This portion goes from February 2010 to April 2010.

Probably the biggest new thing I did at the blog was start “The Rules” series.  Personally, I think all of them are best articles, because they proceed from deeply held beliefs of mine.  So I start with those:

The Rules, Part I

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.

The Rules, Part II

Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge.  If the speculator is undercapitalized, risks to the financial system rise.

The Rules, Part III

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.

The Rules, Part IV

Governments that scam the asset markets (and their citizens) take all manner of half measures to defend failed policies before undertaking structural reform.  (This includes defending the currency, some asset sales, anything that avoids true shrinkage of the role of government.)  The five stages of grieving apply here.

The Rules, Part V

Massive debt issuance on a sector-wide basis will usually have a slump following it, due to a capacity glut.

The Rules, Part VI

History has a nasty tendency to not repeat, when everyone is relying on it to repeat.

History has a nasty tendency to repeat, when everyone is relying on it not to repeat.  Thus another Great Depression is possible, if not likely eventually.

When people rely on the idea that a Great Depression cannot occur again, they tend to overbuild capacity, raising the odds of another Great Depression.

The Rules, Part VII

In a long bull market, leverage builds up in hidden ways within corporations, and does not get revealed in any significant way until the bear phase comes.

The Rules, Part VIII

Illiquidity is a function of total transaction costs, which can be considered barriers to entry.

The Rules, Part IX

Attempting to control a system changes it.

The Rules, Part X

The more entities manage for total return, the more unstable the financial system becomes.

The shorter the performance horizon, the more volatile the market becomes, and the more index-like managers become.  This is not a contradiction, because volatile markets initially force out those would bring stability, until things are dramatically out of whack.

The Rules, Part XI

Could an investment bank go to junk status?

The Rules, Part XII

Growth in total factor outputs must equal the growth in payment to inputs.  The equity market cannot forever outgrow the real economy.

And that’s the end of the “rules” posts for now.  They express deeply held beliefs of mine.

My next group of posts dealt with banking reform:

• A Few Notes From the Fordham Conference
• Dumb Regulation is Good Regulation — How to Regulate the Banks
• A Summary of What Bank Reform Should Be

Most of it comes down to getting the risk-based capital formulas right, raising capital levels, and most of all avoiding borrowing short to lend long.  The asset-liability mismatch is the core of why banking crises happen, because the liabilities run when asset levels are depressed.

The next group deals with debts and liabilities of nations and other lesser governments:

• Default, Inflation, Higher Taxes — Choose One
• Ignore anyone who tells you that debt levels don’t matter.
• A Question of Cultural Failure
• A Question of Cultural Failure (II)
• Of Credit Ratings, Sovereign Risk and Semi-Sovereign Risk
• More on Sovereign Risk and Semi-Sovereign Risk
• The Virtue of a Big Bang
• The Logic of Shared Pain
• Promises, Promises (Deals with the huge entitlement promises all over the world)
• The Whole Earth is Owned; Debts Net Out to Zero

Debt-based economic systems are inherently inflexible.  Governments that make long-term promises without pre-funding them scam their taxpayers, and those to whom they make promises.  All solutions are ugly once the willingness of a government to pay on its promises is questioned.

What is Liquidity? (IV)

My point is that you can’t take illiquid assets and make them liquid.

Moat, Float, Growth

Warren Buffett labors to preserve the company he has built, so that it can last far longer than he will.  An impossible task, but what is Buffett if not one that does things far beyond what most of us can do?

In Defense of the Rating Agencies – V (summary, and hopefully final)

I never did go on CNBC for this.  They figured out what I told them: “This wouldn’t make for good television.  It’s too complex.”  But it does come down to my five realities:

• Somewhere in the financial system there has to be room for parties that offer opinions who don’t have to worry about being sued if their opinions are wrong.
• Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves, or something similar.  The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.  The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
• New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
• There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
• Ratings can be short-term, or long-term, but not both.  The worst of all worlds is when the ratings agencies shift time horizons.

In the recent run-up, there was talk of the infallibility of equities.  This led to a higher level of variable compensation in the economy through option and share issuance and low pressure to raise fixed wages.  This was yet another form of hidden leverage, which hid the unprofitability of enterprises through share dilution.

That was written in 2001, after the flop of the Nasdaq.  I have sometimes said that bubbles are financing phenomena.  That’s true, but we can phrase it more generally: bubbles occur because of an asset-liability mismatch.  People go long a long-duration asset with short-duration funding.  The short duration funding can be borrowing, or vendor finance, or it can be a labor commitment in order to get equity or option awards.

People chase the long-term asset that seems so valuable, and give up time and interest (money’s version of time) to get it.  They give up more than they imagine for something of uncertain value.  In other words, a mania.  Give up something relatively certain in the short run for something with uncertain long run potential.

The attitude could be summed up with a conversation I heard in early 1998 between my boss and his best salesman, where the salesman said, “It’s a no-brainer, have the market pay your employees.”  His idea was that a constantly rising stock market would provide compensation to employees through stock awards, options, 401(k)s, etc., even as the market was straining at valuation limits.  It is probably a sign that the market is overheated, when market-based rewards become common.

Startups by their nature require that employees be flexible, and give up a lot of fixed guarantees.  What payments they receive at the beginning are small, and less than their work might deserve in most established contexts.  But there is the possibility of the big payoff, and the possibility of total loss.  The asset in question has a lot of variability, but the liability, the work that must be put in, is big, and may not vary much for success or failure.

In the tech bubble, many parties extended vendor credit because there were big profits to be made in the future.  Alas, but they lent to those with very uncertain prospects, and in March of 2000, the chain of leverage started to collapse, both for vendors, and for those that worked in the industries.  Just as hedge funds have a hard time holding onto good employees when performance goes bad, so it is for tech companies when financing dries up, and the stock price craters.  Rats desert the sinking ship.

“Free money” brings out the worst in people.  Do something small in the present and reap a huge future.  Sadly, it rarely works that way, except at the very beginning of a boom.  At the end of the boom, it is a maelstrom, with many people demanding to throw their money away in search of riches that will never be.

From a dated piece:

Crowd-following is common to humanity.  It takes a lot to stand apart from highly correlated behavior.  I’ve told this story before, but in late 1999, I was talking with my mother (a very good self-taught investor), she told me about many of my cousins who were speculating in tech stocks.  I said to her, “They don’t know anything about investing!”  My mom replied, “Oh, David.  You’re such a fuddy-duddy.  I just bought some Inktomi!”

Now, to set the record straight, that was just 1% (or less) of my mom’s assets, so an occasional flyer is acceptable.  Call it “Mad Money.”    For my cousins, it was most of their investable assets.  My mom is fine, and the fuddy-duddy did all right also, but the cousins swore off stock investing.

I am close to concluding that it is impossible to teach the average person how to do well in investing.  They don’t have the patience or the willingness to learn. (Few want to be called “fuddy-duddy” by their mothers.)

Getting rich quick is very rare, but it entrances some people several times in their lives, and rarely does it end well.  It is far better for most people to work hard in areas of the economy that are being rewarded, and invest excess cash in a mix of  stocks, long-dated investment grade bonds, money markets, and a little gold.

After all, it’s not what you make, it’s what you keep.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Rebalancing of any sort in investing presumes an underlying stability to the economic system, and thus, market returns.  Rebalancing will not protect against socialism, war, or an overleveraged position.

The concept of rebalancing requires the idea of reversion to mean.  It will not protect you when profound shifts are happening, where the market are moving to a new equilibrium different from the old one.

Many shifts in the markets are precipitous; they don’t allow for slow adjustment.  That’s why many lose out when sharp shifts occur.  Especially in leveraged positions, the question comes: “Do I take my loss, invest more, or just let it ride?”

The best answer is forward-looking, only asking what is most likely.  The best preparation is also forward-looking, but with a glance to the past, asking what could happen at worst, which is worse than the worst of the past.

There are times when it seems that stability is no more, or that the boundaries for stability are far larger than normal, such as now.   At such a time, it may pay to follow market trends, realizing that there many participants like you that are struggling to figure out the situation that everyone is in.

The point is to be forward-looking.  Ignore the past.  Ask what is most promising over your favored time-horizon.

So when it makes sense, add to a position that has lost money.  When it doesn’t make sense, sell the whole position and realize the loss.  Could this be simpler?

The market takes action against firms that carry positions bigger than their funding base can handle.  Temporarily, things may look good as the position is established, because the price rises as the position shifts from being a marginal part of the market to a structural part of the market.  After that happens, valuation-motivated sellers appear to offer more at those prices.  The price falls, leading to one of two actions: selling into a falling market (recognizing a true loss), or buying more at the “cheap” prices, exacerbating the illiquidity of the position.

When an asset management firm is growing, it has the wind at its back.  As assets flow in, they buy more of their favored ideas, pushing their prices up, sometimes above where the equilibrium prices should be.

As Ben Graham said, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”  The short-term proclivities of investors usually have no effect on the long run value of companies.  Rather, their productivity drives their long-term value.

There have been two issues with asset managers following a “value” discipline that have “flamed out” during the current crisis.  One, they attracted hot money from those who chase trends during the times where lending policies were easier, and the markets were booming.  And often, they invested in financials that looked cheap, but took too much credit risk.  Second, they invested in companies that were seemingly cheap, rather than those with a margin of safety.

My poster child this time is Fairholme Fund.  Now, I’ve never talked with Bruce Berkowitz; don’t know the guy at all.  Every time I read something by him or see a video with him, I think, “Bright guy.”  But when I look at what he owns, I often think, “Huh. These are the stocks you own if you are really bullish on financial conditions.”

Yesterday, I saw a statistic that said that his fund was 76% invested in financial stocks as of 8/31.  Now I believe in concentrated portfolios, and even concentrated by sector and industry, but this is way beyond my willingness to take risk.  From Fairholme’s 5/31/2011 semi-annual report to shareholders, here are the top 10 holdings and industries:

Aside from Sears, all of the top 10 holdings are financials.  And, of those financials that I have some knowledge of, they are all what I would call “complex financials.”

In general, unless you are a heavy hitter, I discourage investment in complex financials because it is hard to tell what you are getting.  Are the assets and liabilities properly stated?  Financial companies are just a gaggle of accruals, and the certainty of having the accounting right on an accrual entry decreases with:

• Company size (the ability of management to make sure values are accurate or conservative declines with size)
• Rapidity of the company’s growth
• Length of the asset or liability
• Uncertainty over when the asset will pay out, or when the liability will require cash
• Uncertainty over how much the asset will pay out, or when how much cash the liability will require

It’s not just a question of whether the assets will eventually be “money good.”  It is also a question of whether the company will have adequate financing to hold those assets in all environments.  For financials, that’s a large part of “margin of safety,” and the main aspect of what failed for many financials in the last five years.

Another aspect of “margin of safety” for financials is whether you are truly “buying it cheap.”  All financial asset values are relative to the financing environment that they are in.  Imagine not only what the assets will be worth if things “normalize,” or conditions continue as at present, but also what they would be worth if liquidity dries up, a la mid-2002, or worse yet, late 2008.

Also remember that financials are regulated, and the regulators tend to react to crises, often making a marginal financial institution do something to clean up at exactly the wrong time, which puts in the bottom for some set of asset classes.  Now, I’m not blaming the regulators (or rating agencies) too much; no one forced the financial company to play near the cliff.  Occasionally, for the protection of the system as a whole, the regulator shoves a financial off the cliff.  (or, a rating agency downgrades them, creating a demand for liquidity because of lending agreements that accelerate on downgrades.)

Finally, think about management quality.  Do they try to grow rapidly?  That’s a danger sign.  There is always the tradeoff between quality, quantity, and price.  In a good environment, you can get 2 out of 3, and in a bad environment, 1 out of 3.  Managements that sacrifice asset quality for growth are not good long run investments, they may occasionally be interesting speculations at the beginning of a new boom phase.

Do they use odd accounting metrics to demonstrate performance?  How much do they explain away one-time events?  Are they raising leverage to boost ROE, or are they trying to improve operations?  Do they try to grow through scale acquisitions?

Are they willing to let bad results show or not?  Even with good financial companies there are disappointments.  With bad ones, the disappointments are papered over until they have to take a “big bath,” which temporarily sets the accounting conservative again.

The above is margin of safety for financials — not just seeming cheapness, but management quality and financing/accounting quality.  They often go together.

Fairholme’s annual report should come out somewhere around the end of January 2012.  What I am interested in seeing is how much of his shareholder base has left given his recent disappointments with AIG, Sears Holdings, Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, Brookfield, and Regions Financial.  Even the others of his top 10 have not done well, and the fund as  a whole has suffered.  Mutual fund shareholders can be patient, but a mutual fund balance sheet is inherently weak for holding assets when underperformance is pronounced.

(the above are estimates, I may have made some errors, but the data derives from their SEC filings)

Now, we eat dollar-weighted returns. Only the happy few that bought and held get time-weighted returns.  And, give Fairholme credit on two points (though I suspect it will look worse when the annual report comes out):

• A 9.9% return from inception to 5/31/2011 is hot stuff, and,
• A 6.0% dollar-weighted return is very good as well.  Only losing 3.9% to mutual fund shareholder behavior is not great, but I’ve seen worse.

This is the problem of buying the “hot fund.”  Once a fund becomes the “Ya gotta own this fund” fund, future returns on capital employed get worse because:

• It gets harder to deploy increasingly large amounts of capital, and certainly not as well as in the past.
• Management attention gets divided, because of the desire to start new funds, and the complexity of running a larger organization.
• When relative underperformance does come, it is really hard to right the ship, because assets leave when you can least handle them doing so.  The manager has to think: “Which of my positions that I think are cheap will I liquidate, and what will happen to market prices when it is discovered that I, one of the major holders, is selling?”

That is a tough box to be in, and I sympathize with any manager that finds himself stuck there.  It can be a negative self-reinforcing cycle for some time.  My one bit of advice would be: focus on margin of safety.  If you do, eventually the withdrawals will moderate, and then you can work to rebuild.

Every excess eventually unwinds.  When an excess unwinds, the fall gets exacerbated by trend-followers blowing out of mutual and other pooled funds with lousy relative performance.

If you had a list of who owned a given publicly-traded asset, and when they bought it, you would know a lot about how patient, intelligent, indebted, etc., the holders of the assets are.  That would give some insight into how they might behave if the asset’s price began to fall.  Would they buy more as it went down, or would they sell in a panic?

Now no one has this data, but some approximate the data by a variety of measures.  Dollar volume traded as a fraction of market capitalization is a measure of speculative activity, though truly, I suspect that the holders of most stocks fall into two camps — long-term (years), and short-term (days to months).  Short-term has gotten shorter as computer power has democratized trading.

We can also read the lists of holders from 13F data.  Managers are pretty consistent.  If they are low turnover, they tend to stay that way.  The same for high turnover.

The holders of mutual funds tend to be late to the news.  There are two reasons for this:

1. They aren’t paying close attention because the results of mutual funds give slow and unclear signals, which only become clear when the quarterly statement arrives.
2. Because of loads, and brokers who sold the investors on the funds, regret causes reactions to be slow.

But these holders are late liquidators, and cause funds with bad investment strategies to sell some of their favorite wrong investments, which drives the prices of the investments down further.  This can cause assets to overshoot below their fair value, which value investors quietly accumulate.

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Long horizon investors tend to resist momentum.  Short horizon investors tend to follow momentum.  Long horizon investors tend to have little short-term need for results.  Short-horizon investors want/need results soon.  At bottoms, long-term investors dominate.  At tops, short-term investors dominate.

Mutual funds are in general short term investors, but the few that try to educate their investors that they are long term value investors do get more patient holders, which gets reinforced if the returns are good over a long period.

A Ponzi scheme needs an ever-increasing flow of money to survive.  Same for a market bubble.  When the flow’s growth begins to slow, the bubble will wobble.  When it stops, it will pop.  When it goes negative, it is too late.

Here’s how a Ponzi scheme works for the promoter:

Prior Net Assets + Receipts + True Investment Earnings (if any)  – Withdrawals – Expenses = Net Assets

But this is what it looks like to the investor:

Investor Prior Net Assets + Receipts + Reported Earnings – Withdrawals = Investor Net Assets

The investor’s view of the assets is higher than the actual assets by the cumulative difference between reported and true investment earnings, and cumulative expenses. The promoter wants to keep the good times rolling, and keep the ratio of actual to investor net assets as high as possible.  But to do that requires additional receipts, and a lack of withdrawals, which in turn requires an attractive reported rate of earnings, higher than what could be ordinarily achieved. But the higher the reported rate of earnings goes, the further behind the promoter gets.  Also, at very high levels, the authorities take interest.  At very low levels, the Ponzi dies.  Part of the evil genius of Madoff was striking the balance.  He also did four other things:

• Soft-peddled the marketing so that it was like joining an exclusive club.
• Discouraged withdrawals by saying you would not get back in (for some).
• Deluding regulators into thinking that it was a front-running scam.
• He did not rake off much.

Most Ponzi schemes die rapidly because of the greed and impatience of the promoters.  All Ponzi schemes eventually fail. So how does this relate to market bubbles?  With a market bubble, the increase in market values significantly exceeds the increase in intrinsic values.  This could be due to a number of factors:

• Players see that borrowing to chase a rising asset is a winner.
• Promoters make it easy to do for inexperienced investors.
• An easy monetary policy lowers financing costs, aiding bubble financing.
• Players seek stock gains, and disdain debt claims.
• At the end, investors have to feed the asset to keep it afloat, giving up current income to support the “asset.”

Positive cash flow into the bubble asset class supports valuations for a time, the cash flows driven by momentum, but eventually positive cash flows are overwhelmed by negative cash flow from an overvalued asset class. My advice: avoid speculating on momentum, particularly after it has gone on for a few years.  Put a margin of safety first in your investing, such that you will always be around to invest in the future, no matter how bad the  investment environment is.

Rapid money supply growth with no consumer price inflation can only really occur within the confines of an asset price bubble, or else, where does the money go?  Interest rates are low at such a time because of the incredible liquidity, and complacency of lenders that they will get an equal amount of purchasing power back.  Perhaps another possibility is when a country’s currency is being used more and more as a shadow currency, like the US in the Third World.  But even that will come home someday.

I wrote this sometime prior to 2003.  But can it be more relevant than today, aside from my comment about being a shadow currency?  Alas, the US Dollar is not a store of value anymore.  It is only a unit of exchange, like trading cigarettes in a prison camp.

The Federal Reserve may pretend that it is the guardian of stability, but it is not so with respect to asset values.  The Fed stays within its mandates: labor unemployment and goods price inflation.  Those are not much affected by Fed policy at present.  But asset values are inflated.

What should we expect of monetary policy?  Additional creation of money or credit should affect the prices of something.  If the Fed does not intend on affecting a price somewhere, what is it up to?  The economy is prices.  What is the Fed if it does not affect prices?  Next press conference, ask Ben what set of prices he is trying to affect.  If he mumbles, as he usually does, you can know that he is without knowledge, or lying.  All monetary policy affects prices, and it is either dishonest or stupid to say otherwise.

That’s all for now.  We are in a rough situation because of errors in government and central bank policy, as well as cultural errors that have favored spending over saving.  Ignore the idiots who talk of the paradox of thrift.  They rely on short-term models which are not relevant in the real economy.  Saving is a good thing, but maybe save in currencies that are not subject to government discretion, like gold.

Before I start this evening, I have a request for readers, and a comment for new readers.  (Note: if you are reading this anywhere but directly at my blog, please realize that you have to come to my blog for me to hear what you are saying.  I do not read comments anywhere else but at Aleph Blog.)  First the request: I would like to test the robustness of the Impossible Dream TAA model on another country.  If any of you have data on any non-US market, which would require the following:

• Index price series
• Earnings series
• Dividends series
• And a fixed income return or yield series

Contact me, and we can discuss whether you should send me the data or not.  Monthly data would probably work best, but I am open to other periodicities.

Second, for new readers, welcome to my blog.  Why do I write this after 4 1/4 years of blogging?  May 2011 is my biggest month ever, largely because of the “Impossible Dream” pieces.

For new readers, here is what you have to understand about me: I write about a lot of different things.  I have lots of interests.  I almost named this blog “The Investment Omnivore” but didn’t, because I planned on creating a firm called Aleph Investments back in 1996.  It eventually happened — 14 years later.

So, if I don’t always write about investment strategy, or any other single topic (all crisis, all the time) please don’t get disappointed.  I write in proportion to what is of current interest, and what discoveries I have been making.

So, travel with me on this trail where I cover everything from the global macroeconomy to personal finance issues.  My goal is to help you learn to think about economic/finance/investment issues, and help you see the interconnections between markets, so that you can develop your own perspective on the markets, and not just parrot me.  (Not that many do… )

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All assets represent future goods.  The prices of assets represent the trade-off between present goods and assets.

I wrote a piece recently called Inflation Speculation.  The idea was to explain how it is difficult to save for the future in a way that will transfer today’s purchasing power to the future without diminution, particularly when you have a central bank trying to stimulate the economy through the creation of credit, and the nation as a whole is overindebted.

So, if the Fed is patting itself on the back for:

• lowering corporate yield spreads
• rising stock market prices

I would tell them: it is easy to change the discount rate, but hard to change the cash flows.  Yes, as you flooded the market with credit, the values of risky assets rose.  Big deal.  Most executives are smart — they still see that demand is punk, and won’t do any real creation of plant and equipment that they weren’t already planning to do.  Little new investment took place, the value of existing assets got revalued up.

When asset prices are high, it means that money today will not buy a lot of future goods.  High P/Es, low interest rates tell us that new investments will have low yields, absent some amazing transforming technology that improves productivity dramatically.

Some people will say to me, “I need more yield today.  Yields are so low.”  I say, “When yields are so low, it is time  to avoid yield and preserve capital.  The time to seek yield is when yields are high, and no one wants to part with money to lend to them.

In March of 2009, I helped to rescue the firm of a friend.  He needed cash in the midst of the crisis, and a few of us lent to him at rates exceeding 10%, with warrants, realizing that he might be bankrupt in short order.  But things turned, and not only did he survive but he thrived.  I am still receiving interest, but will likely be redeemed soon.

Maybe that’s not such a good example.  I put 40% of my congregation’s building fund into high yield and low investment grade debt in late 2008 — made up for a lot of 2008 losses.

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Think of it a different way: shares in corporations are a proxy for the future well being of the country.  When P/Es are low, the potential for capital gains is large, as is the ability to keep up with inflation.  When P/Es are high, the potential for capital gains is small, as is the ability to keep up with inflation.  Same for bond yields — better to be aggressive when rates and spreads are high, and defensive when they are low.

Thus I would tell Ben Bernanke to lay off the quantitative easing.  It has not helped.  Yes, you have pushed asset prices up, and interest rates down, but has not created any significant new economic activity.  And why should it?  Consumers are still overindebted, and 30% of those with mortgages will lose money on a sale.  The real problem was the debt overhang, and you did nothing to to address that, not that you could, or should.

Buffett once said that most people should not be glad when they see asset prices rising, because they will need to invest more in the future, and will now have to pay higher prices.  Thus times like September 2008 offer the future at a discount to those who have ready liquidity, whereas 2007 offers the future at a premium price.

To the extent that you can, commit capital when it is most needed, and avoid chasing markets up.

This book was not what I expected.  I expected a book on the current crisis, and got a book on monetary/credit policy over the whole of the existence of the US.  What is more, unlike most books that cover a long sweep of history, this book is even, and does not overemphasize the recent past, which is a humble thing for an author to do, because we don’t know the full ramifications of recent actions yet.

Now, I respect the writings of Chris Whalen at Institutional Risk Analytics and elsewhere — a bright guy.  But this outperformed my high expectations.  Some books I glide through because I know the topic well.  This was a book where I thought I knew the topic well, but found that I did not know as much as I thought, and so I read more slowly than I usually do.

But this book changed my view on financial crises.  Whether one is under a gold standard or a fiat currency standard, the main order for assuring stability is the regulation of banks and credit.

In the same way that people need help in verifying whether a drug is effective or food is pure, they need to know that promises to pay will be honored.  It does not matter what backs the currency if banks are allowed to overlever, or mismatch assets long — there will be a financial panic, and it is not due to gold, silver, or fiat money necessarily, but that that banks made promises that could not be kept under all scenarios.

Yes, I think it is better to be under a gold standard, because it restricts the power of the government.  But that is not the main issue with financial crises; we need to restrict that ability of banks to borrow short and lend long; we also need to restrict their overall leverage.  Do that, and crises disappear — also, banks are far less profitable, and that is a good thing.  We will get fewer banks, and bright people will go to more useful places in the economy.

Other things that stood out to me were the First and Second National Banks of the US, and how their creation led to booms, and dissolution led to busts.  Lincoln is unique in every way, even in monetary policy terms, as he created unbacked paper money to fight the civil war, which funded a lot of it.  After the war, the return to the gold standard, much as it should have been done, was depressive, but it was an effect of paying off the war.

I came away from this book with a more balanced view of US politics — many of those I like came off worse, and those I did not like were shown to have been better than I thought — with the exception of Lincoln, who in hindsight seems to be a radical in most senses.  I am very glad that slavery is gone, but not the way that it got done.

Quibbles

Ignore Roubini’s introduction.  Better Whalen should have gotten a real intellect like James Grant or Caroline Baum.

Also, in the middle of the book, in WWII, the US spends far more than its GDP on the war.  I get it, but I think it would be more reasonable to classify defense spending inside GDP so that we can see what proportion of national output is going to the war effort.

Who would benefit from this book:

Anyone with a moderate intellect or better could learn from this balanced account of America’s monetary and credit policies.  It is very well written; those with little knowledge will learn much, but those with greater knowledge will still learn something.

If you want to, you can buy it here: Inflated: How Money and Debt Built the American Dream.

Full disclosure: This book was sent to me, because I asked for it.

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