For those who haven’t read the articles, tail risk is when even safe investments get hit hard.  Those market outcomes are rare but severe, so some people look for insurance to clip their risks when everything is getting whacked.

Possibly a reasonable goal, and the best time to aim for it is when things are pretty good, because it is best to buy insurance when it is cheap to do so.

But what form should the insurance take?  I can think of three broad categories:

• Assets that come into existence during the disaster.
• Ready liquid assets — short-term and high quality.
• Liabilities that disappear with the disaster.

The first category is the one most people think about.  What can I buy that will do well when the disaster comes?  There are two branches to that question:

• Do I want my downside clipped on this trade (for a price)?
• Do I want to make the bet without paying much, and I could win or lose?

In the first category are puts and buying protection via CDS, which will protect for a time, but cost money to put on the trade.  Worse, you could be right on the event, but wrong on the timing, and they end up expiring worthless.

Note: be wary of products Wall Street would like to sell you here.  Most often, they sell something mispriced to you, though it looks attractive.

But even if you are right, your counterparty/exchange  has to remain solvent in order for the trade to work.  Few factor in the cost of insolvency there.  Think of those who though they were clever laying off risk to AIG, a trade which only worked due to government intervention.

In the second category, there are assets like precious metals and long Treasury zero coupon bonds, each of which will do well in a specific crisis, but not just any crisis.  But there is also the shorting of equities and high-yield bonds, which could potentially deliver big gains, or big losses if the rally continues.

I would offer this test to anyone offering a hedge against tail risk: is it any better than puts or buying protection through CDS, or shorting equities or high yield bonds?  I would suspect in most cases the answer is no.

Then there is my preferred solution: hold cash.  Cash is unique; it can be used for anything; it can be used for almost every contingency.  Cash may offer little to nothing; it may even yield negatively, but that is the cost of security and flexibility.

Then there is the third option: offering catastrophe [cat] bonds.  Why should the guys following hurricane, quake, typhoons, and European windstorms have all of the fun?  There are more and bigger disasters than those in the financial markets.

In simple terms, here’s how a cat bond works: after a disaster that meets the terms of the cat bonds occurs, the principal of the bond diminishes by the size of the covered loss, if it is in excess of certain thresholds.  The advantage of an arrangement like this is that an insurer or reinsurer can get reinsurance against a disaster, by issuing a high-yielding cat bond.

The high-yield investors are happy to buy it because typically cat bonds are highly rated, and offer a good return that is uncorrelated with the returns on other high yield bonds.  Physical disasters seem to happen independently from financial market disasters.

The bond issuer gets reinsurance capacity, which is sometimes scarce, at a price that reinsurers would not match.  Cat bonds can never replace reinsurers, though, because the reinsurers offer more tailored coverages, while cat bonds tend to be more broad-brush.  They are usually cross-hedges for the issuer, covering something that is likely to be highly correlated with their loss exposure in a disaster.

What Might be a New Idea

What if we applied the concept of a cat bond to hedging risky security portfolios?  Think of it as an odd sort of margin account.  A hedge fund borrows money via a special purpose vehicle [SPV], which holds high quality collateral.  The hedge fund pays the SPV for insurance coverage; the SPV pays interest to the cat bond investors.  If a loss event happens, say a large decline in the S&P 500 index below a stated level, the principal of the cat bond is written down, and the SPV pays the amount of the writedown to the hedge fund.

Compared to a cat bond based on a physical event, there is one advantage and one disadvantage.  The disadvantage is that the loss trigger on a financial cat bond is highly correlated with bad high yield bond market performance, eliminating a lot of the diversification advantage.  This would mean that a financial cat bond would have to pay a higher premium than a physical cat bond.

There is an advantage, though: it can be hard to set up a large hedge without disrupting the market, and it is difficult to gain protection over long periods of time.  Most hedging instruments are short dated, and limited in the amount of capacity available for laying off risk.

Would this be attractive to a large hedge fund?  I’m not sure.  This sort of protection has the same sort of drip, drip, drip of cash out that most managers hate to see, whether for writing puts or buying protection via CDS.  It would come down to a question of cost versus a locked-in solution that could last for ten years, with little to no counterparty risk.

Conclusion

But personally, my best solution is lower your leverage and hold some cash.  Nothing beats the flexibility and simplicity of cash in a disaster.  Cash is also an index of humility; we are willing to leave something to the side in case we are wrong.  Being wrong is a normal state of affairs in investing, so take time to prepare for the next time you will be wrong.

New asset management shops start small.  One of the luxuries I have had for the past 18 years is access to a Bloomberg Terminal.  I will not be able to afford one ($20-25K/year), at least not initially, as I start up what is likely to be called Aleph Investments.

I will miss having a Bloomberg Terminal.  At every firm that I have worked at, I have been good at getting it to do tough projects, whether with stocks, bonds (government, corporate, mortgage, bank debt, default swaps), economics, or other investments (munis, money markets, preferred, commodities, currencies, etc.), or getting data on competitors.  I have a deep knowledge of what it can do, compared to most users.

But who needs all of that scope for an average equity management business?  Granted, it’s nice to have the details on all aspects of the capital structure when making decisions, but who has that luxury when your resources are thin?  There is always leafing through the 10-K, a good exercise for all of us who invest.

In my younger days, say 10-15 years ago, I would get most of my investment data via paper.  I would get my kids together and we would stuff envelopes to send out to corporations. Over the next three weeks, the flood of data would be huge, but I would sit down with the kids (they were so cute then) as they reports came in, and show them what the company did and where it was located.  One of them would look at one of the smaller reports and say “10-Q,” to which I would reply “You’re welcome,” which would elicit some giggles.

Ah, the simpler days.  Where was I?

Yeah, I can’t afford a Bloomberg Terminal, but I need a service or a set of services that provides the following (US Traded stocks):

• Current and Historical fundamental data.
• Real time equity prices.
• Price histories.
• Industry fundamental data (I wish, but don’t have to have it)
• Reasonable summaries of common ratios and growth rates. (If need be, I can calculate them.)
• Some economic data (but I can probably cobble that together myself)
• Some technical work (money flow, RSI, intraday RSI, but that’s just a nicety, and I could do it myself…)
• International economic data (dreaming, I know, and I can do without it)
• Commodities, Futures (but I could do without it)
• Option implied volatilities (but I could do without it)

I’m an investor, not a trader.  I trade a 30-40 stock portfolio about 100 times/year, and most of the trades are rebalancing trades, where I buy or sell to bring a company up to its target weight when it hits a portfolio weight 20% above or below my target weight.  I hold companies on average 3 years.

Now, I could probably get by with:

• AAII Professional Stock Screener
• Value Line (paper, limited online, and only the large- and mid-caps)
• Yahoo! Real-Time Quotes
• WSJ & Barron’s market data
• Bloomberg.com
• FRED at the Federal Reserve
• SEC Edgar
• Maybe subscribe to the Financial Times online.
• And free stuff around the web.  Yahoo! Finance is excellent in a pinch for individual company analysis.

But, could I do better?  Many of my readers use sources that I am not aware of.  If you would, would you describe the data sources that you use for data analysis.  It would not only be of value to me, but would be of value to all of our readers.

When I am up and running with Aleph Investments, I will post to let you know what I finally settled on, but for now, let me know what you would use if you were in my shoes.  If you are posting a reply to somewhere other than the comments at my site, please send a copy here.

Thanks to all,

David

When I reviewed the book Priceless, I thought I had reviewed “Fortune’s Formula,” because I had written several pieces on the Kelly Criterion at the blog and at RealMoney (free at TSCM).  But I found that I had not, so I offer you this review of a book I greatly enjoyed:

The book asks a simple question: in making a bet, investment, or business decision, what is the optimal amount of capital to allocate?

But the author, William Poundstone, is not going to give you the answer immediately.  He is going to take you on a journey where you can meet many odd personalities from the ’50s to the early ’00s, and how they came to look at the problem.

Ed Thorp was fascinated with Blackjack, and originated card-counting to improve the probability of winning, to what the card counter had and edge versus the casino.   He meets John Kelly, Jr. while working together at Bell Labs on Information Theory.  He discovered that an economic actor with an edge could size his bets as a ratio of his edge in  betting divided by the odds received on the bet.

Thorp eventually published a paper, “Fortune’s Formula: A Winning Strategy for Blackjack,” which led to a torrent of interest from gamblers.  With the aid of several backers, Thorp tried out the methods with some success in Reno, with two wealthy gamblers as backers.  That tale was hairy, to say the least, but they more than doubled their money.

Thorp later applied himself to the sleepy market for stock warrants in the 1960s. He developed delta-hedging along with a colleague.  As the book progresses, gambling ceases to be the focus, and advanced strategies for making money on Wall Street with little risk becomes the rule.  And, as in Vegas, as they took steps to lessen the edge in blackjack, on Wall Street competition itself eroded the edge.  But Thorp set up a hedge fund to take advantage of securities mispricing.

One odd sidelight is the number of parties that came up with the option pricing formula known as Black-Scholes, long before B-S wrote their paper.  Life reinsurance actuaries had a version of it in the ’60s, Bachelier had a version of it around 1900. And there were others, but the point was that no one took advantage of the knowledge, except in rough ways, prior to the B-S paper.

Yet option theory could be applied to a wide number of situations, convertible bonds and preferred stocks, even corporate bonds themselves, in addition to warrants and options.  Those that did it early made a lot of money.

A more generalized version of the Kelly Criterion says to focus on the choice that offers the highest geometric mean return.  This led to a conflict with academic economists who insisted the optimal strategy was derived from utility maximization.  What is not disputable is that the Geometric mean will maximize terminal wealth, a result found by Bernoulli and Latane.

The book takes us through financial crisis after crisis, showing how bet sizes were too large relative to the results.  It also takes us to the end where a number of the protagonists end up decidedly wealthy from their attempts to beat the market.

Quibbles

Though Poundstone’s aim is the Kelly Criterion, more of the book is dedicated to finding edges, whether beating the dealer in blackjack, or arbitrage of securities.

If you want to buy the book, you can buy it here:  Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street

Who would benefit from this book

Many people would enjoy this book, written in 2005.  Poundstone tells a good story and illustrates how a number of clever men found edges, pursued them, and triumphed.  The reader may not be able to beat the world after reading this, but it may teach him about how bright men found ways to pursue their advantages.

Full disclosure: I bought my copy with my own money.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

I am not sure how many current economic crisis books I have reviewed.  I think I am getting close to a dozen and I am currently reading “Fault Lines.”  I’m not sure I want to do many more crisis book reviews.  Tonight’s review is Complicit, by Mark Gilbert of Bloomberg.

Bloomberg columnists are typically good writers, with detailed knowledge of their subject areas, and a no-nonsense approach to writing.  This book from Mark Gilbert is no different.  As Joe Friday often said, “All we want are the facts, ma’am.”

And for the most part, that’s what you get in Complicit.  It is not a long book at 173 pages, but it comprehensively chronicles the growth in leverage, and how it spread to many areas of the investment markets.

When bubbles grow, everyone is a friend.  Underwriting becomes lax, limits are stretchable, FICO scores are pessimistic approximations, etc.  Risk is transitory; we originate to sell.  Regulators don’t want to stand in the way of seeming prosperity.  Nor do politicians.

Leverage gets higher in explicit and implicit ways.  Credit spreads get tight as a drum.  It is a virtuous cycle… until it become a vicious cycle.

In the bust, credit spreads rise, cutting off the possibility of refinancing.  Then asset defaults come, and GSE and bank insolvencies.

Central banks did not view inflation broadly enough, focusing on goods price inflation, and ignoring the asset inflation that was distorting the economy.  They disclaimed an ability to see, much less deal with bubbles.

The high yield market became a frenzy for yield, with CDO equity bidding for lousy bonds and default protection on lousy corporations.  Debt spreads tightened to levels that indicated perfection had arrived.

Investors chased risk, seeking returns.  There were too many parties willing to make fixed commitments, because they needed to earn a lot.  Balance sheets were ignored, and income statements were everything.  History being bunk, was thrown out the window, because it was different this time, we were in a new era.

The crash in Shanghai was the first warning in February 2007, followed by the equity quant crisis in August 2007, and the breakdown in the money markets.  All of the clever ways parties used to lever up short-term credit blew up, forcing banks to take credit back onto their balance sheets.  At that point, everyone should have dumped the banks, but few did; leverage was too high, and asset prices were falling.

The critical decision was bailing out Bear Stearns.  I agree with Gilbert; either both Lehman and Bear should have been bailed out or neither.  I think not bailing Bear and Lehman out would have led to the best outcome.  After Bear failed, other banks would have moved to straighten themselves out.  We might not have had as much failure had as we eventually did. The inconsistency of regulation, as well as the unwillingness or regulators to be tough added to the crisis.

The book covers the September 2008 climax well, but takes us past that, offering possible solutions.  I particularly liked the ideas of limiting the number of academics in important regulatory posts, and having more regulators with practical experience.  I also liked central bankers being proactive on bubbles, and the asset/liability matching inherent in paying those that make long term decisions with financial instruments that last for the term of the decision, and are contingent on the credit quality of that decision.  An example would be paying securitization originators with pieces of the subordinated tranches.

I liked the book; for those with limited time, the book is particularly suitable, because it is brief.

Quibbles

Gilbert’s style is hard-hitting; though many financial companies took advantage of government largesse, few practically considered the possibility of bailouts while the boom was going on; they were pursuing profit with little thought of systemic risk. There was a lot of greed, but in my opinion, few expected bailouts, but took them when they were offered.

Who would benefit from this book?

The book is available here: Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable (Bloomberg)

Full disclosure: The publishers sent me copies of these books, hoping that I would review them.  I review about 80% of the books that get sent to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

These three book reviews are for books that I scanned, and did not read in depth.

Quantitative Equity Investing

The first book: Quantitative Equity Investing, is a book for practitioners with strong math skills, not average investors.  It reviews basic econometrics and factor analysis, and then applies these tools in an effort to sort out anomalies in investment markets, tease out important factors driving markets, and find workable trading strategies, considering execution costs, slippage, etc.  It has a brief section on algorithmic and high frequency trading.

On the whole, I didn’t find anything that new or amazing in the book.  Though there were a few things in the book that I hadn’t seen before, they were trivial things that I looked at and said, “Oh, yeah, of course.”

The book is generic in the way that it deals with the topic.  It is no going to give you ideas to pursue, but only tools that you can use if you have ideas tht you want to analyze, and turn into strategies.

Who would benefit from this book?

You have to have a very strong math background, including the type of Matrix Algebra that one would use in graduate-level Econometrics.  To that end, this book would be most useful to grad students wanting an introduction to how to apply their math skills to the markets.

The book is available here: Quantitative Equity Investing: Techniques and Strategies (The Frank J. Fabozzi Series)

The New Science of Asset Allocation

This book uses Modern Portfolio Theory in order to analyze asset allocation decisions.  Those that have read me for a while know that I think that is a flawed paradigm, in need of replacement.  For those that want a reasonable understanding of that paradigm in a short space, the book does that very well.

That said, the book has its virtues.  The chapter on the “Myths of Asset Allocation” shows that the authors have some depth of insight into the foibles and misunderstandings that surround asset allocation.  The book also goes into the importance of qualitative analysis of managers, looking up from the numbers so that you can avoid allocating money to the next Madoff.  It also describes the use of derivatives in order to control risk exposures.

Each chapter ends with a short summary of the takeaways from the chapter, which serves to reinforce the points of the book.

Though the book has the word “new” in the title, I did not find much new in it.  If one is looking for novel implementation methods for asset allocation, best to look elsewhere.

Who would benefit from this book?

This is not a book for average investors.  It is for professionals who want to brush up their asset allocation skills, and young professionals wanting insight into asset allocation.

The book is available here: The New Science of Asset Allocation: Risk Management in a Multi-Asset World (Wiley Finance)

The Economics of Food: How Feeding and Fueling the Planet Affects Food Prices

To me, this was the most interesting book of the three, but I feel it was mistitled.  A better title would have been: “Fueled: The Effects of  Using Food for Fuel” or something like that, because the central question of the book is to what degree has using crops to produce biomass for fuel production (usually ethanol) affected the costs of food and fuel.

I found the book is very even-handed, to a fault.  It argues that the use of crops for fuel production had little impact on food costs, and that there were many other factors that made food prices rise when ethanol production was going gangbusters.  Weather, domestic and foreign demand and many other factors had a role in moving food prices, not just ethanol.

After reviewing the book, I have a better sense of the complexity of the question, and that it will not admit easy answers.

Who would benefit from this book?

Anyone who wants a basic understanding of food economics, and how that is impacted by a wide number of factors including using crops for the production of fuel would benefit from this book.  The book is well written, and seemingly balanced.

The book is available here: The Economics of Food: How Feeding and Fueling the Planet Affects Food Prices

Full disclosure: The publishers sent me copies of these books, hoping that I would review them.  I review about 80% of the books that get sent to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

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Onto tonight’s topic: asset allocation.  So, we had a bad quarter for equities.  Not that I can predict things, but I pulled in my horns progressively over the last nine months, culminating in buying a bunch of utilities at the last portfolio reshaping.  I own mostly energy, insurance, utilities, and consumer nondurables stocks, with a little tech thrown in for fun.  At present, median P/E is around 9, and P/B around 90%, with strong balance sheets, and around 17% of the portfolio in cash.  I missed roughly half of the carnage of the last quarter, and this week, I put some money to work, cash falling by 1%.

So, when are equities cheap?  Next question: cheap relative to what?  It’s difficult to say when equities are absolutely cheap, but here are some ideas on cheapness:

• Stocks are absolutely cheap when they trade in aggregate at less than book value, or less than 8x trailing earnings.  Think of Buffett getting excited back in 1974.
• Stocks are relatively cheap to Baa bonds when the earnings yield of stocks plus 3.9% is above the yield on Baa bonds.  But this at present depends on very high profit margins continuing, and sales not shrinking, neither of which are guaranteed.
• When there is significant debt deflation going on, determining cheapness is tough.  Better to ignore the market as a whole, and focus on survivability/cheapness.  Aim at companies in necessary industries with relatively little debt, strong accounting practices, and cheap to earnings/book/sales.
• I don’t have a good metric for when equities are cheap/dear to commodities.  Ideas welcome.

With respect to bonds, credit spreads are not wide enough to make me yell buy, as I did in November 2008 and March 2009.  Beyond that, the spread on GSE debt and guaranteed mortgages is thin.  TIPS look attractive, as few care about inflation.  The US dollar has been strong lately, largely due to weakness in the Euro.  I would be light on non-dollar bonds for now.

What we have been experiencing is creeping illiquidity, where the prior stimulus from the Fed and US Government has been declining.  There isn’t enough private demand growth to drive the economy, because we need to pay off or compromise on debts.  Also, the private sector looks at the growing debts of the government, and gets concerned.  How will the government deal with it?  Higher taxes, inflation, default?  No good scenarios there.

When an economy is overleveraged, there are no good solutions.  If sales fall, then corporations will fire more people, and idle more capacity in order to maintain profits near prior levels.  High quality bonds do well, but stocks do poorly, until enough debts are paid of or compromised, and the economy can work without the fear of mass insolvency again.

I have written before on a new approach to asset allocation.  Broadly, I am looking at a system that:

• Considers the credit cycle first.  Great returns typically happen after credit spreads are wide, and are lousy after they are tight.
• Considers the slopes of the Treasury nominal and TIPS curves.
• Looks at the cash flow yield of all asset classes relative to history, relative to other asset class yields, etc.
• Factors in safety provisions for each asset class.  Stocks need the most, then junk bonds, then investment grade.
• Looks at the short-run and the long-haul returns of each asset class, attempting to analyze when the short run is way above or far below long-haul trends.

At present, I am still happy playing conservative, because I am less confident about debt deflation than most investors are now.  There will come a time to be much more bullish, but it will come after earnings decline, and firms have delevered still further.

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 wth more potential over the next 1-5 years.

I still like energy names here, utilities, and reinsurers, particularly those that are strongly capitalized.  I’m not concerned about hurricanes for the strongly capitalized; they will be around to benefit from the increase in pricing power after any set of hurricanes.

I’m looking for undervalued and stable industries.  Human resources — sure, more part time workers.  Healthcare information?  A growing field, even with the new “health bill.”  Same for Biotech.

Even in a double dip, toiletries will still be purchased.  Phone calls will still be made, and the internet will still be accessed.  Perhaps life insurers are worth a look here; after all, the Bush tax cuts are expiring, and there will be more demand for tax avoidance.

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 more highly cyclical than I have seen in quite a while.  I will be very happy hanging out in dull stocks for a while.

Comerica warrants [CMA/WS] closed at $14.50 today, a price that makes the computer say, “does not compute.”

The Comerica warrants are trading so cheaply that they discount negative volatility.  At zero volatility, the warrants would trade 5% higher:

And at a fair-ish volatility level, 17% higher.

Now there are two ways to extract value here.  Buy the warrant and sell short 2/3rds of a share of the common stock, which is empirically delta-neutral.

As the delta of the positions change, adjust your hedge in the common stock to reflect it.  The other way is not to short the common stock, but to short long dated options.  The most liquid long dated options are the 40s expiring in 2012.  The hedge would be to sell options on 170 shares of stock against every 100 warrants owned.

Over ten months the transaction makes a profit with CMA stock between 30 and 53.  That is one wide band, and there is still room for adjusting hedges in ways that could improve matters.

Now, I am open to feedback from readers/bloggers who trade options.  What’s wrong with this idea?  Free money is rare in the markets, but this warrant really seems like a mispriced security.

Full disclosure: no positions

PS — note that you may not get favorable margining being long the warrant and short the option.

1) You know that I have mixed feelings about the Fed.  They have done a poor job with bank regulation, monetary policy, and managing systemic risk.  The trouble is, if you’re going to have a fiat currency, monetary policy is credit policy, and so your central bank should broadly control credit if you are going to do that at all.  (If not, then set up a currency board, or back your currency with silver/gold.)

So when I hear that the Fed is winning in reconciliation of the finance bill, I think it is good in some ways – yes, they should oversee small banks, but bad because the Fed should not have bailout authority, or at least they should not be able to hide what they do when monetary policy is unorthodox.  It is one thing to delay oversight of ordinary dealings, but rotten to hide debasement of the currency through special dealings with favored entities.

But I see little value in the size of the Fed.  They have too many people doing too little.  Monetary policy and bank supervision?  Fine if they do it well.  But the institution as a whole could be radically slimmed.  Congress should take closer control of the Fed, slim it down, and focus it on the missions that it should attend to.

2) I am not impressed with Donald Kohn.  He has a farewell interview with the Wall Street Journal, and not once does he mention the buildup of debt in our economy, partially fostered by easy monetary policy from the Fed, as a problem.  Blind guy, and even worse, he still doesn’t get that bubbles are typically able to be seen in advance, or, that the Eurozone isn’t structurally flawed.

Thought experiment time.  What if we tossed out all the Fed governors, and replaced them with a bunch of notable value investors?  Value investors suffer from the problem that we see problems early, and adjust portfolios too soon.  That could be of benefit to monetary policy, because value investors often see when things are becoming overdone, well in advance of it becoming too big to handle.  This would be a big improvement on the current system.

3) I get email from congressional staffs asking for advice on issues, or asking me to write about them.  Recently I was asked what I would ask the nominees for the Federal Reserve Board.  This is what I said:

• We find ourselves in this crisis because the Fed ran an asymmetric monetary policy for years: loosen aggressively when the least crisis comes up, and tighten slowly until there are small squeaks of pain.  This led short interest rates progressively lower, until we found ourselves in the liquidity trap that we are now experiencing.  How are you going to get us out of this liquidity trap?

• How are you going to provide decent opportunities to savers so that capital formation can begin again?

• What have you done in your life that qualifies you for this level of responsibility?

• To the economists: neoclassical economics did us no favors with respect to this crisis.  Only a few Austrian economists predicted it, along with a few practical economists in the business world.  We need a new paradigm for monetary policy.  Are you capable of providing it?

• To the non-economist: You will be working primarily with neoclassical economists, with their theories uncontaminated by data.  How will you avoid being sucked in by their groupthink?

4) When I went to hear Raghuram Rajan and Carmen Reinhart at the Cato Institute, I was very impressed with what both of them had to say.  Rajan was the skunk at the farewell party for Alan Greenspan back in 2005 at Jackson Hole, when he was the only one to fully suggest that imbalances were building up due to debts being incurred in the financial sector.  Few aside from The Economist noted what he said.  More noted Donald Kohn’s dismissive response, which was not erudite, in my opinion.

Both noted that the current financial reform bill would do little to fix the real underlying problems, with which I agree.  It constrains in many areas that don’t need it, and does not constrain areas that were significant to the crisis – e.g., the GSEs and the Fed.  Imagine a simple proposal that would immediately force flexibility onto the economy: dividends are deductible, but interest payments (and preferred dividends) are not.  An easy way to lower leverage, and encourage flexible finance.

Also, they noted the possibility that the US Government would engage in financial repression, which would force people to invest in government securities on unfavorable terms.  Ugly stuff.

And as an aside, we met in the F. A. Hayek Auditorium.

5) Can Hayek be cool?  Perhaps, give the recent rap video.  I am not surprised that few neoclassical economists give Hayek any credit; he cuts against most of what they stand for, so why should they commit treason?

As for Glenn Beck, I get tired very quickly of the facile answers that appeal to the anger of the masses.  There are real problems, and we need to deal with them, but oversimplifying the problems will not get us to the solutions; it will only create a new set of problems.  I have no favor toward the Tea Party; they don’t stand for anything coherent.  I am not an Austrian economist, much as I like some of their ideas.  My ideas have been derived from my observation of how financial systems work over the last 25 years.

6) Following Austrian economics would be a huge improvement over what we usually do, though there is a problem.  Once you hit the bust, nothing works.  The Austrian view will be a “big bang” and clean it up fast, but it will be a lot of sharp pain.  The virtue of Austrian Economics is that it would restrain the boom, and thus make it less likely that one faces the pains of the bust.  But there are no easy solutions in the bust.

Focus on the boom, not the bust.  Solve the boom, and the bust does not come.

7) It is common that many debt classes that have few defaults get an aura about the qualitative factors that forestall default.  Well, what of municipal finance?  Under stress, is it possible that the cultural factors that made default less likely might wither, and defaults cascade in likelihood?  Yes, I think that is possible, and I think that is why Buffett is lightening the boat on munis.

8 ) Solve the revolving door problem for the SEC?  Pay them more.  I get it, but are we really willing to pay market-based salaries for expertise?  I doubt it.  The government tends to be chintzy; penny wise and pound foolish.

But if you hired real experts, would the government be willing to set them free and let them corner real frauds?  That is the question.

9) Fannie and Freddie common stocks are on their way to zero.  Their NYSE delisting is just one more step in the road to total dissolution.  The simplest solution is to fold them into GNMA, and slim down the massive operations that don’t do much for the mortgage market.

10) The unequal signal problem exists with the banks that took TARP money.  We hear a lot about those that repay, but little about those that do not pay.  Well, here is an article about those who did not pay.

11) Evan Newmark is occasionally annoying, but often perceptive.  Should President Obama do what he does not want to do?  It couldn’t hurt; his allies on the far left are already disaffected. The question is whether he can be as dispassionate as Bill Clinton, and pursue a centrist course.  I don’t think he is capable of that, because he is too smart, and smart people, unless they moderate their idealism, don’t compromise well.

That’s all for now.

1) A response to those commenting on my piece A Stylized View of the Global Economy: when I say stylized, is does not mean that every nation fits the paradigm, only that most do.  My view is that the debt overages will have to be liquidated, and there is no possible policy that can avoid it except large scale inflation.  Those looking for clever ways out of this bind will be disappointed by what I write.  When nations are heavily indebted their options decline, particularly when they don’t control their own currency.  For the US I say that we should have liquidated insolvent firms rather than bailing them out.

Also, read Falkenstein as he takes on the idea that stimulus spending works.  I have little confidence that the linear reasoning behind stimulus spending yields long-term economic benefits.

2) One blogger that I have some respect for, but have not mentioned often is Bruce Krasting.  He writes some good things on US social insurance programs. His recent post Social Security at Mid-Year highlighted what should shock many: we have hit the tipping point on Social Security.  From here on out it will be a drag on the federal budget.  Expect Congress to remove it from the federal budget.  It no longer aids the illusion of smaller deficits.  (What a cleverly hidden illusion.)

As he commented at the end of his article:

-SS is $2.5T of the $4.5T Intergovernmental account. I believe that this entire group is going cash flow negative. The IG account cost us ~$160 billion in interest last year, but some out there are pretending the IG account does not exist. An example of this is in the following link.

Sorry, U.S. Federal Debt Is NOT Approaching 100% Of GDP Anytime Soon

This kind of thinking is not only lunacy; it is dangerous.

And I agree.  There only two ways to look at the balance sheet of the US.  Look at explicit debt vs GDP, regardless of who is owed the debt.  Or, look at total liabilities vs GDP.  But never look at explicit debt not used to fund social insurance funds.  It is meaningless.  The total liabilities number tells the whole story.

3) Spain is in trouble.  Their banks are borrowing a lot from the ECB, with no end in sight.   Perhaps that leads them to push for stress testing across all European banks.  Or, maybe things are so bad that the banks are identified with the sovereign credit, and both are tarnished.

4) Or consider the Eurozone as a whole: the system begs for debt relief, but the Euro and ECB are tough taskmasters.  The Euro has been an excellent successor to the Deutschmark in terms of preserving purchasing power, but perhaps purchasing power needs to be sacrificed in order to relieve debtors.  The ECB is steps away from monetizing the debts of its governments.  Perhaps they could preserve the Eurozone by destroying the value of the Euro.  Germany might not stand for it, but it has significant unfunded liability issues as well.

As with the US, unless there is a large inflation, debts will eventually have to be liquidated, whether through austerity or default.  There is no other way.  Austerity will have its costs, but unless debts are inflated away or defaulted, those are costs that must be paid.

5) Can pensions be cut?  The typical answer is no, but what if a state pays less than what was promised in inflation-indexed terms?  That is what is being tested.  I think that eventually states and municipalities will be forced into bankruptcy because they can’t make employee benefit payments, and still maintain minimal services to the populace.

6) Debtors prison.  I have mixed feelings here, because I think that those that can’t pay should not be put there for long, if at all.  Those that can pay but won’t, should go there.  Regardless, this is a trend, and those that think they can walk away from debts should think twice before doing so.  You may be setting yourself up for prison.

This is just another front in the war against those who can pay but won’t.  More lenders are suing those who won’t pay, and going after their assets.  My only surprise is that it has taken so long for this to happen.

7) Fannie and Freddie are a giant black hole.  It astounds me that there is any respect given to two companies that have lost massive amounts of money since their inception.  The US would have been better off without them, and will be better off with them in bankruptcy.  The US should not promote single family housing as a goal, because it cannot create the conditions where marginal people can be capable of financing housing on their own.

So, when some suggest one last bailout, I say, let them fail.  Cancel the common and preferred stocks, and fold the remainder into Ginnie Mae.

8 ) Occasionally, there are really dumb articles, like this one.  The time for debt was November 2008 through March 2009, when I recommended investing in junk bonds.  There is little reason to borrow now; valuations are relatively high, don’t take your life into your hands.

9) And, occasionally, smart articles, like this one.  If you are in a volatile profession, reduce your risks by investing in high quality bonds.  If you are in a safe profession, invest in stocks.  When I went to work for a hedge fund, the first thing I did was pay off my mortgage, so that I could take more risk, without worrying about getting kicked out of my house.

10) Felix Zulauf has generally been a bearish guy, and so has done well over the past decade.  But is he right now?  Will stocks revisit their March 2009 lows?  It is possible, but I lean against it.  We would need a situation where most of the developed nations decided to aim for recession and stay there a while.  I do not see that yet.

11) Is it is liquidity problem or an insolvency problem?  If you have to ask, it is usually insolvency.  Consider Richard Koo, and his thoughts on the matter.

12) Using the rubric of the “Tragedy of the Commons” Kid Dynamite points out how it sets up the wrong incentives if we bail out profligate states and municipalities.  As a part of my “new mormal,” it is no surprise to me that this is happening.  It should be happening, and will happen for at least the next five years.

13) Because of my employment agreement, I can’t tell you exactly what I know about the demise of Finacorp.  But I can tell you that the article cited is wrong.  Finacorp never carried an inventory of assets.  It only crossed bonds between buyers and sellers.  The failure of Finacorp occurred for far simpler reasons.