Q: Yes, but we never really got through it. ?Suppose on a nonvolatile day I want to sell $100 in shares of?an open end mutual fund. ?Now suppose I want to sell 5%?of the total shares of the same fund. ?What are my mutual fund shares worth?
A: This problem isn’t any different than that for an individual stock. ?Liquidity carries a price. ?If you want to buy or sell a lot at any given time, and you are the one demanding the trade be done, you will have to pay up for that privilege. ?People who are less motivated than you will have to receive compensation for taking the other side of the trade.
Q: But on a mutual fund, why should the price move on a big trade? ?Shouldn’t everything be tradable at the closing NAV?
A: Can you sell the whole world at the close? ?To whom? ?Where will you get all of the cash?
Q: Huh?
A: Only a tiny fraction of all the assets in the world trade on any given day. ?There isn’t a lot of reason for most assets to trade — in the long run, we make money when we hold , not when we trade. ?Trading itself is a small net economic loss, with money paid to brokers.
This is why there are primary markets, secondary markets, and within secondary markets, block trades. ?Any big trade in stocks or bonds requires special handling — either a trader has to break it up into a bunch of little trades, or he has to hand it off to a specialist who finds someone willing to take the other side as a whole for a price concession, or the block trader takes the trade himself for a concession and tries to cover the position through small trades.
The thing is, there is not one price for an asset at any given point, but many prices — and they change depending upon how many want to buy or sell, and how quickly. ?More buyers? ?Crawl up the supply curve. ?More sellers? ?Slide down the demand curve. ?There is no one price — and when we do name one price, it is a shortcut — a convenience.
Q: I find that confusing.
A: Look, economics has almost always moved in the direction of greater subjectivity over time. ?An asset does not necessarily have the same value to you as it does to someone else. ?Consider my house as an example.
Q: I’ve been to your house — it’s a bit of a hovel. ?You couldn’t pay me to live there.
A: And I love it. ?I have a lot of happy memories there.
Q: Aren’t we off track? ?There’s a lot of difference between a unique house, and a share of a mutual fund.
A: That is only true because we sell identical tiny slices of a mutual fund. ?If you wanted to sell all of the assets of the mutual fund as a whole, it is the same problem.
Liquidity in markets is always limited. ?Always. ?A small stream of trades helps validate prices for a given asset and related assets, but is inadequate to answer the question of what happens to the price when you want to do a big trade in a short period of time. ?After all, supply and demand curves are theoretical constructs — it’s not as if you can look them up in the daily newspaper.
A: Probably. ?I had a knee-jerk response to it, but as I read more about it, I became convicted that I had to study it more before I birthed bits and bytes into the cold abyss of the internet. ?Remember, last time I wrote, I sent it to the SEC, and even talked with their legal staff. ?Off the cuff most of the difficulties could probably be solved by loads that get paid to the mutual funds any time shares are created or liquidated, but that’s just a bias. ?I like simple solutions because perfect regulations are a terror — perfection is impossible, so write something simple that covers 90% of it, and ignore the rest.
Here are two ideas for the Fed, not that they care much about what I think:
1) Stop holding regular press conferences and holding regular meetings. ?Only meet when a supermajority of your members are calling for a change in policy. ?Don’t announce that you are holding a meeting — perhaps do it via private video conference.
Part of the reason for this is that it is useless to listen to commentary about why you did nothing. ?You may as well have not held a meeting. ?Another reason is that governors could act more independently if a meeting can’t be called unless a supermajority of voting members calls for it.
Yet another reason is that the frequent and long communication has not eliminated the Kremlinology that exists to interpret the Fed. ?When changes to the FOMC statement are small, they get over-interpreted — remember the “taper” comment? ?Far better to say nothing than to repeat yourself with small meaningless variations.
Along with that, you could eliminate issuing statements altogether, and go back to the way things were done pre-Greenspan. ?Need it be mentioned that monetary was executed better under Volcker and Martin? ?We don’t need words, we need to feel the actions of the Fed. ?That brings me to:
2) Stop trying to support risky asset markets. ?It is not your job to give equity or corporate bond investors what they want. ?If you do that, too much liquidity gets injected into the system, creating the financial bubbles of 2000 and 2007-9.
Instead, give the risk markets some negative surprises. ?Don’t follow Fed funds futures; make them follow you. ?Show them that you are the boss, not the slave. ?Let recessions do their good work of clearing out bad debts, and then the economy can grow on a better basis. ?Be like Martin, and take away the punchbowl when the party gets exciting.
Do these things and guess what? ?Monetary policy will have more punch. ?When you make a decision, it will actually do something.
If were going to have fiat money, do it in such a way that bubbles do not develop, which means not caring about the effects of policy on risky asset markets. ?This might not be popular, but it would be good for the economy in the long run.
-==-=–==–==–=-=-=-=-=-=-=-=-=-=-=-=-=-=-=–=-=
As a final note let me end with one chart from the recent data from FOMC participants:
I?suspect the FOMC will tighten in December, but remember that the FOMC doesn’t have a roadmap for the environment they are in, and they are acting like slaves to the risky asset markets. ?Another burp in the markets, and lessening policy accommodation will be further delayed.
Information received since the Federal Open Market Committee met in June indicates that economic activity has been expanding moderately in recent months.
Information received since the Federal Open Market Committee met in July suggests that economic activity is expanding at a moderate pace.
No real change.
Growth in household spending has been moderate and the housing sector has shown additional improvement; however, business fixed investment and net exports stayed soft.
Household spending and business fixed investment have been increasing moderately, and the housing sector has improved further; however, net exports have been soft.
No real change. Swapped places with the following sentence.
The labor market continued to improve, with solid job gains and declining unemployment. On balance, a range of labor market indicators suggests that underutilization of labor resources has diminished since early this year.
The labor market continued to improve, with solid job gains and declining unemployment. On balance, labor market indicators show that underutilization of labor resources has diminished since early this year.
No real change. Swapped places with the previous sentence.
Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports.
Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports.
No real change.
Market-based measures of inflation compensation remain low; survey?based measures of longer-term inflation expectations have remained stable.
Market-based measures of inflation compensation moved lower; survey-based measures of longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.
No change. Any time they mention the ?statutory mandate,? it is to excuse bad policy.
Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.
New sentence.? Nods at the recent volatility in risky asset markets here and abroad.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.
Nonetheless, the Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.
No real change.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring developments abroad. Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.
No change.
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.
No change.
No rules, just guesswork from academics and bureaucrats with bad theories on economics.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
No change.? Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
No Change.
?Balanced? means they don?t know what they will do, and want flexibility.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.
Still a majority of doves.
We need some people in the Fed and in the government who realize that balance sheets matter ? for households, corporations, governments, and central banks.? Remove anyone who is a neoclassical economist ? they missed the last crisis; they will miss the next one.
Voting against the action was Jeffrey M. Lacker, who preferred to raise the target range for the federal funds rate by 25 basis points at this meeting.
Lacker dissents, arguing policy has been too loose for too long.
Comments
This FOMC statement was another great big nothing. Only notable change was the influence of risky asset markets and foreign markets on the decision-making process on the FOMC.
Don?t expect tightening in October. People should conclude that the FOMC has no idea of when the FOMC will tighten policy, if ever.? This is the sort of statement they issue when things are ?steady as you go.?? There is no hint of imminent policy change.
Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.? Wage growth is weak also.
Equities flat and long bonds rise. Commodity prices rise and the dollar falls.
The FOMC says that any future change to policy is contingent on almost everything.
Don?t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain?t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
We have a congress of doves for 2015 on the FOMC. Things will continue to be boring as far as dissents go.? We need some people in the Fed and in the government who realize that balance sheets matter ? for households, corporations, governments, and central banks.? Remove anyone who is a neoclassical economist ? they missed the last crisis; they will miss the next one.
Today, I happened to stumble across an old article of mine: Easy In, Hard Out (Updated). ?It’s kind of long, but goes into the changes that have happened at the Fed since the crisis, and points out why tightening policy might be tough. ?Nothing has changed in the 2.4 years since I wrote it, so I am going to reprint the end of the article. ?Let me know what you think.
-==-=-=–==-=–=-==-=-=-=-=-
In normal times, central banks buy only government debt, and keeps the assets relatively short, at longest attempting to mimic the existing supply of government debt.? Think of it this way, purchases/sales of longer debt injects/removes liquidity for longer periods of time.? Staying short maintains flexibility.
Yes, the Fed does not mark its securities or gold to market.? Under most scenarios, it is impossible for a central bank which can issue its own currency to go broke.? Rare exceptions ? home soil wars that fail, or political repudiation of the bank, where the government might create a new monetary standard, or closes the bank because of inflation.? (Hey, the central bank has been eliminated twice before.? It could happen again.)
The only real effect is on how much?seigniorage the Fed remits to the Treasury, or, if things go bad, how much the Treasury would have to lend/send to the central bank in order to avoid the bad optics of negative capital, perhaps via the Supplemental Financing Account.? This isn?t trivial; when people hear the central bank is ?broke,? they will do weird things.? To avoid that, the Fed?s gold will be revalued to market at minimum; hey maybe the Fed at that time will be the vanguard of market value accounting, and revalue everything.? Can you imagine what the replacement cost of the NY Fed building is?? The temple in DC?
Or, maybe the bank would be recapitalized by its member banks, if they are capable of doing so, with the reward being the preferred dividend they receive.
Back to the main point.? What effect will this abnormal monetary policy have in the future?
Scenarios
1) Growth strengthens and inflation remains low.? In this unusual combo, it will be easy?for the Fed to collapse its balance sheet, and raise rates.? This is the dream scenario; and I don?t think it is likely.? Look at the global economy; there is a lot of slack capacity.
2) Growth strengthens and inflation rises.? The Fed will likely raise the interest on reserves rate, but not sell bonds.? If they do sell bonds, the market will back up, and their losses will be horrible.? If don?t take the losses,?seigniorage could be considerably reduced, or even vanish, as the Fed funds rate rises, but because of the long duration asset portfolio, asset income rises slowly.? This is where the asset-liability mismatch bites.
If the Fed doesn?t raise the interest on reserves rate, I suspect banks would be willing to lend more, leaving fewer excess reserves at the Fed, which could stimulate more inflation. Now, there are some aspects of inflation that remain a mystery ? because sometimes inflationary conditions affect assets, rather than goods, I think depending on demographics.
3) Growth weakens and inflation remains low.? This would be the main scenario for QE4, QE5, etc.? We don?t care much about the Fed?s balance sheet until the Fed wants to raise rates, which is mainly a problem in Scenario 2.
4) Growth weakens and inflation rises, i.e. stagflation.? There?s no good set of policy options here. The Fed could engage in further financial repression, keeping short rates low, and let inflation reduce the nominal value of debts.? If it doesn?t run wild, it could play a role in reducing the indebtedness of the whole economy, though again, it will favor debtors over savers.? (As I?ve said before, in a situation like this, or like the Eurozone, all creditors want to be paid back at par on the bad loans that they have made, and it can?t be done.? The pains of bad debt have to go somewhere, where it goes is the argument.)
I?ve kept this deliberately simple, partially because with all of the flows going back and forth, and trying to think of the whole system, rather than effects on just one part, I know that I have glossed over a lot.? I accept that, and I could be dead wrong, as I sometimes am.? Comment as you like, with grace and dignity, and let us grow together in our knowledge.? I?ve been spending some time reading documents at the Fed, trying to understand their mechanisms, but I could always learn more.
Summary
During older times, the end of a Fed loosening cycle would end with the Fed funds rate rising.? In this cycle, it will end with interest of reserves rising, and/or, the sale of bonds, which I find less likely (they will probably be held to maturity, absent some crisis that we can?t imagine, or non-inflationary growth).? But when the tightening cycle comes, the Fed will find that its actions will be far harder to take than when they made the ?policy accommodation.?? That has always been true, which is why the Fed during its better times limited the amount of stimulus that it would deliver, and would tighten sooner than it needed to.
Far better to be like McChesney Martin or Volcker, and be tough, letting recessions do their necessary work of eliminating bad debt.? Under Greenspan, and Bernanke to a lesser extent (though he persists in pushing the canard that the Fed was not too loose 2003-2004, ask John Taylor for more), there were many missed opportunities to stop the buildup of bad debts, but the promise of the ?Great Moderation? beguiled so many.
Removing policy accommodation is always tougher than imagined, and carries new risks, particularly when new tools have been used.? Bernanke can go to his carefully chosen venues and speak to his carefully chosen audiences, and try to exonerate the Fed from well-deserved blame for their looseness in the late 80s, 90s, and 2000s.? Please, Mr. Bernanke, take some blame there on behalf of the Fed ? the credit boom could never have happened without the Fed.? Painting the Fed as blameless is wrong; the ?Greenspan put? landed us in an overleveraged bust.
I?m not primarily blaming the Fed for its current conduct; we are still in the aftermath of a lending bust ? too much bad mortgage debt, with a government whose budget is out of balance.? (In the bust, there are no good solutions.)? I am blaming the Fed for loose policies 1984-2007, monetary policy should have been a lot tighter on average.? But now we live with the results of prior bad policy, and may the current Fed not compound it.
Postscript
The main difference between this time and the last time I wrote on this is QE3.? What has been the practical impact since then?? The Fed owns more MBS and long maturity Treasuries, financed by more reserve balances at the Fed.
Banks use this cheap funding to finance other assets.? But if they want to make money, the banks have to take credit risk (something the Fed is trying to stimulate), and/or interest rate rate risk (borrow short, lend long, negative convexity, etc).? The longer low rates go on through interest on reserves, the greater the tendency to build up imbalances in the banking system through credit and interest rate risks. 1992-1993 where Fed funds rates were held at 3%, was followed by the residential mortgage backed security market melting down in 1994, not to mention Mexico.? Sub-2% Fed funds rates from 2002 through mid-2004 led to massive overinvestment in residential housing, leading to the present crisis.
Fed tightening cycles often start with a small explosion where short-dated financing for thinly capitalized speculators evaporates, because of the anticipation of higher financing rates.? Fed tightening cycles often end with a large explosion, where a large levered asset class that was better financed, was not financed well-enough.? Think of commercial property in 1989, the stock market in 2000 (particularly the NASDAQ), or housing/banks in 2008.? And yet, that is part of what Fed policy is supposed to do: reveal parts of the economy that are running too hot, so that capital can flow from misallocated areas to areas that are more sound.? At present, my suspicion is that we still have more trouble to come in banking sector.? Here?s why:
We?ve just been through 4.5 years of Fed funds / Interest on reserves being below 0.5% ? this is a far greater period of loose policy than that of 1992-1993 and 2002 to mid-2004 together, and there is no apparent end in sight.? This is why I believe that any removal of policy accommodation will prove very difficult.? The greater the amount of policy accommodation, the greater the difficulties of removal.? Watch the fireworks, if/when they try to remove it.? And while you have the opportunity now, take some risk off the table.
This is just a “what if” piece. If one of my readers knows better than me, leave a comment, or email me. Thanks.
The Surprise Dividend
Imagine one day in 2019 that your favorite dividend-paying stock made the following announcement:
Dear Shareholder,
As you may know, we currently pay a dividend of $2/year to holders of our common stock for each share they hold. ?In this current climate where there is uncertainty over whether dividends will be cut at some companies, we would like to guarantee the current payout, and give you more.
We are replacing the current dividend and declaring a special payout?today — an unsecured perpetual junior subordinated bond that will pay 80?cents quarterly per current share, payable to all current shareholders as of June 1st, 2019. ?It will be eligible to trade separately under the ticker [TICKER]. ?You are free to sell this income stream for a current gain, or you can continue to receive this income in perpetuity, as will any future holder of this bond.
Why are we doing this? ?The Total Revenue And Safe Harbor Act of 2018 repealed special treatment of dividends, but interest is still tax-deductible to us as a corporation. ?Much as we like the flexibility of dividends, our cash flow is more than sufficient, and can handle a higher payout. ?This higher payout?is possible partially because this is an interest payment, and we get to deduct the payment from taxable income. ?With our current corporate tax rate of 35%, the effective cost of the new dividend to the corporation is $2.08 per current share.
Many of our shareholders are not taxable, or have taxes deferred. ?Still others are retirees who are in lower personal tax brackets. ?We expect that some current shareholders in higher tax brackets will choose to sell their bonds. ?We would not be surprised to find life insurance companies as willing buyers, given our high credit rating, and their need for long bonds as investments.
Though in the near-term, we will not pay a dividend, that does not mean we will never pay a dividend again. ?We will review our payout?policy regularly, and make changes as we see best. ?It is also possible that future shareholders could see further issuance of these securities if?our reliable excess cash flow grows.
As always, we welcome your inquiries to our Investor Relations Department. ?Please be aware that this does not constitute tax advice, nor will we provide that to you. ?Please give your tax questions to your own personal tax adviser.
Many thanks for being one of our shareholders. ?We hope you prosper in 2019 and beyond.
I left aside the argument that now shareholders could choose their own income preference, and also that the income from a junior subordinated bond could survive bankruptcy (though unlikely), and could control the company post-bankruptcy (also unlikely). ?Mentions of bankruptcy don’t travel well, even in vague terms.
I also did not mention that the package of the junior bond and the post-dividend stock would likely trade at a higher price post-event. ?Might some activist investors try some more severe proposals of?this sort?
Your thoughts on this proposal are welcome. ?I can’t think of any firm that has done something like this in the past. ?Might they do it in the future?
I try not to be an ideologue, and I often fail. One bias of mine is that most macroeconomic policy actions of the government or central bank either don’t help, or merely shift the problem to another place.
Tonight’s issue is the wealth effect, which tends to be favored more by conservatives. ?The wealth effect is the tendency to spend more as the market value of the assets of a person rises. ?I don’t think the wealth effect is zero, but I don’t think can be?very big, and tonight, I will explain why.
Now, imagine that you own some assets and the value of them has grown. ?You’re feeling richer, and you would like to live richer as a consequence. ?How are you going to do it? ?You could:
Sell some of the assets.
Borrow against the assets.
If you control the assets, you could increase the stream of dividends, or pay yourself a higher salary.
Trade the assets for assets that pay a higher income.
Do more exotic things, like sell call options — but let’s ignore those possibilities for now. ?Those are just contingent forms of selling.
Let’s take these in order:
Sell Assets
Selling appreciated assets in most cases means incurring a capital gain and paying taxes. ?It can be an effective way of raising your purchasing power on a one-time basis. ?It also means that someone like you, or, one of their representatives, is going to have to part with money so that you can receive cash for your money. ?The net effect for the economy is not likely to be an increase of cash spent on consumption as a result.
As an aside, some people might be averse to selling assets in a big way because they don’t want to consume capital. ?They may not believe that the remainder of their assets will continue to rise in value, and as such might not be willing to spend from realized capital gains. ?That said, many older people *will* have to consume capital in old age, but they aren’t well-enough off to produce a wealth effect — they worry whether their assets will last.
Borrow Against Assets
I think this is dangerous if done in a big way, though I have seen some crackpots advocating that. ?We should have learned from the financial crisis that if borrowing against stable assets like a home in order to spend can result in disaster, it does not make sense to do it against more volatile assets like stocks or a private business. ?Your home is not an ATM. ?That same logic should apply to a brokerage account.
If you do borrow against an appreciated asset in order to spend, that may increase your spending one time, but unless the value of your assets continually increases, you won’t be able to do it forever. ?And, if asset values fall dramatically, you may find that if your debts are greater than your assets, that your spending may go down considerably as you pay back debt to hold onto your assets.
Now, if a lot of people are inverted in their borrowing, an increase in the overall price level of assets could make some?people un-invert and breathe easier, and after a while, spend more from their incomes. ?But the rise there will likely be offset by others whose savings aren’t worth as much being reticent to spend.
Pay Yourself a Greater Dividend or Salary
If you own all of a given asset, this?becomes a question of taking income versus spending on capital expenditures to grow or maintain the business. ?Greater personal spending is offset by lesser business spending. ?Oh, and you have to pay tax on the income you receive. ?If you own part of the business, but still control it, receiving a higher salary disproportionately helps you versus your minority shareholders. ?You might be able to spend more, but it comes out of their pockets.
Trade Your Assets for Assets that Pay a Higher Income
First, it’s a simple trade. ?You might have more income to spend, but someone else has less on average. ?Beyond that, it makes more sense to pursue investments that give you the best returns regardless of how much income they pay. ?You can decide on the income you need via dividends, selling bits of the investment, etc.
Income is not an inherent aspect of an asset. ?Within bounds, it is arbitrary, as noted in the two articles to which?I linked. ?As a result, choosing a higher income set of assets may not give you more to spend over time. ?Even if Congress passed a law tomorrow saying that all companies, public and private, have to pay a dividend equal to 3% of market value (or fair value, however determined), it might increase personal taxable income, but many would reinvest it while some would spend. ?As for the corporations, they would have to spend less on capital expenditures, or borrow more to fund them. ?A great increase in spending would be unlikely.
Summary
None of the ways I mentioned for getting more money for spending out of investments is likely to produce a lot of additional spending in aggregate across the economy. ?As a result, I think that the Executive Branch, the Congress, and the Federal Reserve should be cautious of trying to make asset values rise, or encourage more borrowing against assets. ?It will likely not have any significant effect to grow the economy over the intermediate -to-long term.
I’m currently reading a book about the life of Jesse Livermore. ?Part of the book describes how Livermore made a fortune shorting stocks just before the panic of 1907 hit. ?He had one key insight: the loans of lesser brokers were being funded by the large brokers, and the large brokers were losing confidence in the creditworthiness of the lesser brokers, and banks were now funding the borrowings by the lesser brokers.
What Livermore didn’t know was that the same set of affairs existed with the banks toward trust companies and smaller banks. ?Most financial players were playing with tight balance sheets that did not have a lot of incremental borrowing power, even considering the lax lending standards of the day, and the high level of the stock market. ?Remember, in those days, margin loans required only 10% initial equity, not the 50% required today. ?A modest move down in the stock market could create a self-reinforcing panic.
All the same, he was in the right place at the right time, and repeated the performance in 1929 (I’m not that far in the book yet). ?In both cases you had a mix of:
High leverage
Short lending terms with long-term assets (stocks) as collateral.
Chains of lending where party A lends to party B who lends to party C who lends to party D, etc., with each one trying to make some profit off the deal.
Inflated asset values on the stock collateral.
Inadequate loan underwriting standards at many trusts and banks
Inadequate solvency standards for regulated financials.
A culture of greed ruled the day.
Now, this is not much different than what happened to Japan in the late 1980s, the US in the mid-2000s, and China today. ?The assets vary, and so does the degree and nature of the lending chains, but the overleverage, inflated assets, etc. were similar.
In all of these cases, you had some institutions that were leaders in the nuttiness that went belly-up, or had significant problems in advance of the crisis, but they were dismissed as one-time events, or mere liquidity and not solvency problems — not something that was indicative of the system as a whole.
Those were the warnings — from the recent financial crisis we had Bear Stearns, the failures in short-term lending (SIVs, auction rate preferreds, ABCP, etc.), Bank of America, Citigroup, credit problems at subprime lenders, etc.
I’m not suggesting a credit crisis now, but it is useful to keep a list of areas where caution is being thrown to the wind — I can think of a few areas: student loans, agricultural loans, energy loans, lending to certain weak governments with large liabilities and no independent monetary policy… there may be more — can you think of any? ?Leave a comment.
Subprime lending is returning also, though not in housing yet…
Parting Thoughts
I’ve been toying with the idea that maybe there would be a way to create a crisis model off of the financial sector and its clients, working off of a “how much slack capital exists across the system” basis. ?Since risky?borrowers vary over time, and some lenders are more prudent than others, the model would have to reflect the different links, and dodgy borrowers in each era. ?There would be some art to this. ?A raw leverage ratio, or fixed charges ratio?in?the financial sector wouldn’t be a bad idea, but it probably wouldn’t be enough. ?The constraint that bind varies over time as well — regulators, rating agencies, general prudence, etc…)
In a highly leveraged situation with chains of lending, confidence becomes crucial. ?Indeed, at the time, you will hear the improvident squeal that they “don’t have a solvency crisis, but just a liquidity crisis! We just need to restore confidence!” ?The truth is that they put themselves in an unstable situation where a small change in cash flows and collateral values will be the difference between life and death. ?Confidence only deserves to exist among balance sheets that are conservative.
That’s all for now. ?Again, if you can think of other areas where debt has grown too quickly, or lending standards are poor, please e-mail me, or leave a message in the comments. Thanks.
Dear Readers, I’m going to try a different format for this piece. If you think it is a really bad way to present matters, let me know.
Question: Why do pensions exist?
Answer: They exist as a means of incenting employees to work for a given entity. ?It can be a very valuable benefit ?to employees, because it is difficult to earn money in old age.
Q: How did we end up with retirement savings being predominantly associated with employment?
A: That’s mostly an accident of history. ?First some innovative firms offered defined?benefit [DB] plans [paying a fixed sum at retirement for life, often with benefits to surviving spouses, and pre-retirement death benefits] in order to attract employees. ?After World War II, many unions insisted and won such benefits, and many non-union firms imitated them.
Q: Why didn’t many defined benefit plans persist to the present day?
A: In general, they were too expensive.
Q: If they were too expensive, why did they get created?
A: They weren’t expensive at first. ?The post-WWII era was one of booming demand and excellent demographics — there was only a small cohort of oldsters to support, and a rapidly growing population of workers. ?Also, the funding mechanisms allowed by the government allowed for low levels of initial funding to get them started, and they assumed that corporations would easily catch up at some later date. ?Sadly, some of the funding was so low that there were some defaults in the 1960s, leaving pensioners bereft.
Q: Ouch. ?What happened as a result?
A: Eventually, Congress passed the?Employee Retirement Income Security Act in 1974. ?That standardized pension funding methods and tightened them a little, but not enough for my taste. ?It also created the Pension Benefit Guarantee Corporation to insure defined benefit plans. ?It did many things to standardize and protect defined benefit pensions. ?Protection comes at a cost, though, and costs went higher for DB plans.
Some firms began terminating their plans. ?In the mid-1980s, some firms found that they could get a moderate profit out of terminating their plans. ?That didn’t sit well with Congress, which passed legislation to inhibit the practice. ?That indirectly inhibited starting plans — few people want to in the “in” door, when there is not “out” door.
Some firms began funding their plans very well, and the IRS didn’t like the loss of tax revenue, so regulations were created to stop overfunding of pension plans. ?These regulations put sponsors in a box. ?Given the extremely strong asset returns of the ’80s and ’90s, it would have made sense to salt a lot of assets away, but that was not to be. ?Thanks, IRS.
Q: Were there any other factors aside from tax policy affecting DB plans?
A: Four?factors that I can think of:
Falling interest rates raised the value of pension liabilities.
Demographics stopped being so favorable as people married less and had fewer kids.
Actuaries got pressured to be too aggressive on plan valuation assumptions, leading to lower contributions by corporations and municipalities to their plans.
By accident, the 401(k) was introduced, leading to an alternative pension plan design that was a lot cheaper. ?Defined contribution plans were a lot cheaper, and easier for participants to understand. ?The benefits were valued more than the technically superior DB plan benefits because you could see the balance grow over time — especially in the ’80s and ’90s!
Q: Why do you say that?DB plan benefits were?technically superior?
A: Seven?reasons:
They were generally paid for entirely by the employer.
A lot more money was contributed by the employer.
It gave them a benefit that they could not outlive.
Average people aren’t good at investing.
Fees for investing were a lot lower for DB plans than for Defined Contribution [DC] plans. ?(Employer provides a sum of money to each employee’s account.)
The institutional investors were better for DB plans than DC plans, because plan sponsors would go direct to money managers with talent, while plan participants demanded name-brand mutual funds that were famous. ?(Famous means a lot of assets recently added, which means poor future performance. ?Should you give your kids what they want, or what you know they need?)
If the companies could continue to afford the benefits, the benefits would be much larger in present value terms than the lump sum accumulated in their DC plans.
The last point is important, because the benefits promised were too large for the companies to fund. ?Eventually, they will be too large for most states and municipalities to fund as well, but that’s another thing…
Q: So?people preferred something that was easier to understand, rather than something superior, and companies used that to shed a more expensive pension system. ?That’s how we got where we are today?
A: Yes, and add in the relative impermanence of most corporations and some industries. ?You need a strong profit stream in order to fund DB plans.
Q: What are we supposed to do about this then?
A: Stay tuned for part two, which I will write next week. ?Believe me, there are a lot of controversial ideas about this, and there are no easy solutions — after all, we got into this problem because most corporations and people did not want to save enough money for the retirement of employees and themselves, respectively.
Too often in debates regarding the recent financial crisis, the event was regarded as a surprise that no one could have anticipated, conveniently forgetting those who pointed out sloppy banking, lending and borrowing practices in advance of the crisis. ?There is a need for a well-developed model of how a financial crisis works, so that the wrong cures are not applied to the financial system.
All that said, any correct cure will bring about a predictable response from the banks and other lending institutions. ?They will argue that borrower choice is reduced, and that the flow of credit and liquidity to the financial system is also reduced. ?That is not a big problem in the boom?phase of the financial cycle, because those same measures help to avoid a loss of liquidity and credit availability in the bust phase of the cycle. ?Too much liquidity and credit is what fuels eventual financial crises.
To get to a place where we could have a decent model of the state of overall financial credit, we would have to have models that work like this:
The models would have to have both a cash flow and a balance sheet component to them — it’s not enough to look at present measures of creditworthiness only, particularly if loans do not fully amortize debts at the current interest rate. ?Regulatory solvency tests should not automatically assume that borrowers will always be able to refinance.
The models should try to go loan-by-loan, and forecast the ability of each loan to service debts. ?Where updated financial data is available on borrowers, that should be included.
The models should try to forecast the fair market prices of assets/collateral, off of estimated future lending conditions, so that at the end of the loan, estimates can be made as to whether loans would be refinanced, extended, or default.
As asset prices?rise, there has to be a feedback effect into lowered ability to finance new loans, unless purchasing power is increasing as much or more than asset prices. ?It should be assumed that if loans are made at lower underwriting standards than a given threshold, there will be increasing levels of default.
A close eye would have to look for situations where if the property were rented out, it would not earn enough to pay for normalized interest, taxes and maintenance. ?When asset prices are that high, the system is out of whack, and invites future defaults. ?The margin of implied rents over?normalized interest, taxes and maintenance would be the key measure, and the regulators would have to have a function that attributes future losses off of the margin of that calculation.
The cash flows from the loans/mortgages would have to feed through the securitization vehicles, if any, and then to the regulated financial institutions, after which, how they would fund their future liabilities would?have to be estimated.
The models would have to include the repo markets, because when the prices of collateral get too high, runs on the repo market can happen. ?The same applies to portfolio margining agreements for derivatives, futures, and other types of wholesale lending.
There should be scenarios for ordinary recessions. ?There should also be some way of increasing the Ds at that time: death, disability, divorce, disaster, dis-employment, etc. ?They mysteriously?tend to increase in bad economic times.
What a monster. ?I’ve worked with stripped-down versions of this that analyze the Commercial Mortgage Backed Securities [CMBS] market, but the demands of a model like this would be considerable, and probably impossible. ?Getting the data, scrubbing it, running the cash flows, calculating the asset price functions, implied margin on borrowing, etc., would be pretty tough for angels to do, much less mere men.
Thus if I were watching over the banks, I would probably rely on analyzing:
what areas of credit have grown the quickest.
where have collateral prices risen the fastest.
where are underwriting standards declining.
what assets are being financed that do not fully amortize, including all repo markets, margin agreements, etc.
The one semi-practical thing i would strip out of this model would be for regulators to score loans using a model like point 5 suggests. ?Even that would be tough, but even getting that approximately right could highlight lending institutions that are taking undue chances with underwriting.
On a slightly different note, I would be skeptical of models that don’t try to at least mimic the approach of a cash flow based model with some adjustments for market-like pricing of collateral and loans. ?The degree of financing long assets with short liabilities is the key aspect of how financial crises develop. ?If models don’t reflect that, they aren’t realistic, and somehow, I expect that non-realistic models of lending risk will eventually be the rule, because it helps financial institutions make loans in the short run. ?After all, it is virtually impossible to fight loosening financial standards piece-by-piece, because the changes seem immaterial, and everyone favors a boom in the short-run. ?So it goes.
This should be a relatively quick note on personal lines insurance. I’m writing this after reading the piece in this month’s Consumer Reports on Auto Insurance. ?I agree with most of it. ?For those that are short on time, my basic advice is this: bid out your auto, home, umbrella and other personal lines property & casualty insurance policies once every three years, or after every significant event that?changes your premium significantly.
Here are a few simple facts to consider:
Personal lines insurance — auto, home, umbrella, rental, etc. is a very competitive business, and the companies that offer it?all want an underwriting formula that would give them the best estimate of expected losses from each person insured.
After that, they want to know how much “wiggle room” that they would have to build in some profit. ?Where might the second place bid be? ?How likely are consumers to shop around?
Most insurers use a mix of credit scores and claim history to calculate rates. ?Together, they are effective at forecasting loss costs — more effective than either one separately.
Read my piece?On Credit Scores. ?They are very important, because they measure moral tendency. ?People with low scores tend to?have more claims than those with high scores on average. ?People with high scores tend to be more careful in life. ?This is a forward-looking aspect of a person’s underwriting profile.
It’s fair to use “credit scores” because they are positively and significantly correlated with loss costs. ?The actuaries have tested this. ?Note that it is legal in almost?all states to use credit scores, or something like them, but not all of them.
As the Consumer Reports article points out, many insurance companies take advantage of insureds that stick with them year by year, because they don’t shop around. ?Easy cure: bid out your policy every three years at minimum. ?If enough people do this, the insurance companies that overcharge loyal customers will stop doing it. ?(Note: when I was a buy side analyst analyzing insurance stocks, one company implicitly admitted to doing this, and I was insured by them. ?Guess what I did next? ?It was not to sell the stock, though eventually I did when I saw that their premium increases were no longer increasing profits.)
Also be willing to unbundle your home and auto policies — there may be a discount, or there may not as the?Consumer Reports article states. ?I’ve worked it both ways, and am unbundled at present.
If they have that much money for amusing advertising, it implies that the market isn’t that rational. ?Bid it out.
But — it is important to realize that insurers don’t all have the same formulas for underwriting, and those formulas are not static over time. ?Bidding out your insurance makes sure you benefit from changes that positively affect you.
Insurers tend to get more competitive as the surplus they have to deploy gets bigger, and vice-versa when it shrinks after a large disaster. ?If your premium goes up after a disaster, bid the policies out. ?If it drifts up slowly when there have been no significant disasters, or claims on your part, they are taking advantage of you. ?Bid it out.
Bid it out. ?Bid it out. ?Bid it out. ?What do you have to lose? ?If loyalty means something to the insurer, they will likely win the bid. ?If it doesn’t, they will likely lose. ?Either way you will win. ?If you have an agent, they will note that you are price-sensitive. ?The agent will become more of an ally, even if it doesn’t seem that way.
I went through this several times. ?Most people who have read me for a while know that I have a large family — I am going to start teaching number seven to drive now. ?I bid it out when kids came onto my policy. ?It produced a change. ?When two of my kids had accidents in short succession, my premiums rose a lot. ?They would not underwrite one kid. ?I got most of it back when I bid it out. ?Since that time, the two have been claim-free for 2.5 years. ?Guess what I am going to do next March, when I am close to the renewal where premiums would shift? ?You got it; I will bid it out.
There is one more reason to bid it out: it forces you to review your insurance needs. ?You may need more or less coverage than you currently have. You might realize that you need an umbrella policy for additional protection. ?You may decide to self-insure more by raising your deductibles. ?The exercise is a good one.
You don’t need transparency, or more regulation. ?You don’t get transparency in the pricing of many items. ?You do need to bid out your business every now and then. ?You are your own best defender in matters like this. ?Take your opportunity and bid out your policies.
Make sure that you:
Choose a range of insurers — Large companies, smaller local companies, stock/mutual, and any that favor a group you belong to, if the group is known to be filled with good risks.
Give them a standardized request for insurance, giving all of the parameters for your coverage, and data on those insured.
Tell them they get one shot, so submit their best bid now… there will be no second looks.
Some companies argue more about paying claims. ?(AIG once had a reputation that way.) ?Limit your bidders to those with a reputation for fairness. ?State insurance departments often keep lists of complaints for companies. ?Take a look in your home state. ?Talk with friends. ?Google the company name with a few choice words (cheated, claim?denied, etc.) to see complaints, realizing that complainers aren’t always right.
Limit yourself to the incumbent carrier and 4-6 others. ?Seven is more than enough, given the work involved.
So, what are you waiting for? ?Bid out your personal insurance business.
Full disclosure: long AIZ, ALL, BRK/B, TRV for myself and clients (I know the industry well)
