When Will the FOMC Tighten the Fed Funds Rate?

Photo Credit: Moon Lee || When is this train going to arrive?

Photo Credit: Moon Lee || When is this train going to arrive?

There are several ways to gauge the Federal Open Market Committee wrong. I am often guilty of a few of those, though I hope I am getting better.  Don’t assume the FOMC:

  • Shares your view of how economies work.
  • Cares about the politics of the situation.
  • Knows what it really wants, aside from magic.
  • Won’t change its view by the time an event arrives that was previously deemed important for monetary policy.
  • Cares about the reasoning of dissenters on the committee.
  • Understands what is actually happening in the economy, much less what its policy tools will really do.

But you can assume the FOMC:

  • Cares about the health of the banks, at least under extreme conditions
  • Wants to do something good, even if their minds are poisoned by neoclassical economics
  • Will err on the side of saying too much, rather than too little, when it feels that its policies are not having the impact desired on the markets and economy.
  • Will act in the manner that most protects its continued existence and privileges.

So if we want to guess when the FOMC will tighten, we can do three things:

  1. Look at market opinion
  2. Look at the FOMC’s own opinions, or
  3. Something else ;)

Let’s start with market opinion.  At present, Fed funds futures have the Fed funds rate rising to 0.25% in the third quarter of 2015, and 0.50% in the fourth quarter.  Now, market opinion has tended to be ahead of the actual actions of the FOMC on tightening policy, so maybe that will be true in the future as well.  So far, those betting for tightening in the Fed funds futures market have been losing over the last few years along with those shorting the long Treasury bond, because rates have to go up.

Okay, so what does the FOMC think?  Starting back in January of 2012, they started providing forecasts to us, and here is a quick summary of their efforts:

central tendency_10374_image001 GDP

In general, they have been overly optimistic about growth in the US economy.  They probably still are too optimistic.

 

 

Unemp

They have been better at forecasting the unemployment rate, even as it has become less useful as an indicator of how strong labor conditions are because of discouraged workers and more lower wage jobs.

PCE

 

In general, they have expected inflation to perk up in response to their policies a lot faster than it has happened.

FF

 

And as a result, like the market, they have expected to tighten in the past a lot sooner than they are presently projecting, which is not all that much different than the view of the market.  Also like the market, you can’t simply take an average of their views as representative of where Fed Fund will be.  Since the FOMC relies on voting, the median view would be more representative than the average Fed funds rate forecast, and that has remained at a relatively consistent “tightening will happen sometime in 2015″ since September 2012.  The median estimate of where Fed funds would be at the end of 2015 has also been 0.75-1.00% over that same period, which is higher than the current market estimate of 0.60%, but lower than the FOMC’s own estimate of 1.1%.

So, where does this leave us, but with a view that the FOMC will tighten policy next year.  But what if the monetary doves on the FOMC remain dominant?  After all, those that are permanent voting members are more dovish than the average participant tossing out an estimate.  That leaves me with this, which reflects the influence of the doves better:

Tighten

 

This graph is based on the average forecast, which includes a decent number of outlier views from some of the doves, which at present suggests tightening in January of 2016, but if you take into account the time drift of views since September 2012, it augurs for tightening in August of 2016.

The drift has happened because the economy has not strengthened the way the FOMC expected it would.  If we muddle along at the average rate of growth over the last two years, the FOMC may very well sit on its hands and not tighten as quickly as presently expected.  After all, labor conditions are soft, and inflation as they measure it is not roaring ahead.  (Please ignore the asset price inflation that aids the non-existent wealth effect.)

As it is, statements from the FOMC have been noncommittal, only saying that they are ending QE.  They are still waiting for their grand sign to act on Fed funds, and it has not come yet.

Summary

Current expectations from the market and the FOMC suggest that the Fed funds rate will rise in 2015.  Prior expectations of FOMC action have signaled much earlier action than what has actually happened.  From my vantage point, it is more likely that the FOMC moves later than the third quarter of 2015 versus earlier than then.  The FOMC has been slow to remove policy accommodation; it is more likely that they will remain slow given present economic conditions.

 

 

The Future Will Be Like The Past, Only More So

Photo Credit -- Javier || Buffett believes in America

Photo Credit — Javier || Buffett believes in America

Yesterday there was an article where Buffett was quoted on getting mortgages to buy houses. Let me quote the most relevant portion:

“You would think that people would be lining up now to get mortgages to buy a home,” Buffett said today at a conference hosted by Fortune magazine in Laguna Niguel,California. “It’s a good way to go short the dollar, short interest rates. It is a no-brainer. But so far home construction pickup has been slower than I had anticipated.”

Now, when I read the comment stream on the article, I was not surprised at the level of disagreement, but the vitriolic nature of the the disagreement.  Buffett is certainly not made of Teflon anymore, and fame has led to its share of detractors.

Now, I don’t think that Buffett is giving the right advice to everyone here, but I also don’t think that he is talking his book because has has investments in firms that sell:

  • Real estate
  • Manufactured housing
  • Building materials
  • Mortgages
  • Etc.

Indeed, Buffett has enough investments that almost anything he says could be talking his book.  I think his character is such that he does not talk his book — his firm is one that is built on “low hype” attitudes, at least, low hype for a company of its size and complexity.

Should everyone run out and get a mortgage because it is a cheap time to be borrowing money?  That is an individual question, hinging on how secure and high your income is versus the likely payment on the mortgage, and other housing-related expenses.

The interest rate may indeed be low relative to history, but how well will the economy do in the future?  Maybe residential housing is too expensive in some areas to get a lot of people excited about buying.

Buffett also said:

“Household formation falls off dramatically in a recession, at least initially,” he said. “But that doesn’t last long. Hormones kick in and in-laws get tiresome, too.”

Unless something changes in US culture, there have been changes to the demand for homes, driven by the following factors:

  • People are marrying later and less frequently
  • They are having fewer kids
  • Urban areas are more attractive for many people to live in, reducing commute time and costs.  Even car-buying is affected.
  • There are fewer move-up buyers because of the financial crisis.
  • The ability of lower middle class people to afford homes has been reduced, particularly in high cost of living areas.
  • The financial crisis has ruined the illusion that residential real estate is an investment that can’t lose money.

There may be more reasons, but even though the 30-year mortgage is the cheapest long-term financing that an average person can get, there are more people than before who are not interested in buying a home.  Renting suits their goals fine.

As such, I think Buffett is wrong here, and that borrowing to buy residential housing will not be as prominent as it was in the past.  But I don’t think he has any bad intentions in what he said — he believes in America, and thinks that we will return to the consumption patterns of the past, which relied on too much debt in my opinion.

Final note: I’m getting tired of reading comment streams.  The people there are often too cynical, and too loose with the truth.  Their expectations for what they deserve in this life are also inflated beyond what is reasonable.  Some turn to conspiracy theories to keep themselves from blaming their bad fortune on their own actions.

Buffett is generally a good guy, and a good example as far as businessmen go — he does not deserve the abuse.  I don’t agree with Buffett’s politics, but I don’t think that he is not sincere.

Full disclosure: long BRK/B and WFC

Managing Money for Retirement

Photo Credit: eric731 -- People can budget, but can they manage risk?

Photo Credit: eric731 — People can budget, but can they manage risk?

Investing is difficult.  That said, we can make it harder still.  We can encourage people with little to no training to try to do it for themselves.  Sadly, many people get caught in the fear/greed cycle, and show up at the wrong time to buy and/or sell.  We get there late, and then our emotions trick us into action, when the rational investor says, “Okay, I missed that move.  Where are there opportunities now, if there are any at all?”

But investing can be made even more difficult.  Investing reaches its most challenging level when you are relying on your investing to meet an anticipated and repeated need for cash outflows.

Institutional investors will tell you, portfolio decisions are almost always easier when there is more cash flowing in than flowing out.  It means that there is one dominant mode of thought: where to invest new money?  Some attention will be given to managing existing assets — pruning away assets with less potential, but the need won’t be as pressing.  (Note: at really high rates of cash inflow, investing gets really tough as well, but that’s another story, and one that I successfully lived though 1998-2003…)

What’s tough is trying to meet a cash withdrawal rate that is materially higher than what can safely be achieved over time, and earning enough consistently to do so.  Doing so as an amateur managing your own retirement portfolio will be a particularly hard version of this problem.  Let me point out some of the areas where it will be hard:

1) You don’t know how long you, your spouse, and anyone else relying on you will live.  Averages can be calculated, but particularly with two people, the odds are that one will outlive an average life expectancy.  Can you be conservative enough in your withdrawals that you won’t outlive your money?

2) My estimate of what the safe withdrawal rate is on a perpetuity is the yield on the 10-year Treasury Note plus around 1%.  That additional 1% can be higher after the market has gone through a bear market, and valuations are cheap, and as low as zero when you are near the end of a bull market.

Now, most people people with discipline want a simple spending rule, and so those that are moderately conservative choose that they can spend 4%/year of their assets.  At present, if interest rates don’t go lower still, that will likely (60-80% likelihood) work.  But if your income needs are greater than that, your odds of yields over the long haul go down dramatically.

3) Will you be able to maintain an iron discipline, and not overspend your assets?  It’s tempting to do so, and the temptation will get greater when bad events happen that break the budget, whether those are healthcare or other needs.  It is incredibly difficult to avoid paying for an immediate pressing need, when the soft cost is harming your future.  There is every incentive to say, “We’ll figure it out later.”  The odds on that being true will be low.

4) How will you deal with bear markets, particularly ones that occur early in retirement?  Can you and will you reduce your expenses to reflect the losses?  On the other side, during bull markets, will you build up a buffer, and not get incautious during seemingly good times?

This is an easy prediction to make, but after the next bear market, look for a scad of “Our retirement is ruined articles.”  Look for there to be hearings in Congress that don’t amount to much — and if they do amount to much, watch them make things worse by creating R Bonds, or some garbage like that.

5) Avoid investing in too many income vehicles; the easiest temptation to give into is to stretch for yield — it is the oldest scam in the books.  This applies to dividend paying common stocks, and stock-like investments like REITs, MLPs, BDCs, etc.  They have no guaranteed return of principal.  On the plus side, they may give you capital gains if you use them right, buying them when they are out of favor, and reducing exposure when everyone is buying them.

Another easy prediction to make is that junk bonds and non-bond income vehicles will be a large contributor to the shortfall in asset return in the next bear market, because a decent number of people are buying them as if they are magic.  The naive buyers think: all they do is provide a higher income, and there is no increased risk of capital loss.

6) Avoid taking too much or too little risk. It’s psychologically difficult to buy risk assets when things seem horrible, or sell when everyone else is carefree.  If you can do that successfully, you are rare.  What is achievable by many is to maintain a constant risk posture.  Don’t panic; don’t get greedy — just stick to your investment plan through the cycles of the markets.

7) As assets shrink, what will you liquidate?  The best thing would be being forward-looking, and liquidating what has the lowest risk-adjusted future return.  What is achievable is selling assets off from everything proportionally, taking account of tax issues where needed.

8 ) Are you ready for Social Security to take a hit out around 2026?  Once the trust fund gets down to one year’s worth of payments, future payments get reduced to the level sustainable by expected future contributions.  Expect a political firestorm when this becomes a live issue, say for the 2024 Presidential election.  There will be a bloc of voters to oppose leaving benefits unchanged by increasing Social Security taxes.

9) Be wary of inflation, but don’t overdo it.  The retirement of so many people may be deflationary — after all, look at Japan and Europe so far.  Economies also work better when there is net growth in the number of workers.  It will be tempting for policymakers to shrink what liabilities they can shrink through inflation, but there will also be a bloc of voters to oppose that.

10) You need a defender of two against slick guys who will try to cheat you when you are older.  If you have assets, you are a prime target for scams.  Most of these come dressed in suits: brokers and other investment salesmen with plausible ways to make your money stretch further.  But there are other scams as well — run everything significant past a smart younger person who is skeptical, and knows how to say no when needed.

Conclusion

If this all seems unduly dour (and I haven’t even talked about defined benefit plan issues), let me tell you that this is realistic.  There are not enough resources to give all of the Baby Boomers a lush retirement, without unduly harming younger age cohorts, and this is true over most of the developed world, not just the US.

Even with skilled advisers helping you, you need to be ready for the hard choices that will come up.  Better you should think through them earlier rather than later.  Who knows?  You might take some actions that will lower your future risks.  More on that in a future post, as well as the other retirement risk issues.

Buying an Inexpensive Car

Photo Credit: FotoSleuth

Photo Credit: FotoSleuth

I bought an inexpensive car a couple of days ago, a 2009 Toyota Corolla with 19,700 miles on it.  It’s in almost perfect condition.  I paid ~$10,300 in cash to get it, inclusive of tax and tags.

Sound like a good deal?  I think so, but let me give you the negatives:

  • Only one key, and no manual.
  • I had to spend some extra time looking for it, and had to travel 50+ miles twice to get it.  (And a third time to get permanent plates…)
  • The vehicle was previously a total loss, as its front end was badly mangled in an accident.  Thus, it only has a salvage title, which limits the ability to finance the vehicle — few banks will lend against it.  That doesn’t affect me, but it might affect others.
  • Also, if it gets wrecked, selling and re-titling a vehicle with a salvage title can be problematic.  (Not that I expect that, but in 2007, I had a car totaled that was parked in front of my house, mostly on my yard.)
  • I had to wait for it to be repaired.

But on the plus side:

  • I traded away an older vehicle to a family that needed a large 15-seat van, at a price that helped them.
  • My auto insurance costs have gone down.
  • Gas mileage has gone up.
  • I’ve bought three vehicles from this niche dealer before, and they have all worked out well.  He selectively buys Toyotas and Hondas at auto auctions that have been deemed total wrecks by insurers, after analyzing them to see what it would take to make them as good as new.  Then he fixes and sells them; that’s all he does.
  • Because I’ve bought from this fellow before, when he heard I was in the market for a car, he mentioned that he had one car he had not listed yet — the one I bought.  All of his deals are good, but this one more so.  I’m flexible about what I drive, and so I’m happy to get a car in good condition for a good price.

Now, most of my readers don’t live in the DC area, so this won’t be so relevant to most of you.  You might not have a niche dealer in your area doing something similar, assuming that you can live with the disadvantages, and get comfortable with the quality of the repaired vehicle.

This does point up the idea of going off the beaten track, and looking non-conventionally for a car, which is a decent-sized expense for most people.  Flexibility helps.  I look for cars that have good repair records on average, and am not wedded to any particular style.  I think that older cars with relatively few miles are at present a niche that few actively target to purchase.  Pricing models break down for them, because they are rare, almost all of them have a story behind them, and many people don’t like driving older cars, even if they are in very good condition.

You may have a better way of finding cars than I do — if you do, feel free to share it below in the comments.  As it is, I’m not really a writer on personal finance, so this is a rare article that may help you practically in buying a car.  A few final points:

  • Befriend someone trustworthy who knows cars well, and is willing to help you.  People who love cars often like helping others find a good deal.
  • When you find someone who offers unusual value, stick with him.
  • Be flexible.  I’ve known a lot of people who have paid a lot more than they needed to for what my father called, “Fancy Rolling Stock.”
  • Consider total costs of ownership.  Older cars don’t need collision insurance.  Some makes and models wear better than others, so repair costs could be lower for those cars.  Analyze likely fuel efficiency.

Finally, if you have a deal that is pretty good, be happy with it.  Don’t overspend time looking for the absolute best deal.  In my opinion, the best is elusive, you can never truly know if you have it, and pretty good is attainable.  And that is true for more than just buying cars — don’t let perfection become the enemy of the pretty good.  (Shall I write about that for investment analysis?  When do we ever get to certainty?…)

What Should the Cost of Equity Be to Value Investors?

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Photo Credit: Sepehr Ehsani — Which project is better, project A or project B?

I can’t remember where I ran into it, but I found this article on a blog that I had not run into before on Calculating [the] Cost of Equity for Value Investors.  I think it gets close to the right answer, and I would like to sharpen it here.

My answer to a lot of economic questions is: what’s the alternative?  Many people look at the shiny formulas in investing but don’t ask what they really mean.  (More people just don’t look at the formulas… which has its pluses and minuses.  The math reveals, but it also conceals hidden assumptions.)

After wisely dismissing how to calculate the cost of equity from Modern Portfolio Theory [beta] and the Gordon model, he considers cost of equity based off of return on equity, and begins to get tied up in problems.  Let me try.

The cost of equity is important for a number of reasons:

  • It helps answer the question, “When should a company issue or buy back stock?”
  • It provides a measure for the alternative use of equity capital on competing unlevered projects/investments of equivalent riskiness.

Note the each of the reasons is structured as a series of comparisons.  I’ll use a discounted cash flow [DCF] analysis as an example.  Imagine a simple project requiring an investment of equity capital.  There is a certain cost, and the risk is enough that you can’t borrow money for financing — it must be funded by equity.  There are expected after-tax cash flows from the project that you think are a best estimate of returns.  When would you invest in the project?

I would compare investments versus other similar investments, and look at as many similar projects from a riskiness perspective, and see which investment yielded the best return.  The second place project as returns go is the alternative project for investment by which the winning project is judged, and surprise, the winning project has a positive net present value evaluated at the rate of the alternative project.

(An aside: it just hit me that I am recreating part of the learning process that I went through back when I was a TA at UC-Davis 31 years ago, helping teach Corporate Financial Management [CFM], while taking quadratic programming [QP] course at the same time — I ended up doing my QP paper on using QP to choose investments to maximize returns without explicitly calculating internal rates of return, thus quietly solving a problem that the undergrad CFM textbook said could not be done.  FWIW, which isn’t much.)

Now, I’m waving my hands at what I mean by risk, but to me it is the best estimate of the probability distribution of outcomes, thus giving you estimates of what the likelihood and severity of adverse outcomes could be.  The thing is, in real life we know these figures poorly at best, but the framework is still useful because the investor making the decision needs to choose the project of a class of projects with roughly the same risk profile.  Though my initial example included only equity-financed projects, this could be expanded to consider all projects, where the amount of debt on projects affects their risk, and the tax-affected debt cash flows are a deduction from returns.

The process would remain the same: look at as many similar projects from a riskiness perspective, and see which investment yielded the best return on the equity.  The second place project as returns on the equity go is the alternative project for investment by which the winning project is judged.

Back to Stocks

Where does that leave us as stock investors?  I subscribe to the “pecking order” theory of the cost of capital, which says that firms use the cheapest form(s) of capital to fund their incremental financing needs, which means they should rarely issue equity. The exception would be if they are undertaking a project so large that it would make the company significantly more risky if they were to issue only debt for financing.

We do see companies engaging in buyback activity when they can’t find better uses for slack capital.  In many cases, there are few large projects begging for the attention of management.  Buying back stock earns the earnings yield for the firm.  Managements buying back stock make the statement that there are no more incremental projects of equivalent risk that would have an unlevered return on equity greater than the earnings yield for the firm.

Now maybe shareholders may have a bigger set of investment choices than the firm does, so perhaps dividends could be a better choice for shareholders, but it will have to be a lot better, because dividends are taxable.

In general, we want to see management teams be careful users of equity capital, taking note of its cost for the benefit of shareholders.  Every good management team should have their schedule of possible projects for investment, but always recognize there is the alternative of buying back stock as a last resort.  In that limited sense, the earnings yield is the cost of equity for the firm, unless big profitable projects beckon.

There’s more to say here, but maybe this is a good start.  Thoughts?

Possible Bond ETF Problems

Photo Credit: Penn State

Photo Credit: Penn State

There have been a few parties worrying about crises stemming from ETFs, because they make it too easy for people to sell a lot of assets in a crisis.

I think that fear is overblown, but I don’t think it is non-existent, and I would like to use a bond ETF as an example of what could be possible.

Most bonds don’t trade every day.  Only the most liquid bond issues trade every day, and they form the backbone for pricing the bonds that don’t trade.

But how do you price a bond when it doesn’t trade?  It’s complicated, but let me try to explain…

When a less liquid bond actually has a trade, the bond pricing services take note of it.  They calculate the yield spread of the less liquid bond versus similar bonds (similar in industry, rating, maturity, currency, domicile, other features) that are liquid, and compare it to:

  • where that yield spread was in the past
  • where the yield spread is relative to other similar less liquid bonds that have recently traded
  • where models might imply the yield spread should be, given other securities related to it (stock, preferred stock, junior debt, other bonds in the same securitization, etc.)
  • where investment banks that make a market in the bonds are indicating they would buy or sell.

Now consider that the bond pricing services are doing this for all the bonds they cover every day, and in real time when the NAVs are made available for ETFs.  The bond pricing services attempt to create a set of prices for all securities that they cover that is consistent with the market activity in aggregate, adjusting at a reasonable speed to changing market conditions.  It’s complex, but it allows investors to have a reasonable estimate of the value of their bonds.

(Note: the same thing is done with illiquid stocks as a result of the late trading scandal in mutual funds back in the early 2000s for setting the NAV of mutual funds —  less liquid stocks have the same problem in a lesser way than bonds.)

The technical name for this is matrix pricing, which is a bit of a misnomer — multifactor pricing would have been a better name.  It works pretty well, but it’s not perfect by any means — as an example, you can’t take the calculated price and trade at that level — it is only indicative of where an uncoerced buyer and seller might trade on a normal day.  It may be a useful guide, though your broker making a market may disagree, which is part of the art of understanding value in the bond markets.

The Possible Problem

Now imagine an ETF with a relatively large amount of less liquid bonds in it, and a market environment where yield spreads are relatively tight, as it is now.  In such an environment, even the less liquid bonds may have their yield spreads relatively tight versus their more liquid cousins.  Now imagine that a relatively violent selloff starts in the bond market over credit issues.

If you were a bond manager at such a time, surprised at the move, but thought it would go further, and you wanted to lighten up on some of your positions, would you try to sell your liquid or less liquid bonds first?  Most of the time, you would sell the liquid ones, because it is relatively easy to get the trades done.  If the selloff is bad enough, it will be impossible to sell the less liquid bonds — practically, that market shuts down for a time.

But if there are very few trades of the less liquid bonds, what does the pricing service do?  Initially, it might rely on the old spread relationships, leaving the less liquid bonds with higher prices than they should have.  But with enough time, a few trades will transpire, and then the multifactor models will catch up “all at once” with where the pricing should have been.

For a time, the NAVs would be high relative to where the bonds actually should trade.  The unit creation/liquidiation process might not catch up with it, because the less liquid bonds are difficult to source, and there is often a cash payment in lieu of the less liquid bonds.  That cash payment figure could be too high in my scenario, leading to a rush to liquidate by clever investors sensing an arbitrage opportunity.

Now, would this be a catastrophe for the markets as a whole?  I don’t think so, but some investors could find the NAVs of their bond ETFs move harder than they would expect in a bear market.  That might cause some to sell more aggressively, but remember, for every seller, there is a buyer.  Someone outside the ETF processes with a strong balance sheet will be willing to buy when the price is right, because they typically aren’t forced sellers, even in a crisis.

Practical Advice

If you own bond ETFs, know what you own, and how much of the portfolio is less liquid.  Have a passing familiarity with how the NAV is calculated, and how units get created and liquidated.  Try to have a sense as to how “jumpy” investors are in the asset sub-class you are investing in, to know whether your fellow investors are likely to chase market momentum.  They may cause prices of the ETFs to vary considerably versus NAVs if a large number of them take the same action at the same time.

Know yourself and your limits, and be willing to hold or add when others are panicking, and hold or sell when others are too optimistic.  If you can’t do that, maybe hand it over to a financial advisor who stays calm when markets are not calm.

Till next time…

 

Inevitable Ineffective Banking Regulation

Photo Credit: Michael Daddino

Photo Credit: Michael Daddino

I am mystified at why people might be outraged or surprised that the Federal Reserve does a poor job of overseeing banks.  The Fed is an overstaffed bureaucracy.  Overstaffed bureaucracies always tend toward consensus and non-confrontation.

I know this from my days of working as an actuary inside an overstaffed life insurance company, and applying for work in other such companies.  I did not fit the paradigm, because I had strong views of right and wrong, and strong views on how to run a business well, which was more aggressive than the company that I worked for was generally willing to do.  Note that only one such company was willing to hire me, and I nearly got fired a couple of times for proposing ideas that were non-consensus.

This shouldn’t be too surprising, given the past behavior of the Fed.  In 2006, the Fed made a few theoretical noises about residential real estate loan quality, but took no action that would make the lesser regulators do anything.  It’s not as if they didn’t have the power to do it.  One of the great canards of financial reform is that regulators did not have enough power to stop the bad lending.  They most certainly did have enough power; they just didn’t use it because it is political suicide to oppose a boom.  (Slide deck here.)

As a result, I would not have enacted Dodd-Frank, because I like my laws simple.  Instead, I would have fired enough of the regulators to make a point that they did not do their jobs.  How many financial regulators were fired in 2008-2009?  Do you hear the crickets?  This is the #1 reason why you should assume that it is business as usual in banking regulation.

You won’t get assiduous regulation unless regulators are dismissed for undue leniency.  I have heard many say in this recent episode with Goldman Sachs, the New York Fed, and Carmen Segarra that those working for the Fed are bright and hard-working.  I’ll give them the benefit of the doubt; my own dealings with those that work for the Fed is that most of them, aside from bosses, are quiet, so you can’t tell.

Being quiet, and favoring the powerful, whether it is bosses, politicians, or big companies that you regulate is the optimal strategy for advancement at the Fed over the last 30 years.  It doesn’t matter much how bright you are, or how hard you work, if it doesn’t have much impact on the organization’s actions.

I try to be an optimistic kind of guy, but I don’t see how this situation can be changed without firing a lot of people, including most of the most powerful people at the Fed, lesser banking regulators, and US Treasury.

And if we did change things, would we like it?  Credit would be less available.  I think that would be an exceptionally good thing, but most of our politicians are wedded to the idea that increasing the availability of credit is an unmitigated good.  They think that because they don’t get tagged for the errors.  They take credit for the bull market in credit, and blame everyone except themselves and voters for the inevitable bear market.

Also, if we did fire so many people, where would we find our next crop of regulators?  Personally, I would hand banking regulation back to the states, and end interstate branching, breaking up the banks in the process.

Remember, the insurance industry, regulated by the states, is much better regulated than the banking industry.  State regulators are much less willing to be innovative, and far more willing to say no.  State regulation is simple/dumb regulation, which is typically good regulation.

But whether you agree with my policy prescription or not, you should be aware that things are unlikely to change in banking regulation, because it is not a failure of laws and regulations, but a failure of will, and we have the same sorts of people in place as were there prior to the financial crisis.

Postscript

I would commend the articles cited by Matt Levine of Bloomberg regarding this whole brouhaha:

A bit more on Carmen Segarra.

Apparently the place to discuss regulatory capture is on Medium. Here is Dan Davies:

Regulated institutions generally have better contacts and relationships with the top central bankers than their supervisors do. And for whatever reason, top central bankers never developed the necessary knee-jerk aggressive response to any attempts to make use of these relationships to affect the behaviour of supervisors.
So banks never need to listen to their line-level regulators because they can always get those regulators’ bosses’ bosses’ bosses to overrule them. Here is Felix Salmon, mostly agreeing. And here is Alexis Goldstein with a litany of Fed enabling of banks. Elsewhere, Martien Lubberink explains the transaction that got so much attention in the Fed tapes, in which Goldman agreed to hang on to some Santander Brasil stock for a year before delivering it to Qatar. He thinks it was pretty vanilla. And Adam Ozimek has a good point:

This American Life ep should lower avg est corruption belief. Goldman and NY Fed secretly taped & all u get is in non-confrontational nerds?

 

AIG Was Broke

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Photo Credit: Ron

There’s a significant problem when you are a supremely big and connected financial institution: your failure will have an impact on the financial system as a whole.  Further, there is no one big enough to rescue you unless we drag out the public credit via the US Treasury, or its dedicated commercial paper financing facility, the Federal Reserve.  You are Too Big To Fail [TBTF].

Thus, even if you don’t fit into ordinary categories of systematic risk, like a bank, the government is not going to sit around and let you “gum up” the financial system while everyone else waits for you to disburse funds that others need to pay their liabilities.  They will take action; they may not take the best action of letting the holding company fail while bailing out only the connected and/or regulated subsidiaries, but they will take action and do a bailout.

In such a time, it does no good to say, “Just give us time.  This is a liquidity problem; this is not a solvency problem.”  Sorry, when you are big during a systemic crisis, liquidity problems are solvency problems, because there is no one willing to take on a large “grab bag” of illiquid asset and liquid liabilities without the Federal Government being willing to backstop the deal, at least implicitly.  The cost of capital in a financial crisis is exceptionally high as a result — if the taxpayers are seeing their credit be used for semi-private purposes, they had better receive a very high penalty rate for the financing.

That’s why I don’t have much sympathy for M. R. Greenberg’s lawsuit regarding the bailout of AIG.  If anything, the terms of the bailout were too soft, getting revised down once, and allowing tax breaks that other companies were not allowed.  Without the tax breaks and with the unamended bailout terms, the bailout was not profitable, given the high cost of capital during the crisis.  Further, though AIG Financial products was the main reason for the bailout, AIG’s domestic life subsidiaries were all insolvent, as were their mortgage insurers, and perhaps a few other smaller subsidiaries as well.  This was no small mess, and Greenberg is dreaming if he thought he could put together financing adequate to keep AIG afloat in the midst of the crisis.

Buffett was asked to bail out AIG, and he wouldn’t touch it.  Running a large insurer, he knew the complexity of AIG.  Having run off much of the book of Gen Re Financial Products, he knew what a mess could be lurking in AIG Financial Products.  He also likely knew that AIG’s P&C reserves were understated.

For more on this, look at my book review of The AIG Story, the book that tells Greenberg’s side of the story.

To close: it’s easy to discount the crisis after it has passed, and look at the now-solvent AIG as if it were a simple thing for them to be solvent through the crisis.  It was no simple thing, because only the government could have provided the credit, amid a cascade of failures.  (That the failures were in turn partially caused by bad government policies was another issue, but worthy to remember as well.)

Spot the failure

Time to Chase Bill Gross?

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Jason Zweig at the Wall Street Journal had a very good piece on whether to follow Bill Gross as he goes from Pimco to Janus.  Let me quote one paragraph:

Morningstar estimates that over the past five years, the average investor fell behind Pimco Total Return’s 5.6% annual gain by 1.6 points a year—largely as a result of buying high and selling low. That gap is among the widest of any large bond fund; at the Vanguard Total Bond Market Index Fund, for example, investors have earned returns only 0.4 point lower than those of the portfolio itself.

In the short run, this offers a reason to follow Bill Gross to Janus.  He is starting with a clean slate, and will be able to implement positions that seem attractive to him that would not have been attractive at Pimco because they would have been too small.  Managing less money lets Bill Gross be more choosy.

Second, in the short run, growth in bond assets at Janus will temporarily push up the prices of bonds held by Janus.  Those that get in early would benefit from that if bond assets grow under the management of Bill Gross.  Just keep your eye on when assets stop growing if you are buying for that speculative reason.

A third potential reason to follow Gross depends on how much Pimco continues to use his quantitative strategies.  If Pimco abandons them (unlikely, but not impossible), Janus would get the chance to use them on much less money, which would make the excess returns greater.  If I were considering this as a reason, I would watch the turnover in Pimco’s main funds, and see if certain classes of assets disappear.

My last point here is that the abilities of Bill Gross will do better managing less money, but the effect won’t be so great if he is competing with Pimco to implement the same strategies.  At minimum, he’s not likely to do worse than at Pimco, and in the short-run, there are some reasons why he will likely do better.

PS — please remember that Bill Gross has two hats: the showman and the quant.  The quant makes money for clients while the showman entertains them.  The showman opines about the Fed, politics, etc.  That can get investors interested because it sounds clever, but that is not how Bill Gross makes money.

This brings up one more point.  If you do decide to invest with him at Janus, review the prospectus to see what degree of flexibility with derivatives Gross will have.  If it similar to what he had at Pimco, he is likely following the same strategy.

Two Questions on Fixed Income from the Mailbag

From my readers:

What are your thoughts on Pimco’s new strategy for its flagship fund?

This concerns me because its one of the few “safe” funds in my company’s 401k plan.

I haven’t heard anyone critique this and thought you’d be the best that I know of.

It seems to me that its a disproportional risk. And that due to its size could potentially cause problems.

 http://blogs.barrons.com/focusonfunds/2014/09/17/deriving-returns-at-pimco-total-return/

This is not a new problem with Pimco.  You can review these two articles here:

Pimco has always used a lot of derivatives, though for marketing reasons some of their funds have fewer derivatives, even as Pimco tries to follow the same strategies.  You can view this three ways:

  • It hasn’t had horrible effects in the past, so why worry now?
  • We haven’t had the market event that would test the limits of this strategy yet, but can it really get that bad?
  • Now that the bond market is more crowded, Pimco’s quantitative bond strategies have less punch.  They don’t have the same room to maneuver.  Like the London Whale, have they become the market?

I lean toward the last of these views.  When you manage so much money, it becomes difficult to wrench alpha out of the market because mispricings are limited, and it is difficult to keep your trades from moving the market.

You might want to split your “safe monies” in your 401(k) plan if you have other credible investments.  That said, the likelihood of a large disaster harming Pimco is small — but you could try to cover that risk by setting a relative stop loss where you would exit Pimco versus a similar maturity fund run by Vanguard.

Another letter:

I’m a fledgling portfolio manager and blog reader.  Would you care to comment on the bounce we’ve seen in Treasury rates this month? (28 bp on the 10-year month to date).  I just don’t get it.  I see global growth continuing to underwhelm, more monetary opiates out of Asia, persistent dovishness from the Fed and the arrival (?) of the Godot that has been ECB stimulus.  These circumstances plus ongoing geopolitical issues make me wonder why Treasury yields have not gone further down or at least held the line.  I know it might be mean reversion or a supply/demand phenomenon but do not feel qualified to say and would enjoy reading your perspective.

Separately, are you aware of any Readers’ Digest Condensed summaries of monetary policy in Europe since 2007?  My career is not so old and each time I read about their approach to sorcery I encounter yet another acronym of which I am ignorant.

Best and thank you!

Back when I was a corporate bond manager, and things were moving against me, I would do a few things:

  • Seek out contrary opinion, and see if there was something I was missing.
  • Go out to lunch for Chinese food, dragging my trading notebook, and a sheaf of research with me, and schmooze over the data while there was no Bloomberg terminal in front of me.

Now, my own current views are conflicted, because I view the global economy like you do.  There is no great growth anywhere.  Geopolitical events should lead to a Treasury rally, and sanctions should weaken growth prospects.  I’m still long a moderate amount of the iShares 20+ Year Treasury Bond (TLT), for myself and clients — it is difficult to see too much of a bear market with monetary velocity so weak.

That said, my recent 2-part series on the shape of the yield curve suggested that the curve shape was the sort where we often get negative surprises.  Despite the Fed’s confident mutterings that amount to little more than “Trust us!” the Fed has never been in a situation like this one and does not have the vaguest idea as to what it is doing.  They are proceeding largely off of untested theories that so far haven’t done much good or bad, aside from allowing the US Government to finance its deficits cheaply, thus cheating savers who deserve a better return on their money.

This is my thought: the slightest hint of tightening coming sooner moves the forward yield curve up, particularly in the 3-5 year region of the curve, but extending to 2- and 10-year notes as well.  But the questions remain how well growth holds up, how sensitive will the economy be to higher interest rates, and whether banks start genuinely lending against their expanded liabilities.

Personally, I expect rates to go lower after further growth disappointments, but I could be wrong, very wrong, so don’t be too bold here — scale into positions as you see opportunity.

Full disclosure: long TLT