Jake at Econompic Data had a good post on credit and equity.  (He runs a good site generally.)  They are correlated, but not all of the time.  As I commented:

When yields are low, equities thrive because financing costs are low.

When the defaults come, future equity returns are low, because financing rates rise, killing some and wounding others.

When yield spreads are very high, future equity returns are high, because returns come as spreads tighten.

You can see more on pages 14-22 of this presentation that I gave:

http://alephblog.com/wp-content/uploads/2009/11/SEAC_Presentation.pdf

Though I promised some posts after my presentation to the Southeastern Actuaries Conference, I never followed up.  Here is part of my belated follow-up.

As I noted in my presentation:

• Credit and equity returns are closely correlated in bear markets.
• Illiquidity events become more common when equity prices are falling, and credit spreads rising.
• Complexity and structure raise illiquidity during crises.
• Bonds with negative credit optionality underperform in a crisis.

I would add that credit and equity returns are closely correlated coming out of a crisis as well.  But here are some examples, starting with 2007-2009

and then 1999-2004:

and then 1989-1993:

and then 1980-1983:

and then 1969-1975:

Finally, 1927-1944:

What I concluded:

• Credit booms are different – equities rise, while credit spreads stay low and stable.
• There are sometimes exceptions when selloffs are sharp, like 1987 or 1998.
• Ignore what the government says. It is impossible to eliminate the boom-bust cycle. The best a good businessman can do is try to understand where he is in the cycle, and be prepared.
• Building liquidity looks dumb after credit spreads have been tight for a few years, but can save a lot of performance. The same is true of an “up in credit trade.”
• During the bust phase, illiquid companies and investments get whacked. It is often good to “leg into” such investments during the panic. This is when credit analysis really pays off, because during the panic, everything gets hit.
• Equity risk shows up in insurance lines of business like Surety, D&O, E&O, Mortgage, Financial, etc.
• If you have equity risk in your liabilities, reduce credit risk in your assets. Same is true if you need to regularly buy equity options. When implied option volatility rises, credit spreads tend to rise as well.

Notes:

There are few corporate yield series that date prior to 1990.  Until computers became powerful enough, bonds traded on a dollar price basis, and yields, much less spreads, were not comprehensively recorded.  One of the few corporate yield series with a long history is Moody’s Corporate Bond Indexes, which goes back to 1919.  There are some oddities to that index, but there aren’t many choices if you go back a long way.  It composed of bonds in a given ratings category, 20-30 years long, unweighted average on yields.  The averages tend to yield more than most bond managers that I have talked with think they can get.

My credit spread variable was the yield on the Baa series less that on the Aaa series.  I think it is a really good proxy for credit conditions and overall market volatility.

Anyway, this was part of a talk that I gave to the Southeastern Actuaries Conference.  I’ll do a few more posts from that, but if you want to look at the report, you can find it here.

Unlike most people who analyze investments, I think there are periods of time where domestic long-only investors may be consigned to low or even negative returns.  As investors, we are generally optimists; we don’t like can’t win situations like the Kobayashi Maru.

When money market funds offer near-zero yields, asset allocation becomes complicated.  Near the beginning of such a period, it might pay to take a lot of risk when credit spreads are wide.  But when they are more narrow, but wide by historic standards, the question is tough.

I start analyses like this the way I do the the piece Risks, not Risk.  I look at the individual risks and ask whether they are overpriced or underpriced.  Here is my current assessment:

• Equities — slightly undervalued at present, particularly high quality stocks.  (US and foreign)
• Credit — Investment grade credit and high yield are fairly valued at present.
  
• Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties.  There will be more defaults, both in commercial and residential.
• Yield Curve — Steep.  It is reasonable to lend long, so long as inflation does not take off.
• Inflation — Low, but future inflation is probably underestimated.
• Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
• Commodities — the global economy is not running that hot now.  There will be pressures on resources in the future, but that seems to be a way off.
• Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

All that said, for retail investors, I am not crazy about the options at present.  I would leave more in money market funds than most would as a part of capital preservation.  I would also invest in high quality dividend-paying stocks, because they are undervalued relative to BBB corporates.

Beyond that, I would consider fixed income investments in the Canadian and Australian Dollars.  I am skittish about the US Dollar, Euro, Pound, Yen and Swiss Franc.  (The least of those worries is the US Dollar itself.)

We live in a world where risk is often not fairly rewarded at present, due to the liquidity trap that the major central banks have enter into.  My view here is to play it safe when conditions are not crazy bad, and take a lot of risk whe credit markets are in the tank.

As for now, I would hold high quality US stocks that pay dividends, US money market funds, and Canadian and Australian short term bond funds.  Commodities and companies that produce them should play a small role as well.

Okay, here is tonight’s rule:

The assumption of normality for asset price changes is wrong in virtually every financial market setting.  The proper distributions are fatter tailed and more negatively skewed.

Normality allows researchers to publish, regardless of the truth.

Normality allows risk managers and regulators to pretend that adequate reserves are held against disaster.  It also allows businessmen to achieve acceptable ROEs, while accepting a probability of ruin far in excess of what is prudent.

The normal distribution is a wonderful creation, because it is so simple.  All we need to know is the mean and the variance, which are very simple to calculate.  And… it seems close to fitting a large number of phenomena in nature where the behavior of one party does not affect the behavior of others.

But in economics and finance, the assumption of normality is perpetually violated.  I would guess that it is wrong more often than it is right.  Academics continue to drag out studies assuming normality because it allows them to publish.  academics get statistically significant results more often than they should, because they pursue specification searches, and get to results that they can publish via data mining (and ARIMA error terms — unless there is an a priori reason them, they facilitate specification searches).

And, lest I be accused of being merely biased against academics, this biases me against many businessmen as well.  Many bankers looked at their loss distributions over the prior 25 years in 2007, and assumed that risks were minuscule.  Yes, there were bad periods, but the Fed always rode to the rescue, and losses were low, aside from a few egregious offenders.

Bankers concluded that they could do no wrong, and underwriting suffered.  Rather than looking at more objective measures of risk, bank managements looked at the need to hit their earnings estimates.  Losses had not been large in the past, so the future should be equally good.

When I was a risk manager, I would look at the level of surplus, and would compare it to expected normalized annual losses — if I didn’t have at least 15x normalized annual losses, then I knew I could not survive a reasonably normal spike in defaults at the bottom of the credit cycle, though an assumption of normality, where losses don’t come in bunches, would have allowed me to lever up more.

And I have known my share of management teams that pushed at the risk manager, telling him he was too conservative.  The company couldn’t earn an adequate return on capital at such low levels of leverage.  Equity analysts expected constant growth out of financial stocks, which sadly are cyclical stocks — it is a mature industry, and mature industries are cyclical by nature.  So they added more leverage, and things worked well for a while, until things blew up.

So long as consumers felt that they could add more debt, the bet could go on, with occasional minor interruptions while the Fed mopped up the damage.  But that stopped when the Fed could not drop rates below zero.  Still, the Fed found new ways to subsidize the debts of privileged parties, by buying up their long term debts and holding them.

Look, if you want to regulate properly, you can’t rely on normality.  It does not work in finance and economics.  When looking at loss statistics, don’t look at the mean or the variance.  Instead look at the maximum 3-year loss, and gross it up by 20%.  The surplus of a company should be able to absorb the maximum amount of losses from 3 years, and then some.  I use this as an example rule; tailor it to your needs as you see best.  I used 3 years because the bust phase of when the credit cycle is rarely severe for more than 3 years in a row.

If you want to manage risk internally properly you should think similarly — look at the outliers, and ask whether you can survive something worse than that.  Here’s a personal example: if someone had come to me two months ago and asked me how likely it would be that my area near Baltimore could get 60+ inches of snow in a one week time span, I would have said, “That’s not impossible, but that is way beyond the prior record, which I think is around 30+ inches.  Very unlikely.”  Well, it happened, and five weeks of warmer weather later, my backyard is still half covered by snow.

Markets, like the weather, are far more variable than we would like to admit, and attempts to tame them often lead to suppressed volatility for a time, but with explosions of volatility later, as economic actors begin to presume upon the low volatility as their birthright, and begin to speculate more aggressively, building up progressively more leverage as they go.

So when analyzing risk look at the worst possible outcomes, and build a plan that can handle that.  Size your leverage to reflect that; in a really risky business, you might have no leverage, and extra bits of slack capital in high-quality short-term debt claims.

Finally, remember my analogy of bicycle versus table stability.  A bicycle has to keep on moving to stay upright. A table does not have to move to stay upright, and only a severe event will upend a large table.

I developed this analogy back when I was a corporate bond manager, because there were some companies that would only stay afloat if they kept moving, i.e., if operating cash flow continued at its projected pace. That is bicycle stability; they have to keep pedaling. There were other companies that could survive a setback in earnings, and even lose money for a time, and the debt would still be good. That is table stability.

This is why stress-testing beats value-at-risk in a crisis, and why the insurers came through the crisis so much better than the banks.  When liquidity disappears, strategies that require continued liquidity can cause their companies to disappear.

Better safe than sorry.  Banks should run their businesses using stress tests that will cause them to have lower ROEs because of the additional capital needed to assure solvency.  The regulations have been too loose for too long.

Dear readers, I am now on Twitter — AlephBlog is my moniker if you want to follow me.

I have been somewhat reluctant to do this, but tonight’s post stems from a file on nonlinear dynamics on my computer that I developed between 1999 and 2003 for the most part.  Not so humbly, I called it “The Rules.”   This is the first in a series of what will likely be long set of irregular posts about what I call “The Rules.”  Please understand that I don’t want to make grandiose claims here.  After all, as I once said to Cramer (yes, that one): “The rules work 70% of the time, the rules don’t work 25% of the time, and the opposite of the rules works 5% of the time.”

My best recent example of the rules not working was when the formulas of the quants were blowing up in August 2007.  There were too many quants following the same strategy, and they had overbid the stocks that their models loved, and oversold the ones that they hated.  For a while, the quant models were poison.  Every investment strategy has a limited carrying capacity, and those that exceed the strategy’s capacity are prone for a comeuppance.

Here is today’s rule: There is no net hedging in the market.  At the end of the day, the world is 100% net long with itself.  Every asset is owned by someone, regardless of the synthetic exposures that are overlaid on the system.

There are many people, particularly dumb politicians, who think that derivatives are magic.  To them, derivatives create something out of nothing, and that something is strong enough to smash innocent companies/governments that have been behaving themselves, but have somehow found themselves caught in the crossfire.

First, if a company or government has a strong balance sheet, and has a lot of cash or borrowing power, there is nothing that speculators can do to harm you.  You have the upper hand.  But, if you have a weak balance sheet, I am sorry, you are subject to the whims of the market, including those that like to prey on weak entities.  Even without derivatives, that is a tough place to be.

With derivatives, for every winner, there is a loser.  It is a zero-sum game.  Yes, as crises arise there are always those that look for a way to make money off of the crisis.  And there are some parties willing to risk that the crisis will not be so bad, at a price.  Derivatives don’t exist in a vacuum.  Same thing for shorting — there is a party that wins, and a party that loses.  So long as a hard locate is enforced, it is only a side bet that does not affect the company whose securities are being played with.

When there are troubles, it is because a company or government has overstretched its limits.  You can’t cheat an honest man (or country).  You can take advantage of countries and companies that have overreached on their balance sheets and cash flow statements.

Cash on the Sidelines, Market is Oversold/Overbought, Money is Moving into or out of…

Every bit of cash on the sidelines is matched by a short term debt obligation somewhere.  Now, that’s not totally neutral, as we learned in the money markets crises in the summers of 2007 and 2008.  If the money markets get too large relative to the economy on the whole, that means there is possibly an asset/liability mismatch in the economy, where too many are financing long assets short.  It costs more in the short run to finance long-life assets with long debt or equity, but in the short run you make a lot more if you finance short… do you take the risk or not?

GE Capital nearly bought the farm in early 2009 from doing that.  CIT did die.  Mexico in 1994.  When you can’t roll over your short term debts, it gets really ugly, and fast.  Think of the way we messed up housing finance in the mid-2000s; one of the chief signs that we were in a bubble was that so much of it was being financed on floating rates, or contingent floating rates with short refinance dates.  Initially, that gave people a lot more buying power, at a price of higher unaffordable rates later.  “The phrase, “You can always refinance,” is a lie.  There is never a guarantee that financing will be available on terms that you will like.

This is also a good reason to go for debt that fully amortizes (i.e., when you get to the end of the loan, the payments haven’t risen, and the loan pays off in full).  I’ve never been crazy about the way commercial mortgage loans don’t fully amortize.  I know why it happened this way.  A) in the late ’80s and early ’90s, insurance companies were issuing GICs by the truckload, and needed higher yielding debt with a 5-year maturity.  Voila, 5-year mortgage loans with a balloon payment.  For the real estate developers, the loans were cheaper, but they had to trust that they could refinance — an assumption sorely tested in the early ’90s.  After the death of many S&Ls, a few insurers and developers, and the embarrassment of a more, borrowers and lenders became a little more circumspect.

But the loss of the S&Ls left a void in the market.  The Resolution Trust Company created some of the first Commercial Mortgage Backed Securities [CMBS], that Wall Street then imitated, filling in the void left by the S&Ls.  But to make the securitizations more bond-like, for easy sale the loans were 10-year maturities with a balloon payment at the end.  That way the deals would closer at the end of ten years.  Maybe some of the junk-grade certificates would be stuck at the end with a some ugly loans to work out, but surely the investment grade certificates would all pay off on time.

And that is a big assumption that we are going to be testing for the next five years.  Will developers be able to refinance or not?

This has gotten long, and have more to say, but I’m going to a wedding of a friend, and must cut this off.  Let me close by saying there is a corollary to the rule above, and it is this:

Long-dated assets should be financed by non-putable long-dated liabilities or equity.  Don’t cheat and finance shorter than the life of the assets involved.  There is never an assurance that you will be able to get financing on terms that you will like later.

1) After reading a piece on Falkenblog yesterday, I decided to add up all of the profits from Fannie and Freddie over the last 20 years.  Ready for how much they made?  Ta-da!  They lost $114 billion.

When writing at RealMoney, I was always skeptical of the GSEs, and felt that they were too lightly reserved, because eventually they would run into a situation where real estate prices would fall.

2) Bruce Krasting comments on the solvency of the FHA.  I comment:

“I’ve argued that FHA would go negative for some time. Even the FDIC is engaged in a bit of chicanery by fronting future premiums forward to avoid borrowing from the Treasury.

We may avoid a banking crisis — at the cost of a sovereign crisis.”

3) I probably have a longer post coming on the paradox of thrift, that bogus concept that Keynes put forth.  But Paul Kedrosky crystallized it for me when he posted this.  And so I wrote:

The problem with the “paradox of thrift” is that it assumes there is only one way to save. Same for the “paradox of toil.” It assumes that all work is interchangeable and uniform.

The aggregation of all saving and all labor is necessary to make these models work mathematically, but isn’t valid in real life.

Yes, if everyone tries to do the same thing, stupid things happen, like bubbles from overinvesting. If there only a fixed possible number of tasks, and people work longer hours, it takes fewer people to do them.

But there are many opportunities, including ones that we don’t presently know about. Businesses that no one could imagine before the crisis can spring out of hard times.

This paper oversimplifies the economy. If the economy were that simple, he would be right. But the economy is not that simple.

4) I don’t know if the Volcker Rule will be eliminated or not, but I do know that the same ends could be achieved through changes in the risk-based capital formulas.  What I wrote:

The same ends of the Volcker Rule can be accomplished through adjusting the risk-based capital formulas — Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

For another off-the-wall idea: ban interstate banking, and let the states rule all depositary institutions. Results: No more too big to fail, and you get back “scaredy cat” regulators who don’t let banks deal in anything they don’t understand, which isn’t much.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing — that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

But Life and P&C insurers survive the process because of RBC, and “scaredy cat” state regulators. What a great system, which prior to the crisis, was criticized as behind the times.

PS — if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.

5) Is the stock market overvalued?  Probably, but consider this article here.  I wrote:

truth, P/Es are best related to corporate yields, not deposit rates or government bonds. And, you have to flip them to be E/Ps. Current E/P on the S&P 500 is 5.4%. A dividend yield of 2.05% is 38% which is close to the long run average.

The longest corporate series that I have is the Moody’s Baa series — because of the growth inherent in stocks, for bonds to be the better deal versus stocks, Baa bonds need a 3.9% premium over the earnings yield, or a yield of 9.3% in the present environment.

So, I’ll take it back, because the present Baa yield 6.45% augurs in favor of stocks versus bonds. Not crazy about bonds in this environment — few categories offer good risk-adjusted yields. Now, maybe both are overvalued vs. commodities, but that one I don’t know.

6) Perhaps the phrase “Greek Banking System” will be a cuss word someday.  Fitch recently gave them a downgrade, and I wrote:

Rating agencies exist to be scapegoats. When they are proactive (yes there have been eras where they have been proactive) the bond buyers scream — “Ratings are supposed to be good over a full market cycle!” When they are reactive, which is most of the time, they get accused of being coincident indicators.

They can’t win, which is why institutional investors ignore the ratings, aside from the capital charges that they force, and instead, read what the rating agency analysts write. The true opinion is in the writing, not the rating.

7)  Barry comments on how Goldman Sachs bags clients.  Truth, almost all investment banks bag clients, selling complex products that they understand better than their clients do.  My comment:

I always advise retail investors not to buy structured notes — Wall Street offers an above-average yield, and has the buyer sell short some expensive option. You lose more in capital losses than you gain in interest on average.

This isn’t any different. It just that bigger players that should have known better are getting hosed.

There is no better defense than “buyer beware,” and “Don’t buy what someone else wants to sell you. Buy what you want to buy.”

Unless we want radical revisions to contract law, you are your own best defender.

8 ) One story with more sizzle than substance is put-backs, at least as far as it affects homeowners.  It was featured by Barron’s and picked up in a piece by Barry.  Investors that purchase a mortgage or any o=ther sort of loan have a limited window of time to give the mortgage back to those that they bought it from for full value.  My comment:

This seems to be useful for investors, but not for homeowners. Reps and Warranties claims can be enforced by investors that bought loans through securitizations. It does not help homeowners.

9) Jeff Matthews wrote a piece that was a little critical of splitting the “B” shares and Buffett’s logic on the Burlington Northern acquisition.  My comment:

I don’t always agree with Warren Buffett, but I do agree here. Index investors are passive investors. Individually, they are dumb. As a group they are smart, because they lower their investment costs.

Warren is also correct on Burlington Northern — it should be like his utilities, and throw off a growing inflation-protected return over time, allowing him to earn a spread over his cost of funds (negative) that his insurance enterprises generate.

He is still a bright man after all these years.

PS — I am a Calvinist Christian; the question asked regarding Jesus is not relevant to the short-term running of Berky, but is relevant to an Christian investor who cares about the ethics of the organization. Also, it is relevant to the long-term well-being of Mr. Buffett. The rest of us will have to face the results of that question one day as well.

10) The Developments blog at the WSJ hides in the shadow of better known blogs, but often puts up some really good pieces.  They recently did a piece on whether it is better to buy a home now or wait a while.  My comment:

Roughly three months later than originally scheduled, the fiscal year 2009 Financial Report of the United States Government came out.  I had predicted a few times (latest here) that the final total of debts and unfunded liabilities would be about 4x GDP.  Well, I was close:

As I commented in my piece The Biggest, Baddest Bubble of Them All:

This doesn’t take into account the value of land and certain less tangible assets that the U.S. Government has. It also does not take into account the considerable operating and capital lease liabilities, deferred maintenance, or liabilities for the GSEs, and other lending guarantee programs of the federal government.

That comment was originally written in October 2003.  As I commented at RealMoney a number of times, I felt that it was possible that the GSEs would fail — they held so little in reserve against mortgage losses.  Back then, the figure wasn’t $57 billion, it was $25 billion for fiscal year 2002, which would be 2.4x GDP.

The US Government has made a lot of promises to pay.  I have no idea how big the annual obligations for capital and operating leases are, but it would be cheaper for the Government  to borrow and buy their buildings, rather than hiding the debts through Credit Tenant Leases.  I also can’t quantify the full range of guarantees they have made, including implicit ones to bail out GSEs, big financials, allies, etc.

A reader wrote me asking: Would you please write a post on what will happen if the US goes bankrupt? This government spending continues to get worse and I am wondering what if anything I, a retired person, can do to get in front of this.

Okay, here goes.  Remember that the US Government has choices.  It can raise taxes, inflate, or default.  I don’t think default, even if it is only an external default, is the most likely option.  Also, the promises for Social Security and Medicare are not guaranteed — they can be reduced or canceled by Congress and the President.  Changing Social Security and Medicare would be political suicide, but suicide is an option.

An aside, why have I not mentioned cutting discretionary spending (or defense or entitlements)?  Because they aren’t that large a portion of the budget.  Defense and entitlements are large, but who could get a consensus on cutting those?  Our culture has a “more is better” mentality, even though spending money on “defense” has probably not made us more secure.

In order of highest likelihood, here is how I see the options:

1. Borrow more
2. Raise taxes
3. Inflation
4. Cut discretionary spending
5. Cut defense spending
6. External default
7. Total default
8. Cut entitlement spending
9. Internal default

Much as I would like to see the US Government reduced in size to only core functions, my views are not the consensus.  They will try to raise taxes, and failing that, inflate the currency.

To the one who asked the question, I am not a tax expert, so consult one to limit your taxes.  On inflation, you probably know the drill: Money market funds, TIPS, commodities, and equities with hard assets or pricing power.

The US government talks about cutting discretionary spending, but rarely does so.  Defense is worse; it always expands.  For the US to cut defense spending would be a mindshift requiring closing overseas bases, and a quiet surrender of the idea that the world is ours to guard/rule.  We think we are neutral, when we are genuinely self-interested.

External default would not be enough to solve the problems the US faces, and, it would enrage the rest of the world.  We would find our assets abroad seized by foreign governments.  Say goodbye to goodwill and globalization.

I don’t know what to say about total default, aside from depression everywhere, with many financial institutions failing in the US and abroad.  If the global reserve currency fails, well, those that rely on it will fail.

I don’t view cutting entitlement spending or an internal default only as likely.  They are political suicide for whoever does it.

My sense is when the ability to raise taxes fails, inflation will be the solution.  If/when the political outcry becomes too great against inflation, then the lesser remedies will be considered.

The pain has to go somewhere — we’ve been really good at ignoring the problem, delaying the payment, etc., but it has only had the effect of building up the eventual pain that will have to be taken.  Our leaders are seemingly opting for a Japan-style solution — stagnation for two-plus decades with debt shifted from private to public entities.  We have better much better demographics, but Japan has had better saving in the past — more of their explicit debts are internally funded compared to the US.

The trouble with offering advice in a situation like this is that the right answer depends on what our officials do.  The best or worst investment could be long Treasury zero coupon bonds.  Or it could be gold.  Remember, many thought the Great Depression would end with inflation, but it didn’t, at least not to the degree that many feared.  Me?  I am invested in a mix of well financed businesses that generate a lot of cash and would be difficult to do without, and some money market funds, where I suffer the punishment of a saver, while retaining flexibility.

There are no easy answers here.

When does a sovereign or semi-sovereign government default?  I have seen three answers:

1) When debt is greater than future seniorage revenue (central bank profits) plus future debt repayments.  (Kind of a tautology, but what is implied is that if future debt repayments are onerous, a government would default.)

2) When the interest rate a government pays is greater than the likely growth rate of revenues. (I.e., if you are paying more than your revenue growth rate, the indebtedness will continue to grow without bounds…)

3) When the structural deficit is high, and total interest paid exceeds the size of the structural deficit.  (In that case, default would bring the budget into balance, at the cost of being shut out of the bond market.  But, given the situation, in the short run, being shut out of the bond market isn’t a problem.  There would be problems if the day comes when they need to borrow again; negotiations would begin over paying old debts.)

I will propose a fourth idea: governments can lay claim to a percentage of the GDP of their country/state/municipality.  How large that can be will vary by culture.  Beyond a certain point, attempts to take more than the natural limit for that culture will not result in higher revenues, because people will hide income, and/or leave the country/area.  When debts and unfunded obligations exceed the present value of maximum GDP extraction by the government, default is likely, the only question is when it will happen – when does cash flow prove insufficient?  Perhaps the earlier three rules can help with that.

Tough Time to be a Municipality

Revenue is declining for almost all states and municipalities.  Given the need to run balanced budgets (on a cash basis), and not having a central bank to fall back on, the problems are much deeper for States and Municipalities than for the Federal Government.  This report from the Rockefeller Institute shows how widespread the loss of revenues is.

But what should larger governments do for smaller governments in this crisis?  Oddly, the best answer is nothing, and even some of the Europeans recognize this.  Smaller governments need to grasp that they have to solve their own problems, and not rely on the Federal government to help – it has enough problems of its own.

So, if I had any great advice for strapped municipalities in California, or any other place in the US, one of the first things I would recommend is that you assume you aren’t going to get any help.  Those that could help you are in worse shape.  Such does the Pew Institute indicate.  Few states have their pension and retiree healthcare benefits funded.  They won’t have excess funds to aid municipalities, and my even compound the problem by reducing revenues shared with municipalities in order to stem their own budget shortfalls.

The Federal Government Won’t Be Much Help Either

The politics of the US are dysfunctional enough with opaque congressional earmarking benefiting local and special interests.  It will be yet more dysfunctional if states and municipalities ask the US Government for aid.  Besides, the US Government has issues of its own.  Tonight, it will release the 2009 Financial Report of the United States Government, somewhat behind schedule.  With all of the chaos, who could blame them for being late?  My suspicion is that when one adds up the explicit debts of the US Government and its unfunded obligations, it will add up to a figure near four times GDP.  If the US dollar were not the global reserve currency, we would have long ago slipped into chaos.

What would it take to make the US’s debt to GDP ratio stop rising permanently?  We would need to run surpluses of around 8% of GDP, if I understand the charts on page 5 right.  Absent some major shift in governing philosophy, that’s not even close to being on the table.

As I wrote in my seven part article, My Visit to the US Treasury, Part 5: After the meeting, I said to one Treasury staffer, “One of the quiet casualties of this crisis is that you lost your last bit of slack from the entitlement systems.”

“What do you mean?”

“Just this, prior to the crisis, Social Security and Medicare would produce cash flow surpluses for the Government until 2018.  Now the estimates are 2016, and my guess is more like 2014.  The existing higher deficit takes us out to the point where the entitlement systems go into permanent negative cash flow.  This means that the US budget is in a structural deficit for as far as the eye can see, fifty years or more, absent changes to entitlements.”

He looked at me and commented that it would be the job of a later administration.  No way to handle that now.  To me, the answer reminded me of what I say to myself when I go on a scary ride at Six Flags with my kids.  There is nothing we can do to change matters.  The only thing to adjust is attitude.  So, ignore the fact that you are afraid of heights, and enjoy the torture, okay?

Now, with interest rates so low on the short end, there is one further risk: that the Fed would keep rates low simply to keep  the US Government’s financing costs down.  As the Kansas City Fed’s President Hoenig said recently,

“Depending on your assumptions about the economy, that federal debt will grow at an unsustainable level starting immediately, or in a very few years,” Hoenig said. “We do have significant private debt, so that’s in place, so what worries me about that [is] that puts pressure on the Fed to keep interest rates artificially low as you try to deal with that debt.”

The US Government is in a tough spot financially, and if inflation rises (which is not impossible, consider stagflation in the 70s), its ability to continue to finance itself cheaply will erode.  On the bright side, the US is still viewed as a safe haven, so if there are troubles in Europe or Japan, the US will benefit from additional liquidity in the short run.

Back to the States

For another summary of how tough things are at the states, consider this piece from the Center on Budget and Policy Priorities.  Because many state budgets assume a better economy than they actually got, and some were quite optimistic, the average state has a 6.6% gap to fill as a percentage of its 2010 budget.  The gap projected for 2011 is 17% of the 2010 budget.  Not pretty, and if you want to look at it from a bottom-up perspective, this article offers a lot of links to the various emerging troubles.

One further wrinkle in the matter is Vallejo, California, which is in Chapter 9 now.  In the past, muni bond investors and insurers felt assured that in defaults by cities and counties that they would eventually be paid back in full.  With Vallejo, that may not happen; bondholders may have to take a haircut.  If that happens, and it establishes a precedent for Chapter 9 cases, yields will rise for cities and counties that can file for Chapter 9, in order to reflect the increased risk of loss.  Higher future borrowing costs will further burden city and county budgets.  There is no free lunch in the muni bond market.  (For more good articles by Joe Mysak of Bloomberg, look here.)

Conclusion – Why do I Write This?

This is a pretty gloomy assessment, but it is consistent with the deleveraging process that is rippling through the US economy.  All sorts of hidden leverage have been revealed including:

• Reliance on optimistic economic assumptions in budgets.
• Reliance on a robust housing sector.
• Reliance on financial guarantee insurers.
• Reliance on increasing leverage at banks, and sloppy underwriting of loans.
• Reliance on Fannie and Freddie to absorb poorly underwritten mortgages.
• Reliance on large pension and retiree healthcare promises to keep wages low, and not funding those promises to keep taxes low.
• Reliance on high stock returns to pay for pensions.
• Reliance on increasing debt levels in households.
• Low bond yields make it difficult to invest for pensions.

And there may be other things we have relied on that may fail.  Banking crises often lead to financial crises, as is pointed out in the excellent book, This Time is Different.

• The US government can always borrow more.
• The Treasury and Federal Reserve can stimulate the economy out of any crisis.

My main message is that this is a serious situation almost everywhere in the US.  We have borrowed ourselves into a corner.  I write this so that all parties can understand the dynamics going on, so that when muni defaults happen, and the normal dynamics in the bond market shift, you won’t be surprised at the results.  Also, now you have links to a wide number of reports indicating how serious the problems are with Federal and State debts and unfunded liabilities, so that you can do your own digging on the topic.

This is a book that gives a feeling for being in hedge fund management, rather than a dry description of what needs to be done if you are in the rare position of being asked to manage a hedge fund.

The author was an ambitious guy.  Growing up in Canada, he wanted to play professional hockey.  He played ably in youth leagues, the minors, and college.  Making the pros was not to be.

So, what does a competitive guy do when he can’t pursue his dream?  He pursues another dream, managing money. He works hard, and gets one break after another, and eventually manages his own firm, which he sells out to a larger one.  He gets a plum job at a firm that proves less than patient with his current performance, and he gets let go.  Even that is a triumph for the author.  He starts his own firm, which is what he is still doing today.

Think of an analogy to sports — every player makes mistakes, but the best players recover from mistakes well and learn from them.  The author definitely got his share of breaks, both good and bad, but he responded to the bad breaks well, and came out the better for it.

Though this book is about hedge funds and other areas of investing, really, this book is about the author.  It tells his story, and as the story gets told, you pick up incidental points along the way:

• What is it like to be an intern at a trading firm?
• How do you learn as you go?
• What was it like inside CSFB during the dot-com bubble?
• How to interview management teams to get an edge.
• How to sense if someone is lying.
• In general, the Fund of hedge funds operators are not desirable clients.
• Get a sense of the strength of consumers
• Get a sense of the three time horizons — days/weeks, months, and years.  (He uses other terms than this, but I appreciated his logic here, because it seemed a lot like what I did as a corporate bond manager.  Have a sense of short-term momentum, medium-term trend and long-term mean-reversion.)
• Very good to good means sell
• Very bad to bad means buy
• The value of keeping a trading journal, and reviewing performance.
• Be careful who you do business with, because eventually they may show you the door for less than good reasons.
• Surviving the credit bubble’s bust.  Buying back in when people are panicking.

The book runs 204 pages, but roughly 30 don’t have much on them.   The book is breezy, and though I mentioned a lot of things that I got out of the book, readers less familiar with the subject matter might miss some of the points.  He does not spend a lot of time on the details. On the other hand, a reader less familiar will get a feel for what it is like to be a part of a fast-paced area in investments.

Who would benefit from the book:  Those that would like to read the tale of an interesting guy who had a tiger-by-the-tail initial career in investments.

If you want to but the book, you can get it here: Diary of a Hedge Fund Manager: From the Top, to the Bottom, and Back Again.

Full disclosure: The publisher sent me this book. They send me a lot of books, and I review as many as I can. I don’t like every book that I receive, but typically I review the ones that seem the best, and let the rest pile up. Anyone entering Amazon through my site, and buying anything, I get a small commission, but your price does not go up. Such a deal.

PS — the blog for the author’s firm is here.

When I was a corporate bond manager, I often dealt in less liquid bonds.  Why?  They had more yield, I only bought those that my credit analysts liked, and I had a balance sheet that could hold them.  I had the option of holding those bonds, but not the obligation of holding those bonds.  As credit conditions improved in early 2003, to leave my successor with a simpler portfolio, I decided to lighten my holdings of bonds issued by a private bank.  I held 35% of the issue, and bought most of it near the height of the panic.

I told my secretary, “The phone will start ringing off the hook in 30 seconds.”  She gave me that usual sweet smile and said, “Okay, David.”  I offered a chunk of the bonds 0.2% below the last trade in spread terms, without guaranteeing the level.  To my surprise, I got a lot of bids rapidly, to the point where I said “whoa! there are too many that want these bonds.”  I recalibrated my levels and offered a “supply curve” of bonds, where I offered more the higher the price went.  I ended up selling 2/3rds of my holdings, and made significant gains for my client.  The final trade was 1/2% tighter than my initial proposed trade.

Having traded small and microcap stocks, and traded illiquid bonds, I am less afraid of illiquidity than many are.  Illiquidity is something that one can absorb, if he has a strong balance sheet and a patient disposition.

The great Peter Lynch would buy small cap stocks for Magellan, with strict orders on price.  Then he would let them sit, while they gained in value on average.  Marty Whitman buys in “safe and cheap” small cap stocks that are illiquid and holds them until their value is recognized.

If you have a strong balance sheet or patient investors, take advantage of it, and buy investments that are less liquid, where value may take a while to obtain.

But liquidity is not natural to all assets.  Most things in an average person’s life will not be liquid.  Your house and car are not liquid.  It will take a lot of effort to sell them and buy a different house and car.  So why should futures on property values be liquid, or residential mortgage-backed securities?

Well, debts that are very certain will always be liquid.  Debts that are less certain will be liquid during boom-phases, and illiquid during bust-phases.  In general, that is why AAA-rated asset-backed securities, which are usually “last loss” securities are fairly liquid, while lesser-rated securities trade rarely.

My point is that you can’t take illiquid assets and make them liquid.  Assets are liquid because they are short term, where one knows the cash flow to be received soon.

Are public stocks, like Exxon Mobil, liquid?  In one sense, yes.  During the day, when trading is in session, and there is
no news hitting the wire, then yes, quite liquid — one can get in and out of a position easily with little difference between the bid and ask.  But, when news hits, or from the closing price to the next day’s open, the price can move considerably.

Over a long period of time, the shares of two companies in identical businesses, one publicly traded, and one privately held, could deliver the same value over a long period of time.  The public company would have the ability to adjust its capital structure to buy in shares when they are cheap, and sell when they are dear, unlikely as that behavior is.  The public company would adjust its debt levels more frequently, while the private company would likely keep debt high and equity low, to keep taxes low.  The private company could act quietly and think longer term, subject to the constraints of their loan agreements.  The public company would have more bumps to its seeming value from news events, including earnings releases.

For the holder of shares in the public company, though liquidity is available, the value of the shares will vary.  For the public and private companies alike, liquidity for any large amount of the shares would be an event.  And, aside from successful maturity dates, the same would be true of large amounts of debt — there might be a public market available for small amounts of it, but just try to buy or sell a big amount, and pricing conditions are rarely favorable.  My example at the start of the post, where I sold 20% of the total issued amount for a favorable price, only happened because the willingness of investors to take risk increased dramatically since the last trade.  Yield greed had set in.

But that brings up the other definition of liquidity — what does it cost to enter/exit fixed commitments?  Tight credit spreads mean that corporations can (borrow) enter fixed commitments cheaply, and lenders, dearly.  The same applies to Fed policy — a wide Treasury curve means that it is expensive to borrow long, and cheap to borrow short — but borrowers want more security than to have a short maturity leash.

But when lenders are scared, they gravitate to short loans and high quality — cash equivalents lent to the Treasury.  If enough do that, short term yields get really low.  They can even go negative.

I remember arguing with a visiting professor at Wharton back in 1990 that negative interest rates were possible.  He told me I was nuts, people would sit on cash.  I replied, “what if you can’t keep the cash safe?”  Maybe I should have said, “What if it is inconvenient to transfer and guard several billion dollars in cash?  There are costs to that as well.”

In a liquidity trap like we are in, short-term money managers that must have US Treasury collateral must bid for it, no matter what.  They can’t move to cash.  Cash to them is very short-term debts of the most creditworthy entity that they know — their Government, the one that controls the Fed, sorta.

But the volume of lending, particularly to smaller business borrowers is light.  Is there really a lot of liquidity out there?  Or, is it being used primarily by the US Government and its affiliates while the economy is weak?  I think that is the case.

Liquidity is not magic; it can’t be created or destroyed — it just travels where it is needed.  During booms, liquidity appears abundant because of loose monetary policy and high willingness to take credit risk.  It seemingly disappears in the bust, as the marginal fixed income investor attempts to eliminate credit risk — liquidity then flows to the highest quality assets.

Liquidity is always around; it is only a question of where the marginal credit buyer has migrated.  In the current environment, it is short high-quality obligations that are still king, and lower-quality longer obligations that trail, though not as badly as last winter.

I am sure that I will write more on this topic, should I live so long.  My contentions are:

• Securitization does not create liquidity, it only redirects it.
• The Fed does not create liquidity, it only redirects it.
• The Treasury does not create liquidity, it only redirects it.

Liquidity is a function of human action.  We all have to work and trade to survive.  Liquidity is where people are transacting at any given moment toward that end.  Structural changes in the economy, whether by the government or through private channels will shift where liquidity goes, but it will not change the amount of liquidity, unless the changes are so severe that the economy itself becomes much less productive.

I think earnings quality is one of the great neglected concepts of investing.  Why do many growth investors blow up on seemingly promising companies?  The answer is often that the investors did not review earnings quality.  Why do value investors fall into value traps?  The answer is often that the investors did not review earnings quality.

I have reviewed a number of books, and written many articles about earnings quality  Because so much of the investment world is blind here, the idea still has punch.

Thornton O’Glove hits at the subject in a traditional way — accrual accounting entries are always more suspect than cash entries.  He focuses on:

• Being skeptical — don’t trust management, analysts, auditors.
• Look for inconsistencies in disclosure.  Who tells a happy story broadly, bet is serious in regulatory filings?
• Who plays games with one-time events?  What companies push the limits in determining what is a one-time event?
• How do companies play with their accruals in order to report income?
• Is taxable income significantly out of whack with GAAP income?

The book was written in the Mid-1980s, before it was easy to review SEC filings.  That has changed, but few really review filings today, even though it is easy to do so.

This is a good book, and you can learn a lot from it, but many of the references are dated, as in the classic version of “The Intelligent Investor.”  I mean, I recognize most of the examples, but many readers will say, “Huh, I’ve never heard of that company!”

Do you want to improve your investing?  Look to earnings quality.

Who could benefit from the book?  Any investor could benefit from the book, particularly those that analyze fundamentals.

If you want to buy the book, you can buy it here: Quality of Earnings

Full disclosure:  I bought this book.  I review books old and new.  This old book still has value, and I recommend it.  It will require more effort than most investors are willing to put forth, but I believe it will yield value to those who work with it.  This is simple stuff, but it is work, and there is always a barrier to entry around work.

Also, anyone entering Amazon through my site and buying anything — I get a small commission, but you don’t pay anything more.  I love it when both my readers and I win.