Ethics – Page 12 – The Aleph Blog

You Can’t Cheat an Honest Man

Posted on 27 February 2010 by David Merkel

An honest man knows that you can’t get something for nothing.? Discounts?? Sure, when warranted, but nothing is ever truly free.? Someone has to pay.

That is one reason why I have been skeptical about Greece and Goldman Sachs.? It would be really hard to trick an honest government into using derivatives in order to get into the EU.? Honesty requires full disclosure when the parties on the other side have asked for it, even if they are not checking too closely for their own reasons.

Which brings up another angle of the story.? If EU governments cared that much about the sanctity of the Euro, why did they not inquire more closely about derivatives?? Why is it a surprise now?? At the time when Greece entered the EU, the use of derivatives was well-known, why did the governments of the EU not challenge Greece, given its checkered history with respect to default.

Even if Goldman was marketing swaps to marginal European governments wanting to get into the EU, with many other investments banks imitating them, the governments weren’t dumb.? “What, we get to get into the EU, and all we have to do is pay a lot more 15-20 years from now?? That’s a deal.? (We will grow out of these promises.)”

Alas, but the growth does not come, but the debts come due.? As I often say, “you can’t cheat the cash flows.”? Income statements and balance sheets may lie, but it is hard to lie about cash flows.? Those are indisputable accounting entries.

Even if they did the swaps, I do not lay the major portion of the blame on Goldman Sachs, but on Greece.? Greece was the one in need, and they could have cut their budget, but would not do so for political reasons.? Now that trouble is back, bigger and badder than ever.

The same applies to Jefferson County, Alabama.? They played a variety of games to lower current costs, and assumed that it would be so for the future.? Fools.? You can’t get something for nothing.? You will either pay something in the future, or bear a risk that you do not understand.? Anyone who is mature enough to be a board member in the county had better be worldly wise enough to know that you can’t get something for nothing, and that advisors may have ulterior motives.

Did investment banks like Goldman Sachs take advantage of a bunch of rubes?? No.? They took advantage of politicians who were looking for a cheap deal, and were willing to cut corners in their due diligence.

You can’t cheat an honest man.? Honest men don’t cut corners, and they pay in full, on ordinary terms.? But those wishing for a low-cost way out of the political troubles on the cheap are great targets for those that want to cheat others.

How Long, To The Point Of No Return?

Posted on 20 February 201021 February 2010 by David Merkel

Alea posted a paper, and The Big Picture a slideshow on sovereign debts, by the same author.? We have had a blessed period post-WWII, where there have been no defaults of major nations.? But that is not normal.? Nations default on their debts if they get too large, or they repudiate through inflation, or they raise taxes on a docile public.

The main point of the paper is that we are past the point of no return in most major nations, without significant changes that would diminish living standards for some time.? Add the implicit obligations to the explicit debt, and there is quite a mountain to climb.? Defaults are coming, the only question is what nations will default.

I often think that economists need to get out of the math ghetto, and study history.? Math is not capable of capturing nuances.? I write this as one who uses advanced statistical analyses regularly.? History is more robust than mathematical analyses.? Math occludes understanding in economics because it forces a numerical simplification of matters that have more dimensions than are admitted in the analysis.

Are there doubts about this?? Here are some simple tests: How well do macroeconomic models forecast, particularly at turning points?? On microeconomics, what kind of R-squared are they getting when they test the general equilibrium neoclassical model?? Are many of the testable hypotheses are not rejected?? When last I looked, R-squareds were in the percentage single digits, and most testable hypotheses were rejected.

So why do we think that developed nations could not default on their debts?? The book This Time is Different, should disabuse such notions.?? Major nations have often defaulted on their debts.? It is regrettable, sinful, but normal.

Personally, I think that all of the developed nations as a group have gotten lazy, and also do not realize the degree to which they are interconnected, particularly through their banks.? This is not a call for governments to reach out and help one another, but a yellow flag to say, “Don’t bail out other nations.? Focus on the effects on your own country; if you must do bailouts at all, focus on your local financial institutions, and then create risk-based capital rules that penalize foreign lending, and encourage diversification in what foreign lending is done.? This is logical in a credit-based system, because you only regulate one side of the transaction.

I am not arguing for isolationism in investing, but there is a tendency in the bull phase of the credit cycle to assume that nations don’t default, and so lending to sovereign credits that are weak becomes the trade of the moment.? Good regulation of financials limits the ability of those regulated to be yield hogs, particularly in the bull phase of the credit cycle.

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Nations are mortal.? They don’t last forever, historically, if they last 200 years, that is significant.? Even with nations that last so long, they can repudiate debts multiple times in their lives, though there is a cost — being shut out of the bond market for a time, until lenders forget.

So, what is the calculus on national default?? It is an option, but what influences the choice?

Willingness of public to accept more taxes.
Willingness of the public to accept reductions in services.
Strength of the economy.
Willingness of foreign creditors to buy more debt.
Willingness of locals to save through buying national debt.

Default happens when a nation gives up; they conclude that there is no way that they can pay off the debts incurred.

Nations have not given up so far, but unless economic growth increases significantly, there will be defaults in many places eventually.

A Question of Cultural Failure (II)

Posted on 17 February 2010 by David Merkel

Good cultures balance short and long-term goals.? Focusing too much on the long-term can lead to overinvestment, and problems like Japan still faces.? Focusing on the short-run can lead governments and companies to focus on manipulating budget and earnings numbers to fulfill their own selfish ends.

At present, we have no surplus of long-termism, but a surfeit of short-termism.??? Many economic players have decided that it is in their interest to play for time? — make things look good in the short run, and maybe a magical fix will appear for long run problems.

It seems that the EU thinks that if they can make Greece behave, that all will be right.? Well, tell that to those that protest in Greece.? Let each EU nation rather take a step back and ask, “What is cheaper in the long-run, bailing out Greece, or bailing out my banks with Greece exposure?”? The latter is probably cheaper, but not certainly so.? Given the lack of unanimity, the situation would lean toward bailing out domestic banks, because bailing out Greece requires the cooperation of separate nations, many of which have electorates that strongly oppose a bailout of Greece.

But, that could mean a virtual dissolution of the Eurozone.? Not necessarily.? You could end up with a lot of nations in default, and shut out of the bond markets (the PIIGS), while the rest do seemingly fine, as they quietly bail out their banks.

In that situation, the Euro would still exist, and might continue to be the currency of nations that are in default.? They just could not borrow any more at any rate in Euros, and perhaps not in any currency.

But the Eurozone itself would be in tatters, at least from a marketing standpoint.? What is good about being in the Eurozone?? Free trade?? Well Britain has that, even though they are a basket case, at least they control their own destiny, sort of.? The veneer that being in the Eurozone means that you are a high quality borrower is shattered.? Credit spreads over the German Euro benchmark will be high indeed for nations that have been undisciplined in their finances.

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People and governments like stasis.? No change.? Why?? It makes policy simple.? If something is in trouble, give it aid.? But — what if the trouble is an indication that people don’t want what is being produced by the one that is in trouble?? Capitalism is wonderful because it is dynamic. It can quickly adjust to changing conditions, unlike socialist bureaucrats.? Rather than volatility being a negative, with capitalism it is a positive.? It shows that the economy needs to change, that losses on prior bad investments should be recognized.? Failure to see things like this lessens the flexibility of the economy, and makes the eventual adjustments much larger than they would have to be if we did not interfere in the economy.

Now, this applies all over the world.? China is creating some of the biggest white elephants in history, so it seems.? Like Japan in the late 80s, they are building up useless industrial capacity.? Naive Keynesianism says that it does not matter what one spends money on, what matters is that the money gets spent, and quickly.

We may as well throw bricks at every window we see with that logic, knowing that GDP will record that glassman’s wages, but will not record the loss from a broken window.

Alas, we have too much automotive capacity, so we support automotive firms in the US.? We have too many bankers and too much capacity to build homes, so we support that as well.? Far better that we let firms fail, and let the assets be released to better uses.? Why waste your life or capital in an industry where there is not enough demand?

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In one sense, my claim of cultural failure boils down to not being willing to recognize losses.? In another sense, it is using the political process to invalidate economics.? Why should the government bail out company A and not company B?

The present political climate in the US could be summarized as a question of fairness.? Why should some benefit from bailouts, and not others?? There should be some answer here that doesn’t sound lame.? Lame answer: we were protecting the whole economy by protecting banks.? Better answer: we goofed in protecting the banks.? We should have let them fail, and bailed out depositors.? Don’t bail out anyone; let housing prices drop until ordinary people can afford them.? But if you must bail out, go down to the lowest level, and bail out those with mortgages, which will benefit not only them, but everyone above them.

This leaves aside moral hazard — all bailouts are a mistake.? Far better to let all fail, and let the system reset.? Run a hard culture where failure is punished.? That will cause people to avoid failure with greater assiduousness.

I will have more on this in the likely final segment for this topic.

A Question of Cultural Failure

Posted on 13 February 201014 February 2010 by David Merkel

I’ve said this before in different ways, but I will say it once more, “Governments are smaller than markets; markets are smaller than cultures.”? The reasoning is simple:

Governments can only control a fraction of what an economy or culture does.? Governments that are overbearing on an economy or culture may gain greater proportional control, but the size of the pie will shrink.? More of the economy or culture goes into hiding, away from the prying eyes of the government.
Markets only express a fraction of what mankind does.? They cover the tradeable aspects of what we do, but typically do not give us our deeper goals or desires for ourselves, and the culture as a whole.

When I look at the biggest economic problems facing the world today, many of them stem from deeper cultural problems.? Let’s start with the current poster child, or, canary in the coal mine, Greece.

Greece got into the Eurozone via subterfuge; they lied about the true status of their indebtedness, and Wall Street (with its counterparts in European investment banking) helped them do it.? So did a number of the other nations in the Eurozone that are presently under stress.

Now, the core members of the Eurozone wanted the Euro to grow as a currency — they were committed to an ever-wider and -deeper union.? The dream of a united Europe made them willfully blind to the low probability that the nations which were fiscal basket cases had genuinely changed.? The core should have been skeptical, and now they are paying the price, though not paying any money, yet.

The core nations that could pay or guarantee to help Greece are playing a tight game.? They act as an internal European IMF, insisting on reductions in the Greek budget deficit.? Greece does its part by saying it hasn’t asked for aid, which is unlikely.? At the same time, reductions in the Greek budget deficit bring the competing political factions inside Greece out in force.? Protests!? Strikes!? There are few arguing for what is best for Greece overall, and many arguing for a larger piece of what is a shrinking pie.? In a situation like this, it might be better for outsiders to let Greece fail,but they won’t do that.? Why?

The banks in the core nations can’t afford a default by Greece if by contagion it leads to defaults in Portugal, Spain, Italy, and Ireland.? A failure of the banking system does not conduce well to maintaining power for elites.

I have already talked about the perverse incentives for the core European nations to do anything to support Greece.? If Europe was rational, they would abandon the experiment now, or press for a Federal Europe akin to the US.? I don’t see either happening — I just see slow suffering for now, and futile playing for time.

Dubai is a place where anything can get done.? Anything indeed, but who pays the bills?? Dubai is a place of big ideas and little responsibility. ?? It is a moral flaw to bite off more than you can chew, particularly if you do so on behalf of others.

Many US States and Municipalities are in a world of hurt, because they compromised their long-term financial position to solve short-run budget crises.? That is the nature of the crises that we face today.

The same is true of the current US government — they fight for short term political advantage, rather than the long term good of the nation.? Who will favor the long-term and sacrifice for the greater good?

A simple summary statement here is “Greed is not good.”? Societies that are willing to sacrifice self interests have a much better probability of succeeding than societies that pursue self interest.

That’s all for now, I will pick this up in part II.

Blaming Bonuses is Politically Easy but Wrong

Posted on 23 January 2010 by David Merkel

A senior aide to a Congressman emailed me regarding the debate on Capitol Hill.? I responded:

Nell Minow knows what she is talking about, but this paragraph on page 5 is the money shot:

But the key is the board. It is unfathomable to me that many of the very same directors who approved the outrageous pay packages that led to the financial crisis continue to serve on boards. We speak of this company or that company paying the executives but it is really the boards and especially their compensation committees and until we change the way they are selected, informed, paid, and replaced we will continue to have the same result. Until we remove the impediments to shareholder oversight of the board, we cannot hope for an efficient, market-based system of executive compensation.

Pay can’t be reformed unless corporate governance is reformed.? Her suggestions above that are “mom-and-apple pie,” but they never get implented because boards are captured by their executives.? What she says on board reform after the aforementioned paragraph is crucial.

Away from that, anyone structuring incentives quickly learns:

Short-term incentives motivate more.
Incentives based on what the employee can control motivate more than those he can’t.
Cash now is preferred to anything else — it motivates more, unless there is tax deferral as a goal, or, inflation of apparent corporate profits, because the issuance of stock does not hit the income statement as a cost.
Some incentives are near-guaranteed because there are goals of not destroying the firm through taking too much risk — those should disappear during a crisis.? In this case, they didn’t but they should have disappeared.

That’s why Wall Street’s incentives were designed the way they were — they motivate to a high degree; that is the culture of Wall Street.? They should have cancelled bonuses because of the crisis — they would have if they had not been bailed out, which the Government stupidly did, and even then did it stupidly.

If the government had merely backstopped the derivatives counterparties, while sending losses to the holding companies until they were insolvent, and running an RTC 2, rather than just handing cash to holding companies, this all could have been avoided.? The systemic risk would have passed — most firms on Wall Street would be in insolvency, and bonuses would not have been paid.

The fault belongs mainly to the Fed and Treasury; they botched their jobs.

Back to incentives — the four points above work best for companies when revenues and expenses of the business are short term in nature.? But when the results of business take a while to develop, like selling a life insurance policy, the accounting gets complex.? So do the incentives.? Life insurance companies typically pay agents most of their compensation in a lump at the sale.? There are limited clawbacks.? Other methods of compensating agents more gradually have been tried, and generally, they don’t work so well with making sales.

But management aren’t salesmen — they should be bright and motivated on their own, or they shouldn’t have their jobs at all.? They shouldn’t need the “immediate gratification” incentives, and should be able to live with the eight reforms that Nell Minow suggests.? This is particularly true for financial companies, the the true results of activity will not be known for years.? Creating longer-term incentive structures will aid stability and improve managment of the firms.? The firms will be less aggressive, and that is good.? Aggressive financials almost always blow up.

To close, if you want to see this happen, corporate governance should be changed, where boards cannot so easily be captured by their managements.? Otherwise, this issue will return.

David

Book Review: Wealth, War & Wisdom

Posted on 20 January 2010 by David Merkel

The first thing I do when a PR flack sends me a book is throw away their summary.? Unlike other reviewers, I read the books.? The publisher sent me this book, but I did not ask for it.

All that said, I thought Wealth, War & Wisdom was a great book, and I spent more time on it than I normally do for books of equivalent length.? Why?? It covered areas of history that I was not as aware of.

This book is really two books in one.? It is a book that covers the history of WWII in an eclectic and cursory way.? After that, it asks the harder question of how one can assure the preservation of wealth in a volatile world.? In a lesser way, I have talked about that recently.

Regarding the history of WWII, I came away with a greater appreciation of:

The troubles Britain faced.
The cruelty that the people in the nations overrun by Hitler and the Soviets faced.
The compromises many nations made to have an easier time in the War.
The courage that it took to oppose aggression in the face of initially bad odds.

One commonality between Germany and Japan was a lack of resources, and rather than produce and trade to get them, they chose conquest.

But the greater problem is how one preserves wealth over all contingencies.? The problem is almost insuperable.? Even as some wealthy people today are buying farmland, that was one strategy to preserve wealth in WWII.? Homely farms that were reasonably productive, but not ostentatious, were ideal to preserve wealth and lives.? Away from that, investing abroad was wise for the rich.? Also, commodities and TIPS, which did not exist then might preserve some wealth.? Gold and other precious items, if small could also preserve wealth, or at least life.

For those who live in the US today, we live in a special time and place.? We are free from the losses that come from aggression on our home soil.? We largely agree with one another, much as politicians may disagree on that point.? Americans are exceptional in so many ways, though not all of them are good.

Preserving wealth means owning productive land locally, and having flight capital abroad.? Away from that, Biggs counsels owning stocks because good times happen more often than they should.

I liked this book, more than many, and if you want to buy it, you can find it here: Wealth, War and Wisdom.

Full disclosure:? Publishers send me books.? I review some of them.? I try to review the best of them, but I promise the publishers nothing.? If you click on a link that leads you to Amazon through my website, and you buy something, I get a small commission.? My view is that you should buy what you want.? Don’t reward me for something that you don’t like.? Rather, enter Amazon through my website and buy what you want; it will cost you nothing more.

Don’t Strategically Default on your Mortgage

Posted on 9 January 201010 January 2010 by David Merkel

I like Roger Lowenstein; he is a bright guy.? I have reviewed several of his books, and would recommend to readers that they are worth buying.

But, I disagree with Lowenstein in some ways regarding defaulting on home mortgages.? I want to give some credit to my wife here.? My dear wife of 23 years, who I thought about many times while we were attending a wedding today (I could not sit with her because I was leading the singing), and who does not have an economic bone in her body, helped me think about the issues around defaulting on home mortgages.

There is a false notion that because firms default when it is in their economic interest to do so, so should homeowners whose mortgages are greater than the underlying house value.

First, firms can’t so easily enter Chapter 11.? How does Chapter 11 work for firms?? Two things must be true — a firm must not be able to raise cash to make a debt payment, and the assets of the firm are worth less than the liabilities.? If a firm can’t pass both tests, the bankruptcy court should refuse the filing, forcing the firm to sell assets to make a payment.

To use this analogy for defaulting on a home mortgage, it is one thing to take out a mortgage in buying a home, having reasonable margins for error, and then disaster hits, and the mortgage payment can’t be made.? It is quite another thing to have the capacity to make the mortgage payment, and default.? Corporations usually can’t get away with that (please ignore KMart); if they can make payments on the debt, they can’t go into Chapter 11 bankruptcy.

Bankruptcy primarily exists as a protection for borrowers who have suffered loss, leading to inability to pay their debts.? It does not exist to allow people with the capacity to pay to slip out of contracts, simply because the creditor won’t go after them because it is not worth their effort, or, they don’t want the negative PR.

Would you borrow from a relative and default, because you know they would never sue you?? Would that be ethical?? Taking advantage of the extreme kindness of others may be legal, but it is never ethical.

If you can pay, you should pay.? That the mortgage lender will not enforce their rights does not mean that the one who can pay but defaults is ethical.

Imagine a society where any can default at their pleasure.? My, but the interest rates should get high to reflect the possibility of loss from borrowers that could pay but won’t.

If you can keep your word, and make your payments, do so.? You entered into the mortgage agreement with no assurance of where housing prices would go.? That they turned against you is no reason to default; but if your ability to pay has declined, well, that is another thing — default if you must.

The Trill is Gone

Posted on 8 January 2010 by David Merkel

This should be my last post on Trills.? Let me begin it by suggesting that we sell all of our national parks (and other land owned by the US Government) to the Saudis in exchange for forgiveness of our debts.? Wait, we could do better.? Disney could create theme parks, even on the national mall, making being American far more fun than the stuffy Smithsonian.

What’s that you say?? We are selling our patrimony?? How dare we sell our precious resources to exploiters/foreigners?? Uh, times are tough, and much as we make paper promises, eventually something hard and enduring has to back them up.

I feel the same way about Trills.? If the US Government ever were to sell trills, it would be the same as selling away a share in the take from the IRS in perpetuity.? Selling shares in the IRS, ridiculous, right?? Well, that is what a trill is — selling a share of the IRS.

Imagine that the US Government taxes at 20% of GDP, and then they sell Trills equal to 1% of GDP.? Initially, the US? Government would get a flood of cash, but would have given up 5% of their income stream.? If we had angels running our government, focusing on long-term projects, I would not object so much, but we spend in the present and neglect the future.

A government that issues Trills reduces its flexibility.? Initially not so, they get a lot of cash in, and don’t have to put a lot out.? The US government at present has explicitly issued debt with a market value around 75% of GDP.?? Implicitly, the funding shortfall when you add in the excess liabilities from the entitlements is 400% of GDP.

To keep things simple, let’s assume that the initial yield of Shiller’s trill is correct (1%), not only for small amounts of issuance, but large amounts.? That is probably a bad assumption in this case, after all, the proportion of Treasury issues out past 20 years is a small minority of Treasury issuance, and even with existing demand, the yield curve is quite steep.? Trills, being perpetual bonds with a growing coupon, are longer than any fixed income instrument that I have ever seen, so if they were issued in large amounts, who knows what the initial yields would be?

(Note to potential investors: if trills ever see the light of day, they could be an interesting buy, but I would let the first few auctions pass until the curve gets satiated and the initial coupon rises to a higher level, i.e., the price falls for all trills. You might even wait for the government to announce the last trills auction to buy.? One thing about trills — every issuance will raise additional doubts about ever being paid back.? They would be more valuable when the government says it won’t create any more of them.)

So, back to the application, imagine the US government auctioning off $11 Trillion (yes, with a “Tr”, not a “B”) of trills to retire the explicit debt.? Assume that the 1% initial coupon holds — we have now walled off 0.75% of GDP as a permanent expense in the Federal budget — keeping the numbers simple, that would be 3.75% of all Federal revenues in perpetuity.? Doesn’t sound like much, but we replace the existing debt with a exponentially growing stream where debt service is initially $110 billion.? That could help balance the budget at present, but at a cost to all future generations, until the US shall be no more.

Now, the 1% initial coupon would not hold for such large issuance.? Say the coupon ends up being 2%.? Now 7.5% of Federal revenues are dedicated to debt service in perpetuity, and 1.5% of GDP.

This would become addictive to the US Government — trills raise a lot of money relative to their initial cashflows, and they have no rollover risk.? Now imagine the US issuing a present value of $70 Trillion in trills (5x current GDP) over the next 30 years to roll over existing debt, take care of all the unfunded liabilities, and cover all of the structural deficit for the next 10 years.? At my assumed coupon of 2%, that would wall off 10% of GDP in perpetuity, or half of Federal revenues to pay for the sins of the past.? The bad human proverb recorded in the Bible might return to common parlance, “The fathers have eaten sour grapes, and the children’s teeth are set on edge.”? (Note: at/near the exile of Judah, some complained they were being punished for the sins their forbears committed, and not their own sins.? God corrects the proverb, saying that people are punished for their own sins.)

Potentially, trills are a heavy burden to place on all future generations for the fiscal profligacy of the last 80 years.? I would rather not see trills see the light of day as a result.? It would postpone the eventual day of reckoning where the US Government would have to slim down dramatically, and live within its budget.? Trills would make the US government more reckless, not more cost conscious.

But, if trills are to be issued, let some more desperate entity issue them first, like Greece or California, and then let the rest of us watch the consequences.? They would provide help in the short run, at a likely cost of a bigger failure later, with more damage to creditors, and the general economy.

This should be my last piece on this, though one final thought tugs at me — the derivatives market that would grow up around trills would be a hoot.? GDP futures and options, stripping coupons to create discount trills and income trusts.? The investment bankers would have a field day, with the cheap cost of burdening all future generations, who I am sure will remember Dr. Shiller warmly.

Fourteen Comments on the Financial Economy

Posted on 7 January 2010 by David Merkel

1) Yield-seeking — it is alive and well.? Check out this article on pay-in-kind bonds.? With PIKs, one can be concerned with the return on the money, and the return of the money at the same time.? The history of returns on PIK bonds are such that you are usually better off putting the money under a mattress.

2) More yield-seeking — spreads on mortgage bonds over Treasuries are at a 17-year low, and as I measure it, and all-time low.? Investors have gone maniac for GSE insured mortgage bonds.

3) I am as close to neutral on PIMCO as anyone I know.? I have written articles explaining how they make money, which is different from the public pronouncements of Gross and McCulley.? The current missive of Gross impresses me as fair, recognizing the limits of the Federal Government and the Fed.? PIMCO is taking less risk, selling US and UK debt, and buying German debt.? This is conservative; they are giving up yield.

4) Bruce Krasting notes that the Social Security system paid out more in 2009 than it took in.? That event was not supposed to happen until 2016 or so.? Aside from that, he notes the negative COLA adjustment.? As for me, I look at this and say, “Whether it comes slower or faster, it will come.? Medicare and Social Security will destroy the Federal budget eventually, or will be scaled back to where those that were taxed complain about it.

5) If you want to consider a technical reason for rates being so low, consider all of the mutual fund buyers.? They have favored bonds.? This is a contrary sign for interest rates — they are headed higher.

6) Bernanke blames bank regulation so that he can absolve monetary policy.? Typical.? Blame what you control less, to absolve what you control directly.? A better and brighter economist (in my opinion), John Taylor disagrees.? He views the mid-decade low rate policies as contributing to the lending frenzy.? Don’t get me wrong.? Bank regulation was lousy, but monetary policy was lousier, helping to create the boom that now gives us the bust that normalizes things.

7) How amazing was the junk bond market?? Better, how amazing was the distressed debt market?? Oh my, though junk bonds paced equities, distressed debt did far better.? Such is the case when a turn happens; this one was forced by the US Government.

8) If you want to understand how finance reform gets blocked, read this article.? Better than most, it explains the intricacies of why the Democrats have a hard time passing the legislation that the radicals would like.

9) I am not a Buffett-lover or hater.? When I read his opposition to Kraft raising its bid, I said to myself, “Of course.? Don’t overpay.? Most deals are best avoided.”? Which is true — M&A is in general a value destroyer.

10) Personal bankruptcies are rising in the US.? It is a messy time.

11) Let the Chicago School of Economics die.? I have already argued for their demise.

12) The CMBS market is experiencing delinquencies that have not been seen before.? This is just another example of the difficulties many commercial mortgage loans are in.

13) Strip malls have high vacancy rates.

14) I appreciate Tyler Cowen’s article, suggesting that things are pretty good.? We should be glad that other places in the world did well, even if we did not do so well.

Nine Notes and Comments

Posted on 31 December 2009 by David Merkel

As I roll through the day, i often make comments on the blogs and websites of others.? I suppose I could gang them up, and post them here only.? I don’t do that.? Other sites deserve good comments.? Today, though, I reprint them here, with a little more commentary.

1) First, I want to thank a commenter at my own blog, Ryan, who brought this article to my attention.? I’ve written about all of the issues he has, but he has integrated them better.? It is a long read at 74 pages, but in my opinion, if you have 90 minutes to burn, worth it.? I will be commenting on the ideas of this article in the future.

2) My commentary on Dr. Shiller’s idea on Trills drew positive attention, but the best part was being quoted at The Economist’s blog.

3) Tom Petruno at the LA Times Money & Company blog is underappreciated.? He writes well.? But when he wrote Fannie and Freddie shares soar, but for no good reason.? I wrote the following:

From my comments to my report on financials yesterday ?Federal Home Loan Mortgage Corp [FRE] and Federal National Mortgage Assn [FNM] Rise as U.S. Removes Caps on Assistance ? this gives the GSE stocks more time, and hence optionality. I still think they will be zeroes in the end, but there will be a lot of kicking and screaming to get there. The government is engaged in a failing strategy to reflate the housing bubble, and they aren?t dead yet.

I write a daily piece on financials for my company’s clients.? The stock of the GSEs rose because the odds of them digging out of the hole increased.? You can’t dig out of the hole if you are dead, so when you are near that boundary, even small changes in the distance from death can affect sensitive variables lke the stock price.? Plus, the odds rise that the US will do something really dumb, like convert theor preferred shares to common.

4) Kid Dynamite put up a good post on CDOs, I commented:

KD, maybe we should play chess sometime. Spotting a queen and rook is huge. I have beaten Experts, though not Masters on occasion (except in multiple exhibitions), and I can’t imagine losing to anyone who has spotted me a rook and queen.

All that said, I never gamble, and as an actuary, I know the odds of most games that I play.

Now, all of that said, I never cease to be amazed at all of the dross I receive in terms of ideas that look good initially, but are lousy after one digs deep.

Good post. Makes me wonder how I would have done in the same interview. Quants need to have a greater consideration of qualitative data. When I was younger, I didn’t get that.

5) Then again, Yves Smith comments on a similar issue at her blog.? My comment:

I?m sorry, but I think jck is right. The risk factors were clearly disclosed. Buyers should have known that they were taking the opposite side of the trade from Goldman.

As I sometimes say to my kids, ?You can win often if you get to choose your competition,? and, ?Winning in investing comes from avoiding mistakes, not making amazing wins.?

As a bond manager, I was offered all manner of amazing derivative instruments. I turned most of them down. Most people/managers don?t read the prospectus, but only the term sheet. Not reading the prospectus is not doing due diligence.

Since we are on the topic of Goldman Sachs, in 1994, an actuary from Goldman came to meet me at the mutual life insurer where I worked. I wanted to write floating rate GICs which were in hot demand, and all of my methods for doing it were too risky for me and the firm.

Goldman offered a derivative instrument that would allow me to not take too risky of an investment strategy, and credit an acceptable rate on the GIC. So, as I read through the terms at our meeting, a thought occurred to me, and so I asked, ?What happens to this if the yield curve inverts??

He answered forthrightly, ?It blows up. That?s the worst environment for these instruments.? Now, if you read the docs, it was there, and when asked, he told the truth. The information was not up front and volunteered orally.

But that?s true of almost all financial disclosures. You have to read the fine print.

As for the derivative instruments, in early 2005, many large financial institutions took billion dollar writedowns. All of my potential competitors in the floating rate GIC market left the market. I went back to buyers, and offered the idea that I could sell them the GICs at a lower spread, which would give them a decent return, but with adequate safety for my firm. All refused. They basically said that they would wait for the day when the willingness to take risk would return.

And it did, until the next blowup in 1998 around LTCM.

My lesson: the craze for yield drives many derivative trades. What cannot be achieved with normal leverage and credit risk gets attempted, and blows up during hard times.

Structure risks are significant; the give up in liquidity is significant. The big guys who play in these waters traded away liquidity too cheaply, and now they are paying for it.

=-=-=-=-=–=-==-=-Whoops, where I said 2005, I meant 1995. That loss I avoided for the firm was one of my best moves there, but we don?t get rewarded for avoiding losses.

6) Then we have CFO.com.? The editor there said they want to publish my comment in their next magazine.? Nice!? Here is the article.? Here is my comment:

Time Horizon is Critical

Yes, Wheeler did a good job, as did MetLife, including their bright Chief Investment Officer.

What I would like to add is the the insurance industry generally did a good job regarding the financial crisis, excluding AIG, the financial guarantors, and the mortgage insurers.

Why did the insurance industry do well? 1) They avoided complex investments with embedded credit leverage. They did not trust the concept that a securitized or guaranteed AAA was the same as a native AAA. Even a native AAA like GE Capital many insurers knew to avoid, because the materially higher spread indicated high risk.

2) They focused on the long term. The housing bubble was easy to see with long-term perception — where one does stress tests, and looks at the long term likelihood of loss, rather than risk measures that derive from short-term price changes. Actuarial risk analysis beats financial risk analysis in the long run.

3) The state insurance regulators did a better job than the Federal banking regulators — the state regulators did not get captured by those that they regulated, and were more natively risk averse, which is the way regulators should be.

4) Having long term funding, rather than short term funding is critical to surviving crises. The banks were only prepared to maximize ROE during fair weather.

I know of some banks that prepared for the crisis, but they were an extreme minority, and regarded by their peers as curmudgeonly. I write this to give credit to the insurance industry that I used to for, and still analyze. By and large, you all did a good job maneuvering through the crisis so far. Keep it up.

7) Then we have Evan Newmark, who is a real piece of work, and I mean that mostly positively.? His article My comment:

Good job, Evan. I don?t do predictions, except at extremes, but what you have written seems likely to happen ? at least it fits with the recent past.

But S&P 1300? 15% up? Wow, hope it is not all due to inflation.

8 ) Felix Salmon.? Bright guy.? Prolific.? His article on residential mortgage servicers.? My response:

Hi Felix, here?s my two cents:

I think the servicers are incompetent, not evil, though some of the actions of their employees are evil. Why?

RMBS servicing was designed to fail in an environment like this. They were paid a low percentage on the assets, adequate to service payments, but not payments and defaults above a 0.10% threshold.

Contrast CMBS servicing, in which the servicer kicks dud loans over to the special servicer who gets a much higher charge (over 1%/yr) on the loans that he works out. He can be directed by the junior certificateholder (usually one of the originators) on whether to modify or foreclose, but generally, these parties are expert at workouts, and tend to conserve value. The higher cost of this arrangement comes out of the interest paid to the junior certificateholder. Pretty equitable.

Here?s my easy solution to the RMBS problem, then. Mimic the CMBS structure for special servicing. An RMBS special servicer would have to be paid a higher percentage on assets than a CMBS special servicer, because he would deal with a lot of small loans. The pain of an arrangement like this would get delivered where it deserves to go: to those who took too much risk, and bought the riskiest currently surviving portions of the RMBS deal.

The underfunded RMBS servicers may be doing the best they can. They certainly aren?t making a bundle off this. As a former mortgage bond manager, I always found the RMBS structures to be weaker than the CMBS structures, and wondered what would happen if a crisis ever hit. Now we know.

9) But then Felix again through the back door of Bronte Capital.? My comments:

I don?t short. Short selling is socially productive though. Here is how:

1) Sniffs out bad management teams.

2) Sniffs out bad accounting.

3) Adds liquidity.

4) Defrays the costs of the margin account for retail investors. Institutional longs get a rebate. Securities lending programs provide real money to long term investors, with additional fun because when you want to sell, you can move the securities to the cash account if the borrow is tight, have a short squeeze, and sell even higher.

5) Provides useful data for longs who don?t short. (High short interest ratio is a yellow flag in the long run, leaving aside short squeeze games.)

6) Allows for paired trades.

7) Useful in deal arbitrage for those who want to take and eliminate risk.

8) Other market neutral trading is enabled.

9) Lowers implied volatility on put options. (and call options)

10) And more, see:

http://alephblog.com/2008/09/19/governme nt-policy-created-too-hastily/Short selling is a good thing, and useful to society, as long as a hard locate is enforced.

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That is what my commentary elsewhere is like.? I haven’t published it here in the past, and am not likely to do it in the future, but I write a lot.? Amid the chaos and economic destruction of the present, the actions are certainly amazing, but consistent with the greed that is ordinary to man.