten the system as a whole.

There was one idea that I thought could be put into practice immediately, Treasury Trust Bonds optionally backed by gold.  If nothing else, like TIPS, it would give the Fed another indicator on how credible their monetary policy is.

Conference Zeitgeist

The Taylor Rule got some respect.  Many suggested that if it had been followed, we would not have gotten into this crisis.  I’m a little less optimistic there, because bank regulation was co-opted allowing for too much risk to be taken relative to liquidity and capital.

Most felt that the Fed was the major player in causing the crisis, with the GSEs playing a lesser role.  The overpromotion of home ownership, and the constant provision of liquidity to the markets led borrowers to become reckless amid asset price inflation.

Incentives also played a role. Managerial and shareholder liability at banks would help prevent reckless behavior.  Wall Street worked better when it was a bunch of partnerships, rather than limited liability corporations.

Most thought that things are worse now than the ’70s.  The debt levels are higher, which makes demand punk, and businessman more skittish to expand and hire.  Government policy is less predictable as well.

The speakers largely expect more inflation; more debt monetization is the path of least resistance.  Politicians get what they want without a vote being taken.  On the question of where to invest, everyone was an inflationist.  Gold, silver, TBT, were trotted out.  Personally, I’ll stick with my stock investing.

People

Jeffrey Lacker showed courage in coming to the conference.  He made a really good point that the Fed should focus on its liability policies, and limit itself to investing in Treasuries.  The Fed gets bad press and popular dislike when it uses its assets for special lending programs and bailouts, leading to charges of favoritism.

Zoellick was a reasonable guy regarding the problems in the Eurozone.  Germany has to figure out what it wants.  To me, it boils down to this:

1. You can have a suboptimal euro that is not a good store of value, and bail less well-disciplined governments out via the ECB sucking in their debts, or,
2. You can have a smaller Eurozone en route to no Eurozone, or,
3. You can have a Federal Europe, and dissolve Germany into Europe as a state of the whole, as the 13 colonies did after the Articles of Confederation.

Personally, I would choose #2, because people in Europe identify themselves with their nations, not as Europeans.  Political and economic systems must derive from cultural systems or they will not work in the long haul.

It was fun seeing my old professor, Dr. Steven Hanke.  I reminded him of nine years earlier, when he gave a talk to the (then called) Baltimore Security Analysts Society, and we discussed why we thought the Euro would have a tough time surviving.  Most of that discussion is now taking place.

Ron Paul was Ron Paul.  He doesn’t change much — that’s one of his apolitical virtues.

John A. Allison was entertaining; he argued that capital levels are too low, and regulation too high.  He thinks that you can’t expect much, and don’t get much from regulation.  Especially interesting were the discrimination in lending allegations by the regulators that BB&T fought and won twice.

Conferences like this attract cranks.  Lots of people with odd political agendas hoping to get noticed, others with odd business propositions.

Other

As a final note, the concept of free banking and/or competitive currency issuance, I think invites more problems than it solves.  Think of it this way: people aren’t very good at evaluating financial promises.  The fewer the better, and the lower level of complexity, the better as well.  There has to be some monitoring of financial promises, some intelligent regulation of banks, or things can go badly wrong.  US history backs such an idea up, regardless of whether we have a gold-, silver-, or commodity-backed currency, or a fiat currency as we do now.

Update — thanks to Eddy Elfenbein for catching a typo/thoughtless mistake in paragraph 4.  For France, it was inflation, not deflation.