This is not my ordinary book review.? These are good books that will only appeal to a small fraction of my readers, because few will have need for the knowledge. Both are written by Espen Gaarder Haug, who is kind of a character.? He collects option pricing formulas the way some people collect Barbie Dolls, Beanie Babies, or Baseball Cards.? He has interacted with some of the brightest minds in the field, and collaborated with a few of them.? In both books the math is significant — it would help if your calculus was sharp, and for any value some algebraic knowledge is needed.
Let’s start with the more esoteric of the two books, The Complete Guide To Option Pricing Formulas.? Almost every option formula is included there, together with ways of estimating volatility, certain statistical techniques, aspects of compound interest math, etc.? The book is very comprehensive, and for those that need how to estimate the value of standard and non-standard options, it is a good book to keep on hand as a reference, together with the free CD-ROM containing an Excel add-in that allows you to use the formulas inside Excel.? I have used them for some of the insurance companies I have worked for; the software was easy and reliable.
The second book Derivatives, Models on Models, is different.? He interviews 15 significant thinkers on options and derivatives, and presents 15 papers by them.? Most of them contain tough math; some I couldn’t understand.? The real value of the book was in the interviews, where many of the interviewees showed significant knowledge of the limitations of their models, and how derivatives were misunderstood by the public, or by their users.
There are quirky aspects to this book, including cartoons and photos that are somewhat self-aggrandizing to the author, but make the point in a humorous way.? I liked both books, but only a modest fraction of my readers should have any interest here.
PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? My objective is to aid my readers, and not explicitly take money from them.
1) So many managers lose confidence near turning points, like Bruce Bent in this article.? Still others maintain their discipline to their detriment, not realizing that they have a deficiency in their management style.? Alas for Bill Miller.? A bright guy who did not get financials, or commodity cyclicals.
2) We will see rising junk bond defaults in 2009.? Some defaults will be delayed because covenants are weaker than in the past.? But defaults primarily occur because cash flow is insufficient to finance the interest payments on debts.? That can’t be avoided.? After Lehman, what can you expect?
4) I am not a fan of workouts on residential mortgage loans.? Most of them don’t work out.? Loans typically default because of one of the 5 Ds, and modifying terms is adequate to help a small number of the borrowers.
5) I’ve talked about this for a while, but Defined Benefit pensions (what few remain) have been damaged in the recent bear market.? What should we expect?? When companies offer a fixed benefit, and rely on the markets to fund it, they rely on the kindness of strangers, who they expect to buy equities when they need to make cash payments on net.
6) There are two credit markets.? Those that the government stands behind, and those that it does not.? That is the main distinction in this credit market, with Agency securities falling into a grey zone.
7) If we were dealing with your father’s financial instruments, we would use his financial rules.? As it is, more complex financial instruments that are more variable in their intrinsic value must be valued to market, or, the best estimate of market. There are problems here, but remember that market does not equal last trade for illiquid, complex securities.? Also, there should be caution over level 3 modelled results.? From my own work, those results are squishy.
8 ) During a crisis, many relationships boil down to liquidity.? Who has it? Who needs it, and at what tradeoff?? The same is true of venture capital today.? Who will fund their commitments?? Beyond the issue of dilution looms the issue of survival.? VC backed companies lacking cash will have a hard time of it in the same way their brother public companies do.
9) The Fed ain’t what it used to be.? Today it has all manner of targeted lending programs, and a disdain for stimulus through ordinary lending.
11) How can SunTrust be in this much trouble, needing a second does of TARP funds so soon?? I don’t get it, but it is endemic of our banking sector.? The TARP Oversight Panel is supposedly going to ask a bunch of questions to the Administration regarding past use of TARP funds, but the questions are vague and easy to answer in generalities.
12) There were warnings of trouble inside both Fannie and Freddie, as well as a few recalcitrant analysts outside as well (including me).? Now they recognize the trouble they are in, maybe.? (Also: here.)? Congress does what it can now, not to identify what went wrong, but to divert attention and blame away from themselves.? No one supported the expansion of Fannie and Freddie more than Congressional Democrats.? Political critics were marginalized.
13) The euro makes it to its ten-year anniversary, and we are told… see, as sound as a Deutschmark.? Well, maybe.? Having a strong currency might be fine for Germany, but what of Greece, where the credit default swap market is pricing in a 12%+ probability of default over the next five years?? They might like a weaker euro.
14) Is Britain a greater default risk than McDonalds?? Is the US a greater default risk than Campbell Soup?? Sovereign default is a different beast than corporate default.? Corporations don’t control their own currency (hmm… does that make Greece more like a corporation of the Eurozone? or more like California in the US?), and so bad debt decisions compound over longer periods of time, until we end up with inflation, a forced debt exchange, or an outright default.? It is possible for the US to default without Campbell Soup defaulting, but the life of any US corporation would be made so much more difficult by an outright default of the US government, that I would expect an outright default to cause most US companies, states, and other nations to fail as well, because of implicit reliance on the creditworthiness of the Treasury.
Bottom-callers are out in droves, with many sophisticated arguments.? They all hinge on one idea: that we can return to normalcy soon with a compromised financial system, and debt levels that are record percentages of GDP.
The basic idea behind the two pieces is this: sure, we’re at average valuation levels now, but in a real bear market values can get cut in half from here.? My view is this: we’re not at table-pounding valuation levels yet, but someone with a value and quality bent will make money over the next ten years.
An End to Redemption-Related Selling by Hedge and Mutual Funds
Increased Lending
Tax Cuts
I fear this confuses the symptoms with the disease. Yes, it would be nice if many of these happened, but with the deficit hitting record levels, 2 and 5 are problematic.? In an over-indebted economy 1and 4 are tough as well.? As for point 3, you may as well argue with the sunrise, because most investors are trend-followers, whether they know it or not.? Redemptions typically end after the market has turned significantly.? It’s not a leading indicator, nor is it necessarily an “all clear.”
19) From the “read your bond prospectus with care department,” Catastrophe bonds are only as good as the collateral backing the deal or creditworthiness of the obligor.? Though it may have seemed a good idea at the time, allowing for lower quality collateral has caused the creditworthiness of several catastrophe bonds to suffer as Lehman defaulted, and as losses on subprime mortgages rose.? My take is this: analyze all the risks on a bond, even the obscure ones.? A lot of exchange traded note [ETN] investors probably wish they had paid more attention to who they were lending the money to, rather than the index attached to the notes.
20) The “read your bond prospectus with care department” does have a humorous side, as Paul Kedrosky points out on this amendment to some new Illinois GO bonds.? They don’t sound too worried, but maybe the lawyers have to be more pro-active, and put the following new risk factor into the prospectus:
Endemic Political Corruption
Your investment in the state of Illinois is subject to risks involving political corruption, which is a normal fact of life in Illinois. In lending to the State the lender bears the risk that the corruption level gets so great that it affects the trading value of these securities, and that interest and principal repayment could be impaired.
21)? Even if you don’t have 5 of your last 9 Governors removed due to scandal, like illinois, it’s tough to be a state nowdays.? Now you have the credit default swap [CDS] market spooking investors in your bonds.
I’m not sure, but I would be careful here.? What can be used for a single limited pupose today can be put to unimaginable uses tomorrow.? The Fed’s balance sheet is already at much higher levels of leverage than it was three months ago.? Does it really want to take on more?? Granted, seniorage gains/losses go back to the Treasury, which then can borrow less or more in response, but as the Fed’s balance sheet gets more complex, it makes it more difficult to gauge their policy responses, and I think it will lead to a lack of trust in the Fed and the US Dollar.
23) With conditions like these, should we be surpised that volatility is high in the equity markets?? By some measures, it is higher than that in the Great Depression.? I’m not sure I would call it a “bubble” though.? Extreme Value Theory tells us (among other things) that when a probability distribution is ill-defined, don’t assume that the highest value that you have seen is as high as it can get.? Records beg to be broken.
24) It’s not as if I am the only one thinking about issuing longer US Treasury debt.? Now the Treasury is thinking about it as well.? It will fill a void in our debt markets that life insurers, endowments, and DB pension plans will want to invest in (and create a bunch of new leveraged fixed income investments for speculators).
Sometimes I wonder whether there are elements of the economic system that are hard to discern, that lead economic players down a path they want to go on in the short-run, but don’t want to go on in the long-run, but that short-run choices inevitably lead to a bad long-run result.? Another way to say it is that past mistakes were the result of logic that linear thinkers would consider rational even now.
This post derives from MIchael Pettis’ post regarding a post of Dani Rodrik.? Beijing wants to employ many people who are migrating from the farms to the cities, and so it wants to produce more goods that they can export.? To make those goods competitive, they don’t want the Yuan to appreciate.? And over the past week, it has depreciated.
If you want a Keynesian stimulus to work more powerfully, you don’t want its effect to leak out to other nations, and thus, a tendency toward protectionism.? Interventionism begets more interventionism.? Everyone protecting their own interests leads to a collapse of the division of labor, and greater poverty.
No fun, I say, and it will be interesting if the US and China can strike a better deal than protectionism.
I voted for a third-party candidate for President this year.? Aside from voting for Bob Casey, Sr. for governor back when I lived in Pennsylvania, that is unusual for someone who has generally voted Republican.? Though I am generally a libertarian on economics and a conservative on social issues, I try to stay flexible enough that I can appreciate where each side of the political spectrum is coming from.? Even as I write about economic policy, I write on two levels:
Optimal policy (usually non-interventionist, or correcting mistaken prior interventions)
Okay, since optimal isn’t on the table, what’s the best you can do if you are going to meddle?
So, I heard our president-elect on the radio today, and my friends that I met with mentioned what they heard as well.? When he spoke to the Conference of Governors, he said in closing:
Now, let me just wrap up by saying this. I know these are difficult times. I don?t think anybody here is viewing the situation through rose-colored glasses. We?re going to have to make some hard choices in the months ahead about how to invest these tax dollars. We?re going to have to make hard choices like the ones that you?re making right now in your state capitols, we?re going to have to make in Washington.
And we are not, as a nation, going to be able to just keep on printing money. So at some point, we?re also going to have to make some long-term decisions in terms of fiscal responsibility. And not all of those choices are going to be popular.
But what I can promise you is this. That I?m going listen to you. I?m going to seek your counsel. And, by the way, I?m going listen to you especially when we disagree because one of the things that has served me well at least in my career is discovering that I don?t know everything. And all of you, I think, are going to be extraordinarily important in keeping us on track, not allowing Joe and myself to get infected with Washingtonitis, and to constantly be reminded of the realities that are happening to folks back home.
If he wants me to think that he has a head on his shoulders (not required in politics), he has made a good start.? Yes, we can’t make our way out this situation by printing money, or borrowing money.? My view is that we will only get out of this mess as overall debt levels are reduced to around 1.5x GDP, and ordinary lending to high quality borrowers begins again.? It will be a smaller financial sector, but a more stable one.
2) Yes, others have noticed the move in the Yuan.? This is a worry.? If China wants to compound their own adjustment problems, and finance the US Treasury at the same time, that is a way to do it.
1) What a mess.? I had been lightening up on equity exposure over the last week, but seemingly not enough.? The last three months have been hard for me, with my performance trailing the S&P 500 in each of the last three months.? Well, at least I admit it when I lose; let’s see if I can’t do better in the future.
2) The rally in long Treasuries is the cousin to the fall in equities.
A $4 move in the long bond would be significant enough — that is a top 5 move, but the shocker is seeing the 30-year yield near 3.20%.? That should lead to lower mortgage yields, refinancing, and perhaps, lower rates in the short run.? The long run is another matter.
3) Part of this came from Bernanke’s comments that the Fed would buy Treasuries.? If I may, what isn’t the Fed going to buy?? Do they really want to flatten the yield curve when the long end is this low already?? Don’t they have enough to do with instruments that have credit risk?? They can flatten the Treasury curve, but the corporate yield curve is out of their reach for now.
4) One example of that is the junk bond market, where the average yield is now over 20%.? Areas where the government does not guarantee see little liquidity, because government guarantees in other areas help siphon liquidity away.
6) TIPS, excluding the long end, are trading below par.
Also, the on-the-run securities are trading at a premium, because their inflation factors are close to 1 because they are young securities.? The inflation factors can’t go below 1, but older securities can see more past inflation erased, should we get a period of sustained deflation.? I don’t see that coming over the intermediate-term, but in the short-term we could see that.? Eventually the Fed will have to monetize many of the promises that it is making.
7) Perhaps we need another means of calculating how bad it is for non-guaranteed areas of the market, like A2/P2 CP.? That is a true horror.? I remember criticizing those investing in levered nonprime CP back when I was writing for RealMoney, but most of those investors are dead or gone now.? My measure of credit stress, the 2-year Treasury less A2/P2 yields, is at a new record.
8 ) It is no surprise here that GM is scrambling, as are the other automakers.? Let them try to get debtors to compromise.?? They will try to get the PBGC to take on the pension liabilities in foreclosure, though that may not be so easy.? They have refused to accept some liabilities in the past.
9) I was an early critic of reverse auctions organized by the US Treasury, largely because of the complexity involved.? I guess it took Paulson longer to realize the immensity of setting up those auctions.? It’s not as if the problem is unsolvable, but it would take a lot of work, and the payoff at the end is uncertain.
10) Is anyone else concerned that the Yuan is falling relative to the US Dollar? This graph gives the history since they “floated” the Yuan.? (Note the dirty float free market-like movements. 😉 )
Granted, it is a large-ish 2-day blip, but for the global economy to heal, we need China to begin to use the large surpluses that they have built up, buy abroad, and build up their domestic markets.
It would be a simple matter of fairness as well.? As it is, the surpluses in the government’s hands fuel a bloated financial system and inflation, which could be partially solved by importing more goods for their citizens to buy.
11) It’s my view that the economics profession comes out of this crisis with a black eye or two.? There is a lot of room for humility here.? Neoclassical economics does a lousy job of understanding how the real economy (goods and services) interacts with the financial economy (stocks, bonds, etc.).? That is a strength of the Austrian school, though.
Even on a microeconomic basis, periods of stress like this can make one question some of the theorems of Modigliani and Miller.? The way that assets are financed does make a difference when there is financial stress, and even more in insolvency.? Also, the financing windows are not always open.? Theories that rely on markets remaining open and liquid, such as many arbitrage-type arguments are not valid except when the market has “fair weather.”
12) There is no shortage of liquidity for the US Treasury, which takes that liquidity, gives T-bills to the Fed, which uses them to replace bail out specific lending markets, and downgrade the quality of their balance sheet buy up securities where liquidity is temporarily in short supply.? Personally, I don’t think it will work.? It is much easier to get into a market than to get out, particularly if you are a large player with no profit motive.? Three last semi-related articles that I found interesting:
T-bills are in high demand, perhaps the government should take advantage of it and issue a lot of them.? There are some dangers though:
a) This could be what finally does in the dollar.
b) The US debt maturity structure has been shortening of late — I wouldn’t want it to get too short, or we could face rollover risk, as Mexico did in 1994.
It might be better for the US Government to lock in long funding rates while they are available.? Who thought the 10-year or 30-year could be so low?
So Jimmy Rogers thinks the US dollar is going down?? He might be right.? There are few roads out of this crisis (more than one can be used):
High inflation (raise the nominal value of collateral behind loans, maybe?)
Internal Default (with depression)
External Default (including currency controls, and forced conversion to a new currency)
Large rise in taxation (leading to deep depression).
The Japan game, where the government attempts to force liquidity into the economy, leading to a low- or no-growth malaise.
At present, I think the government is pursuing the last of those, and avoiding inflation for now.? It is not in the DNA of the Fed to inflate, ever since the era of the ’70s.
Now, there is one idea floating around that I would like to suggest that we don’t do, or, if we do do it, let’s do it in limited amounts, like TIPS.? There is a proposal for Obama bonds — bonds issued by the Treasury in a currency other than dollars, such as the Japanese Yen.? It’s been done before; but I would urge against it because it gives up a key advantage that all of our debt is denominated in a currency that we think we control.? Why outsource that advantage to another central bank?
A Modest Proposal for Balancing the US Budget in the Short-Run
1/9/2007 11:06 AM EST
This is not meant seriously, but an easy way to balance the US Budget in the short run is to issue Japanese Yen-denominated debt. Current interest costs would drop rapidly, and the budget would balance.
What’s that you say? What if the Yen appreciates versus the Dollar? The US has an ill-disclosed balance sheet, with many of its liabilities omitted, or merely disclosed as footnotes… Medicare, Social Security, the old Federal Employee defined benefit plan, etc., are all off the balance sheet. (And on the plus side, so is the value of most of the property of the government, as well as the present value of its taxation capabilities.)
Leaving aside other things that are off-budget (e.g., Iraq, Katrina relief), borrowing in foreign currencies is just another tool that the Federal government can use to put off today’s costs off to a future date. It’s something that our government does well.
Position: none, though I own TIPS, realizing that they are only second best to developed market foreign currency debt, and the US Labor department controls the CPI calculation…
My Idea
Lest I merely seem to be a critic, I have another idea that I think is more powerful: Issue 40-, 50-, 75-, and 100-year bonds.? Issue TIPS versions as well.? Hey, issue a perpetual — Consols!? As I have said earlier:
George, I’m really glad to see that the Treasury has finally gotten a lick of sense, and is re-issuing the 30-year, which they should be able to at yields lower then the current long bond maturing in 2031 (probably 10 basis points lower).
Timing is anyone’s guess, but I would suspect two auctions — in November 2005 and February 2006 — in order to give the new benchmark bond sufficient liquidity. Given the absence of long issuance, demand for this bond will be very strong in the hedging community.
Now, the Treasury won’t do this, but my guess is that there is even more demand for a 50-year, or even a century bond (100 years). It would help pension funds and structured settlement writers match their liabilities. Those bonds could sell at yields less than the 10-year. Won’t happen, but I can dream.
none mentioned, though I own Treasury Securities of various sorts, both directly and indirectly (don’t we all?)
There is a decent amount of demand for safe long-dated debt from pension plans, life insurance companies, and other long-term fixed income investors.? These bonds would likely have lower yields than the 30-year bond, because of buyers that like long fixed income because of its reliability in a crisis.? (And, for bond geeks — high positive convexity.)
Personally, I think the market would happily digest a lot of really long debt from a seemingly strong entity like the US Government.? What, are we going to let the Europeans have a monopoly on long sovereign debt here? ;)? US Treasury, be innovative — show the world how confident we are in the future of the US by issuing debt as long as we think this republic will last.? Surely that is longer than 30 years.
This book is big, very big at ~700 pages. It is a testimony to the idea that history doesn’t repeat itself, but it often rhymes.
The book is arranged chronologically, and geographically within each time period.? Time is spent on each are roughly in proportion to the amount of unique data that we have from each era.? Thus, the recent past gets more pages per year.? Roughly one-quarter of the book goes from ancient times to 1800, and one quarter to the 19th century.? Half of the book is 1900-2005.
There are several things that the book points out, common to each time and area investigated.
1) It is very difficult to eliminate interest.? Even when governments or religions try to restrict interest, either in rate charged or in entire, systems arise to create promises to pay more in the future that than full payment today.
2) The more technologically advanced economies get, the lower interest rates tend to get.
3) Boom/bust cycles are impossible to avoid.
4) Governments introduce currencies and often cheat on them (debasement, or inflation of a fiat currency).
5) Governments do sometimes fail, whether due to a lost war, civil war, or default, taking their currencies and debt promises with them.
6) The economic cycle across the world is usually more correlated than most people believe at any given point in time, even in ancient times.? (How much more today… decoupling indeed…)
7) Cultures that allowed for a moderate amount of debt financing prospered the most, in general.
Those are my summary points after reading the book.? Homer and Sylla drew some but not all of those conclusions.? It’s an ambitious book and and ambitious read.? Sidney Homer did a lot of significant work researching from the past to the middle of the 20th century, and Richard Sylla did an admirable job giving the grand sweep of the increasing complexity of the bond markets as the 20th century progressed until 2005, which was an interesting point at which to end the fourth edition.? The fifth edition, should there be one, will prove even more interesting as it surveys the end of the housing and credit bubbles, and the shape of the financial system in their aftermath.
This book is a must for those that like economic history.? I really enjoyed it.? For those without such an interest, it’s a big, somewhat-expensive, show-off book that will be occasionally useful as a reference.
PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? I’m not out to sell things to you, so much as provide a service.? Not all books are good, and not every book is right for everyone, and I try to make that clear, rather than only giving positive book reviews on new books.? I review old books that have dropped of the radar as well, like this one, because they are often more valuable than what you can find on the shelves at your local bookstore.
Things have been bad in the bond market of late, but many amazing things happened in the bond market yesterday.? I printed out a number of screens from my Bloomberg terminal near 4PM yesterday:
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And this blast from the past:
It is hard to convey the depth of the panic gripping the bond market of late, but when t-bills are priced at less than 10 bp of yield, and the 30-year bond rallies almost 9 bucks (46 bp) in one day, that says a lot.? The last graphic above is from Black Monday, when the stock market crashed in 1987.? The move in T-bonds was even greater than that day in spread terms, which is pretty astounding, because ther was a lot more spread to grab in 1987.? In dollar terms, that was a $3+ move, so the move today was unprecedented.
Also consider that 30-year TIPS fell at the same time as the large move up in nominal bonds.? Inflation protection is being given away for free in some cases (zero for 10 years), at very nominal fees in other cases (0.7% for 30 years), and being paid in other cases (-0.5% for 5 years).? The forward inflation curve looks pretty bizarre.? If I can find time, perhaps I can put up a graph.
Away from that, 30-year swap spreads closed near -60 basis points.? Swap rates are supposed to be similar? to where AA banks borrow/lend, so something is broken here.? My suspicion is that long duration managers (pension plans, life insurers) have for some reason felt forced to buy fixed-rate? promises through the swap market, rather than buying zero coupon bonds, the longest of which yield more than 3.5%, considerably more than swap rates.? Anyone holding a position to receive 30-yr fixed, pay floating saw it appreciate by 9-10%, which is pretty amazing.
Many of the rates on the Treasury curve are record low yields as far as I can tell. This contrasts against all of the other bond markets, including agencies, where rates are significantly above Treasuries.? Investment grade and high yield bond spreads are at record levels.? My view is that they should be bought selectively, realizing that purchasing power in this market is supreme, and not give it up easily.
Read Across the Curve for how investment grade corporate spreads are moving out.? CMBS spreads have gotten destroyed.? If I were running life insurance money, and my client felt his liabilities could not run, I would be buying AAA CMBS hand over fist, carefully selecting older deals with better credit quality.? That said, you can see the effects of the carnage in the shares of life insurers, which are the biggest providers of long-term credit.? (ouch with tears)
There are still more oddities to the current bond market, most of which involve parties that can’t take certain risks any more.? We can expand that to banks, and toss in Citi.? Citi is trading like it is going out of business.? Now, Citi is one of the “too big to fail” [TBTF] banks, along with JP Morgan, Bank of America, and Wells Fargo.? If they are in trouble, I’m not sure who can buy them; they would probably be too much for even a coalition of the other TBTF banks to handle.? Is there a foreign bank that wants them?? I doubt it.? This would be another area where a new TBTF chapter of the bankruptcy code would be useful.
I’ll have a more detailed response to my piece, It’s Called a Depression later.? I would say that I found the commentary interesting, particularly the places where some suggested that:
I focused too much on financials.
Negativity itself is the problem.
Why don’t you focus on what’s going right?
Aside from the Great Depression, every other recession since that time, the banks, insurers, etc., may have had a large subset under stress, but not to this degree.? Our economy is credit-based, and the amount of credit is a record multiple of GDP.? That credit in the past greased the gears of non-financial companies.? The troubles in financials is affecting the whole economy.? There will be a sustained decline in demand, because much of the prior demand relied on the ability to borrow.
I have long felt that this is no “crisis of confidence” as many in the government will say.? Rather, it is a realization that when one marks many positions to their market clearing levels (at a lower degree of leverage for the financial system as a whole), that many financial institutions are insolvent.? The government can try to reflate the bubble but it is too small to do so.? Reflating bubbles is not generally achievable, anyway, because the negative dynamics around the old deflating bubble preclude it.? Typically we blow a new bubble instead.
Now, I try not to be controversial.? I don’t like trotting out words like Depression or Stagflation for their shock value.? I bring them out when I think they can be useful in clarifying the situation at hand.? I am not a doom-and-gloomer? by nature.? I would much rather be running my “long only” equity portfolio during a bull market.? Relative performance, at which I have done well, is nice, but nothing beats absolute performance.
Ask yourself, though.? If you were at the start of a new depression, what would it look like?? My list yesterday is an example of what I think it would look like.? Given the freeze-up in lending where the government has not intervened, such as A2/P2 commercial paper and corporate bonds, this is a situation where problems in financials are spilling over to nonfinancials.
Now, as for what is going right, I invite readers to offer their ideas.? Please comment.? I will offer four:
Residential mortgage rates are declining a little (though rates are above the levels when Bernanke and Paulson introduced their “scare tactics.”)
The dollar is performing well.
The US government can borrow at amazing rates. (That no one else can touch, unless you are a long term swap counterparty…)
Commodity prices are falling, hard.
These are all consistent with a depression scenario.? Demand for safety, and lack of global demand for the basics.? That said, it is a lot more pleasant filling up my tank.
In closing, as some of my older friends who have passed on once said to me, “If the locusts eat your crop, at least you don’t have to harvest.”? This is true, but cold comfort.? I would be happier with the economy that I argued was unsustainable for so long.
PS — As an aside, the government, by protecting some sectors of lending, has intensified the crisis in theareas it did not protect.? The rally in nominal Treasuries is a grab for safety at any price.? The crash in corporate bonds is the opposite.? Money runs (so to speak) from unprotected to protected sectors in a crisis, and so, the government helps create crises, and diminishes liquidity by protecting some favored sectors of fixed income.
Before I try to explain what a Depression is, let me explain what a bubble is.? A bubble is a self-reinforcing boom in the price of an asset class, typically caused by cheap financing,? with the term of liabilities usually shorter than the lifespan of the asset class.
But, before I go any further, consider what I wrote in this vintage CC post:
In light of Jim Altucher’s and Cody Willard’s pieces on bubbles, I would like to offer up my own definition of a bubble, for what it is worth.A bubble is a large increase in investment in a new industry that eventually produces a negative internal rate of return for the sector as a whole by the time the new industry hits maturity. By investment I mean the creation of new companies, and new capital-raising by established companies in a new industry.This is a hard calculation to run, with the following problems:
1) Lack of data on private transactions.
2) Lack of divisional data in corporations with multiple divisions.
3) Lack of data on the soft investment done by stakeholders who accept equity in lieu of wages, supplies, rents, etc.
4) Lack of data on corporations as they get dissolved or merged into other operations.
5) Survivorship bias.
6) Benefits to complementary industries can get blurred in a conglomerate. I.e., melding “media content” with “media delivery systems.” Assuming there is any synergy, how does it get divided?
This makes it difficult to come to an answer on “bubbles,” unless the boundaries are well-defined. With the South Sea Bubble, The Great Crash, and the Nikkei in the 90s, we can get a reasonably sharp answer — bubbles. But with industries like railroads, canals, electronics, the Internet it’s harder to come to an answer because it isn’t easy to get the data together. It is also difficult to separate out the benefits between related industries. Even if there has been a bubble, there is still likely to be profitable industries left over after the bubble has popped, but they will be smaller than what the aggregate investment in the industry would have justified.
To give a small example of this, Priceline is a profitable business. But it is worth considerably less today than all the capital that was pumped into it from the public equity markets, not even counting the private capital they employed. This would fit my bubble description well.
Personally, I lean toward the ideas embedded in Manias, Panics, and Crashes by Charles Kindleberger, and Devil take the Hindmost by Edward Chancellor. From that, I would argue that if you see a lot of capital chasing an industry at a price that makes it compelling to start businesses, there is a good probability of it being a bubble. Also, the behavior of people during speculative periods can be another clue.
It leaves me for now on the side that though the Internet boom created some valuable businesses, but in aggregate, the Internet era was a bubble. Most of the benefits seem to have gone to users of the internet, rather than the creators of the internet, which is similar to what happened with the railroads and canals. Users benefited, but builders/operators did not always benefit.
none
Bubbles are primarily financing phenomena.? The financing is cheap, and often reprices or requires refinancing before the lifespan of the asset.? What’s the life span of an asset?? Usually quite long:
Stocks: forever
Preferred stocks: maturity date, if there is one.
Bonds: maturity date, unless there is an extension provision.
Private equity: forever — one must look to the underlying business, rather than when the sponsor thinks he can make an exit.
Real Estate: practically forever, with maintenance.
Commodities: storage life — look to the underlying, because you can’t tell what financing will be like at the expiry of futures.
Financing terms are typically not locked in for a long amount of time, and if they are, they are more expensive than financing short via short maturity or floating rate debt.? The temptation is to choose short-dated financing, in order to make more profits due to the cheap rates, and momentum in asset prices.
But was this always so?? Let’s go back through history:
2003-2006: Housing bubble, Investment Bank bubble, Hedge fund bubble.? There was a tendency for more homeowners to finance short.? Investment banks rely on short dated “repo” finance.? Hedge funds typically finance short through their brokers.
1998-2000: Tech/Internet bubble.? Where’s the financing?? Vendor terms were typically short.? Those who took equity in place of rent, wages, goods or services typically did so without long dated financing to make up for the loss of cash flow.? Also, equity capital was very easy to obtain for speculative ventures.
1998: Emerging Asia/Russia/LTCM.? LTCM financed through brokers, which is short-dated.? Emerging markets usually can’t float a lot of long term debt, particularly not in their own currencies.? Debts in US Dollars, or other hard currencies are as bad as floating rate debt,? because in a crisis, it is costly to source hard currencies.
1994: Residential mortgages/Mexico: Mexico financed using Cetes (t-bills paying interest in dollars).? Mortgages?? As the Fed funds rates screamed higher, leveraged players were forced to bolt.? Self-reinforcing negative cycle ensues.
I could add in the early 80s, 1984, 1987, and 1989, where rising short rates cratered LDC debt, Continental Illinois, the bond and stock markets, and banks and commerical real estate, respectively. That’s how the Fed bursts bubbles by raising short rates.? Consider this piece from the CC:
One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:
2000 — Nasdaq
1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed
1994 — Mortgages/Mexico
1989 — Banks/Commercial Real Estate
1987 — Stock Market
1984 — Continental Illinois
Early ’80s — LDC debt crisis
So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.
But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it.
Position: None
Bubbles end when the costs of financing are too high to continue to prop up the inflated value of the assets.? Then a negative self-reinforcing cycle ensues, in which many things are tried in order to reflate the assets, but none succeed, because financing terms change.? Yield spreads widen dramatically, and often financing cannot be obtained at all.? If a bubble is a type of “boom phase,” then its demise is a type of bust phase.
Often a bubble becomes a dominant part of economic activity for an economy, so the “bust phase” may involve the Central bank loosening rates to aid the economy as a whole.? As I have explained before, the Fed loosening monetary policy only stimulates parts of the economy that can absorb more debt.? Those parts with high yield spreads because of the bust do not get any benefit.
But what if there are few or no areas of the economy that can absorb more debt, including the financial sector?? That is a depression.? At such a point, conventional monetary policy of lowering the central rate (in the US, the Fed funds rate) will do nothing.? It is like providing electrical shocks to a dead person, or trying to wake someone who is in a coma. In short: A depression is the negative self-reinforcing cycle that follows a economy-wide bubble.
Because of the importance of residential and commercial real estate to the economy as a whole, and our financial system in particular, the busts there are so big, that the second-order effects on the financial system eliminate financing for almost everyone.
We face a challenge as great, or greater than that at the Great Depression, because the level of debt is higher, and our government has a much higher debt load as a fraction of GDP than back in 1929.? It is harder today for the Federal government to absorb private sector debts, because we are closer to the 150% of GDP ratio of government debts relative to GDP, which is where foreigners typically stop financing governments. (We are at 80-90% of GDP now.)
We also have hidden liabilities through entitlement programs that are not reflected in the overall debt levels.? If I reflected those, the Debt to GDP ratio would be somewhere in the 6-7x GDP area. (With Government Debt to GDP in the 4x region.)
We are in uncharted waters, held together only because the US Dollar is the global reserve currency, and there is nothing that can replace it for now.? In the short run, as carry trades collapse, there is additional demand for Yen and US Dollar obligations, particularly T-bills.
But eventually this will pass, and foreign creditors will find something that is a better store of value than US Dollars.? The proper investment actions here depend on what Government policy will be.? Will they inflate away? the problem?? Raise taxes dramatically?? Default internally?? Externally?? Both?
I don’t see a good way out, and that may mean that a good asset allocation contains both inflation sensitive and deflation sensitive assets.? One asset that has a little of both would be long-dated TIPS — with deflation, you get your money back, and inflation drives additional accretion of the bond’s principal.? But maybe gold and long nominal T-bonds is better.? Hard for me to say.? We are in uncharted waters, and most strategies do badly there.
Last note: if you invest in stocks, emphasize the ability to self-finance.? Don’t buy companies that will need to raise capital for the next three years.
There is a common error with contrarian investing.? It is not a question of identifying things that people believe that are wrong, but finding things that people rely on that are wrong.? Reliance is the critical component.? I don’t care about what people think if they don’t have any skin in the game.? When someone relies on a certain result happening (or not happening), then there will be series of behaviors that happen as what he believes in fails, from intensifying the bet in the early phases, to throwing in the towel in disgust at the end.
I’m going to take this idea and twist it a different way tonight.? One thing that the Democrats and Republicans (except Ron Paul) agree and rely on is that they know how to avoid a repeat of the Great Depression.? The textbook answer is:
Easy Money
Fiscal Stimulus
Don’t Raise Trade Barriers
Ben Bernanke learned this as a young college student, and built it up in his Ph. D. dissertation.? He has the same moral certainty about this that George Bush, Jr. does about fighting terrorism.? And, I’m going suggest that Bernanke, and most of the political establishment (which hasn’t really changed in the last few days) are wrong.
What is a bubble?? My definition: a bubble is a self-reinforcing cycle where monies invested obtain a negative return in aggregate over the long haul.? It is characterized by significant borrowing at low rates to invest in already appreciated assets in order to profit from a momentum-driven market.? When cash flow is insufficient to pay the interest to finance the bubble, the bubble pops, and a self-reinforcing bear market ensues.? When that bear market encompasses most of the financial system, we call it a depression.
What is a depression?? A severe recession where the banks are impaired.? In an ordinary recession, lowering the Fed funds rate can stimulate the banks to lend.? Not so now; the banks are licking their wounds, and letting profits grow by financing at lower rates, and sucking in bailout cash to shore up their balance sheets against future real estate lending losses.
The Great Depression ended when the Debt to GDP ratio dropped below 150%.? When enough debts were extinguished by payoff or default, the system could once again be normal.? Virtually none of the efforts of FDR focused on eliminating debts; in my opinion, he lengthened and intensified the Depression by not encouraging the liquidation of bad debts.? And now we do the same thing.? We perpetuate the misallocation of resources by trying to keep house prices high, by bailing out institutions that should go through the bankruptcy process.? This fails to convert bad debts into equity in newly solvent businesses.
All the US government is doing is creating a bigger bubble.? What will happen when the Treasury auctions fail, or, stretch the yield curve so wide that there is panic.? We don’t want our financial institutions to fail, so we are willing to wager the creditworthiness of the nation in order to save them.? I don’t like that bet.? Many empires have died choking on debt.? Is the US to be next?
When I wrote articles opposing the bailout, I did so because I did not think it would work, and that one-off conservations/liquidations would be preferable, but not optimal.? Optimal to me would be using the bankruptcy code on a expedited basis, wiping out junior capital, and making senior capital take haircuts.
But in the present, we contemplate borrowing to bail out all manner of problems — bail out homeowners, automakers, banks, insurers, guarantors, etc.? The end to this phase will come when the creditors of the US write off their prior lending, and decide not to throw good money after bad.? I have no idea when that time will come, but the dreamy schemes of politicians aiming to solve every financial hurt will help to force such a time to happen.
This is not my ordinary book review.? These are good books that will only appeal to a small fraction of my readers, because few will have need for the knowledge. Both are written by Espen Gaarder Haug, who is kind of a character.? He collects option pricing formulas the way some people collect Barbie Dolls, Beanie Babies, or Baseball Cards.? He has interacted with some of the brightest minds in the field, and collaborated with a few of them.? In both books the math is significant — it would help if your calculus was sharp, and for any value some algebraic knowledge is needed.
The second book Derivatives, Models on Models, is different.? He interviews 15 significant thinkers on options and derivatives, and presents 15 papers by them.? Most of them contain tough math; some I couldn’t understand.? The real value of the book was in the interviews, where many of the interviewees showed significant knowledge of the limitations of their models, and how derivatives were misunderstood by the public, or by their users.
