Public Policy – Page 13 – The Aleph Blog

Deeds, not Words? Or, Say Less and Mean More

Posted on 19 March 2015 by David Merkel

There was a lot of hoopla yesterday over the FOMC removing the word “patient” from its statement. ?But when you read the sentence that replaced the sentence containing the word patient, you shouldn’t think that much has changed:

Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range.

There are two contingencies here, which are both subject to considerable latitude in interpretation:

Seeing further improvement in the labor market
Being?reasonably confident that inflation will move back to its 2 percent objective over the medium term

I have long argued that the FOMC doesn’t have a strong theory for what they are doing, and have designed their language in speaking to the markets to maximize their flexibility. ?It has not been the obfuscation of the overly confident Greenspan era, but the endless blather that comes from trying to be “transparent” and drown the market in communications, because they never quite understand us properly.

Now, for the first time in a while, the FOMC statement shrank, and for that, I thank the FOMC. ?It should shrink further, and it would be better if the FOMC said nothing, and went back to pre-Greenspan practices, and let the actions of the Open Markets Desk at the New York Fed do the talking. ?Deeds, not words.

Now, data isn’t the same as deeds, and they aren’t always as clear as words, but the FOMC gave us a release of the forecasts of its members yesterday. ?The graphs in this piece reflect the central tendency of their estimates, giving proper weight to the dominant views, as well as less weight to the views from the?outliers.

Start with the graph at the top of this article. ?The average of all of the views suggests tightening in September. ?Now, with 15 favoring a move in 2015, a move will likely happen this year. ?If you look back through their data releases, a preponderance of opinion has pointed to 2015 since September of 2012, with never fewer than 12 members pointing to a move in 2015 since then.

But what of the shift in opinions regarding the level of the Fed Funds rate over time? ?What happened to that with the removal of the “patient” language?

My but they got more dovish... — My but they got more dovish…

Look at the reduction in the expected end of year Fed Funds rate — down 0.35% in 2015 (to 0.77%), 0.51% in 2016, 0.32% in 2017, and 0.12% in the long run. ?That last number is significant, because of the change in composition of those giving opinions, and it indicates a more generally dovish group.

But the downward moves in values indicate fewer tightening moves for 2015 — at present the estimate would be 2-3 quarter-percent moves. (And five more eaches in 2016 and 2017, for those who dream that savers might get some compensation, and that the government’s budget works at higher levels of interest rates)

A big reason for the shift is the move in views on PCE inflation:

Still behind the deflationary curve... — Still behind the deflationary curve…

That’s a 0.59% move down in PCE inflation estimates for 2015. Odds are, it will be lower than that. The FOMC as forecasters always chase trends, and rarely get ahead of them. They also believe in the power of monetary policy to produce inflation, and more perversely, growth. As it is, their actions have produced little of either.

It does explain why their estimates for 2016 and beyond are so high. Would any of the members dare to break from the lockstep, and concede that monetary policy does not have significant power to affect the economy for good?

Here is the real GDP graph:

Note the continued move down in estimates for all future periods. Interesting to see the pessimistic shift.

Finally, the unemployment rate graph:

Discouraged workers of the world unite, you have nothing to lose but... — Discouraged workers of the world unite, you have nothing to lose but…

There are many jobs to be had, if people will search for them, and if they think the wages are worth taking, versus alternatives of leisure, working in unreported labor markets, etc…

Conclusion

Looking at the data, the FOMC certainly isn’t hawkish at present. That is consistent with the change in language in the statement, which left timing for any future hikes in the Fed Funds rate vague, and subject to interpretation. This explains the fall in the US Dollar, and the rise in the prices of stocks, long bonds, and commodities. The markets viewed it all as continued monetary lenience, and given the composition of voting members on the FOMC, that should come as no surprise at all.

Until something breaks, expect the FOMC to continue to err on the side of monetary lenience… it’s the only thing they know.

Redacted Version of the March 2015 FOMC Statement

Posted on 18 March 2015 by David Merkel

Comments

I will still argue that this was a nothing-burger. The patience language was eliminated, but what were left in its place were contingent conditions that are subject to a wide degree of interpretation.
Pretty much a nothing-burger. Few significant changes.? The FOMC has a weaker view of GDP and exports.
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.
Forward inflation expectations have continued to fall.
Equities rise 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 FOMC actually chops out ?dead wood? from its statement. Brief communication is clear communication.? If a sentence doesn?t change often, remove it.
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 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.

On Bitcoin

Posted on 12 February 2015 by David Merkel

I’ve generally been quiet about Bitcoin. ?Most of that is because it is a “cult” item. ?It tends to have defenders and detractors, and not a lot of people with a strong opinion who are in-between. ?There’s no reward for taking on something that has significance bordering on religious for some… even if it proves to be a bit of a “false god.”

I view Bitcoin as a method of payment, a collectible item, a commodity that is not fully fungible, and not a store of value. ?It is not a currency, and never will be, unless a government takes it over and adopts it.

In order for a tradable item to be a store of value, the amount of variation in value in the short- to intermediate-term versus other items that has to be limited. ?If there are other tradable items with greater stability toward the other items, those tradable items would be better stores of value. ?Thus Bitcoin is inferior as a store of value versus the US Dollar, the Euro, the Yen, etc. ?It is far more volatile versus goods and assets that one might want to buy, and goods and liabilities that one might want to fund.

Now as an aside, the same thing happens in hyperinflationary economies. ?Merchants have to change their prices frequently, because the currency is weak. ?Often another currency will begin to replace the weak local currency, like the US Dollar or the Euro, even if that is not legal.

Fungibility implies that any Bitcoin is as good as any other Bitcoin. ?But with failures like Mt. Gox, a Bitcoin exchange that had Bitcoins under its care stolen from it, a Bitcoin under the care of Mt. Gox was not as valuable as one elsewhere. ?(Another aside: that happened in a minor way with the Euro when Euros in Cypriot banks were forced to have a “haircut,” while Euros elsewhere were unaffected.)

Bitcoin is a means of payment, a way of transferring value from one place/person to another. ?It seems Bitcoins move well, but they are less good at being safely stored.

The theft of Bitcoins points out the need for there to be a legal system to protect property rights. ?Licit participants in Bitcoins as a group have not been adequate to assure that the rightful owners might not lose them as the result of computer hacking. ?Contrast that with the protections that credit card holders have when false transactions are applied against credit card accounts. ?The credit card companies eat the losses, funded by profits from interest charged an interchange fees.

The libertarian vision of a currency that does not require a court, a government to protect it is misguided. ?Where there are thieves, there is a need for courts to try cases of theft, and deal with questions of equity if theft leads to an insolvency.

Now, governments can be less than fair with their own judicial systems. ?I think of Dennis Kozlowski, formerly CEO of Tyco, who was barred from using his own money in self-defense when the US Government brought him to trial. ?Much as you might like to have value protected from the clutches of the government, that is easier said than done, and there are thieves that will pick away at those who?get value away from governments, because ultimately in an interconnected world, you have to trust other people at some points, and trust can be violated as much as the rights of a citizen can be violated. ?Repeat after me: THERE IS NO PERFECTLY SAFE PLACE ON EARTH TO STORE VALUE! ?That said, though, there are safer places than others, and so you have to live with the risks that you understand, and are prepared to take.

If you think that Bitcoin fits that bill, well, knock your socks off. ?Have at it. ?I will stick with US Dollars in banks, money market funds, bonds, and public and private stocks. ?Maybe I will even buy some gold that does nothing, just for the sake of diversification. ?But ultimately my store of value is in the bank of Heaven, as it says in Matthew 6:19-21:

“Do not lay up for yourselves treasures on earth, where moth and rust destroy and where thieves break in and steal; but lay up for yourselves treasures in heaven, where neither moth nor rust destroys and where thieves do not break in and steal. For where your treasure is, there your heart will be also.”

There is no perfect security on Earth, try as hard as you like. ?Bitcoins may keep value away from the government under some conditions, but who will protect your property rights in Bitcoins in the event of theft? ?You can’t have it both ways, so Bitcoins as property would?either be taxed and regulated by governments, or be totally underground, which would diminish utility considerably.

One final note: Bitcoins can’t be used of themselves to produce something else. ?They are a fiat currency, and only has value to the degree that users place on it. ?I liken it to penny stocks, where traders can bounce the price around, because there is nothing to tether the price to. ?At least with gold, you have jewelers demanding it to turn it into jewelry, and a broader pool of people who are somewhat less jumpy about what the proper exchange rate between gold and dollars should be.

But, gold can be stolen… again, no Earthly store of value is perfect. ?All for now.

An Idea Whose Time Should Not Come

Posted on 4 February 20154 February 2015 by David Merkel

I get fascinated at how we never learn. Well, “never” is a little too strong because the following article from Bloomberg, Meet the 80-Year-Old Whiz Kid Reinventing the Corporate Bond had its share of skeptics, each of which had it right.

The basic idea is this: issue a corporate bond and then package it with a credit default swap [CDS] for the same?corporate bond, with the swap cleared through a clearinghouse, which should have a AAA claims-paying ability. ?Voila! You have created a AAA corporate bond.

Or have you? ?Remember that bond X?guaranteed by?Y has many similarities to bond Y guaranteed by X, because both have to fail for there to be a default. ?I used to help manage portfolios that had many different types of AAA bonds in them. ?Some were natively AAA as governments, quasi-governments (really, Government Sponsored Enterprises) like Fannie and Freddie, or corporations. ?Some were created by insurance guarantees from MBIA, Ambac, FGIC, or FSA. ?Others were created via?subordination, where the AAA portion took the losses only if they were greater than a highly stressed level. ?Lesser lenders absorbed lesser losses in exchange for the ability to get a much greater yield if there was no default.

There is a lot of demand for AAA bonds if they have a high enough yield spread over Treasuries. ?The amount of spread varies based on the structure, but greater complexity and greater credit risk tend to raise the spread needed. ?Here are some simple examples: At one time, you could buy GE parent corporate bonds rated AAA, or GE Capital corporate bonds with an identical rating, but no guarantee from GE parent. ?The GE Capital bonds always traded with more yield, even though the rating was identical. ?AIG had a AAA credit rating, but its bonds frequently traded cheap to other AAA bonds because of the opacity of the financials of the firm (and among some bond managers, a growing sense that AIG had too much debt).

So?how would one get a decent yield spread?under this setup? ?The CDS will have to require less spread to insure than the spread over Treasuries priced into the corporate bond.

How will that happen? Where does the willingness to accept the credit risk at a lower spread come from? ?Note that the article doesn’t answer that question. ?I will take a stab at an?answer. ?You could get a number of hedge funds trying to make money off of leveraging CDS for income, the excess demand?forcing the CDS spread below that implied by the corporate bond. ?Or, you could get a bid from synthetic Collateralized Debt Obligations [CDOs] demanding a lot of CDS for income. ?I can’t think of too many other ways this could happen.

In either case, the CDS clearinghouse is dealing with weak counterparties in an event of default. ?Portfolio margining should be capable of dealing with small negative scenarios like isolated defaults. ?Where problems arise is when a lot of default and near defaults happen at once. ?The article tells us what happens then:

ICE requires sellers of swaps to backstop their contracts with various margin accounts. If the seller fails to pay off, then ICE can tap a ?waterfall? of margin funds to make the investor whole. In the event of a market crash, it can call on clearing members such as Citigroup and Goldman Sachs to pool their resources and fulfill swap contracts.

There?s still a danger that the banks themselves may be unable to muster cash in a crisis. But this shared responsibility marks a sea change from the bad old days when investors gambled their counterparties would make good on their contracts.

That shared responsibility is cold comfort. ?Investment banks tend to be thinly capitalized, and even more so past the peak of a credit boom, when events like this happen. ?Hello again, too big to fail. ?Clearinghouses are not magic — they can fail also, and when they do, the negative effects will be huge.

Two more quotes from the article by those that “get it,” to reinforce my points:

The bond is a simple instrument with a debtor and creditor that?s proven its utility for centuries. The eBond inserts a third party into the transaction — the seller of the swap embedded in the security who now bears its credit risk.

Such machinations may be designed with good intentions, but they just further convolute the marketplace, says Turbeville, a former investment banker at Goldman Sachs.

?Why are we doing this? Is our society better off as a result of this innovation?? he asks. ?You can?t destroy risk; you just move it around. I would argue that we have to reduce complexity and face the fact that it?s actually good for institutions to experience risks.?

and

?The way we make money for our clients is by assessing risk and generating risk-adjusted returns, and if you have a security that hedges that risk premium away, then why is it compelling? I would just buy Treasuries,? says Bonnie Baha, the head of global developed credit at DoubleLine Capital, a Los Angeles firm that manages about $56 billion in fixed-income assets. ?This product sounds like a great idea in theory, but in practice it may be a solution in search of a problem.?

And, of course, fusing a security as straightforward as a bond with the notorious credit-default swap does ring a lot of alarms, says Phil Angelides, former chairman of the Financial Crisis Inquiry Commission, a blue-ribbon panel appointed by President Barack Obama in 2009 to conduct a postmortem on the causes of the subprime mortgage disaster. In September 2008, American International Group Inc. didn?t have the money to back the swaps it had sold guaranteeing billions of dollars? worth of mortgage-backed securities. To prevent AIG?s failure from cascading through the global financial system, the U.S. Federal Reserve and the U.S. Treasury Department executed a $182 billion bailout of the insurer.

?When you look at this corporate eBond, it?s strikingly similar to what was done with mortgages,? says Angelides, a Democrat who was California state treasurer from 1999 to 2007. ?Credit-default swaps were embedded in mortgage-backed securities with the idea that they?d be made safe. But the risk wasn?t insured; it was just shifted somewhere else.?

The article rambles at times, touching on unrelated issues like index funds,?capital structure arbitrage, and alternative liquidity structures for bonds. ?On its main point the article leave behind more questions than answers, and the two big ones are:

Should a sufficient number of these bonds get issued, what will happen in a very large credit crisis?
How will these bonds get issued? ?When spreads are tight, no one will want to do these because of the cost of complexity. ?When spreads are wide,?who will have the capital to offer protection on CDS in exchange for income?

I’m not a fan of financial complexity. ?Usually something goes wrong that the originators never imagined. ?I may not have thought of what will?go wrong here, but I’ve given you several avenues where this idea may go, so that you can avoid losing.

Redacted Version of the January 2015 FOMC Statement

Posted on 29 January 2015 by David Merkel

Comments

Pretty much a nothing-burger. Few significant changes.? The FOMC has a stronger view of GDP and Labor, and deems the weak global economy to be a reason to wait.
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.
Forward inflation expectations have flattened out.
Has the FOMC seen how low the 30-year T-bond yield is?
Equities fall and long bonds rise. Commodity prices are flat.? 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 FOMC need to chop out more ?dead wood? from its statement. Brief communication is clear communication.? If a sentence doesn?t change often, remove it.
In the past I have said, ?When [holding down longer-term rates on the highest-quality debt] doesn?t work, what will they do? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.? The Fed is playing with forces bigger than themselves, and it isn?t dawning on them yet.
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 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.

On Financial Risk Statements, Part 1

Posted on 13 December 2014 by David Merkel

Most formal statements on financial risk are useless to their users. Why?

They are written in a language that average people and many regulators don’t speak.
They often don’t define what they are trying to avoid in any significant way.
They don’t give the time horizon(s) associated with their assessments.
They don’t consider the second-order behavior of parties that are managing assets in areas related to their areas.
They don’t consider whether history might be a poor guide for their estimates.
They don’t consider the conflicting interests and incentives of the parties that?direct the asset managers, and how their own institutional risks affect their willingness to manage the risks that other parties deem important.
They are sometimes based off of a regulatory view of what can/must be stated, rather than an economic view of what should be stated.
Occasionally, approximations are used where better calculations could be used. ?It’s amazing how long some calculations designed for the pencil and paper age hang on when we have computers.
Also, material contract provisions that are hard to model/explain often get ignored, or get some brief mention in a footnote (or its equivalent).
Where complex math is used, there is no simple language to explain the economic sense of it.
They are unwilling to consider how volatile financial processes are, believing that the Great Depression, the German Hyperinflation, or something as severe, could never happen again.

(An aside to readers; this was supposed to be a “little piece” when I started, but the more I wrote, the more I realized it would have to be more comprehensive.)

Let me start with a brief story. ?I used to work as an officer of the Pension Division of Provident Mutual, which was the only place I ever worked where analysis of risks came first, and was core to everything else that we did. ?The mathematical modeling that I did in there was some of the best in the industry for that era, and my models helped keep us out of trouble that many other firms fell into. ?It shaped my view of how to manage a financial business to minimize risks first, and then make money.

But what made us proudest of our efforts was a 40-page document written in plain English that ran through the risks that we faced as a division of our company, and how we dealt with them. ?The initial target audience was regulators analyzing the solvency of Provident Mutual, but we used it to demonstrate the quality of what we were doing to clients, wholesalers, internal auditors, rating agencies, credit analysts, and related parties inside Provident Mutual. ?You can’t believe how many people came to us saying, “I get it.” ?Regulators came to us, saying: “We’ve read hundreds of these; this is the first one that was easy to understand.”

The 40-pager was the brainchild of my boss, who was the most intuitive actuary that I have ever known. ?Me? I was maybe the third lead investment risk modeler he had employed, and I learned more than I probably improved matters.

What we did was required by law, but the way we did it, and how we used it was not. ?It combined the best of both rules and principles, going well beyond the minimum of what was required. ?Rather than considering risk control to be something we did at the end to finagle credit analysts, regulators, etc., we took the economic core of the idea and made it the way we did business.

What I am saying in this piece is that the same ideas should be more actively and fully applied to:

Investment prospectuses and reports, and all investment and insurance marketing literature
Solvency documents provided to regulators, credit raters, and the general public by banks, insurers, derivative counterparties, etc.
Risk disclosures by financial companies, and perhaps non-financials as well, to the degree that financial markets affect their real results.
The reports that sell-side analysts write
The analyses that those that provide asset allocation advice put out
Consumer lending documents, in order to warn people what can happen to them if they aren’t careful
Private pension and employee benefit plans, and their evil twins that governments create.

Looks like this will be a mini-series at Aleph Blog, so stay tuned?for part two, where I will begin going through what needs to be corrected, and then how it needs to be applied.

Lagging Long Yields

Posted on 22 November 201423 November 2014 by David Merkel

I’m a very intellectually curious person — I could spend most of my time researching investing questions if I had the resources to do that and that alone. ?This post at the blog will be a little more wonky than most. ?If you don’t like reading about bonds, Fed Policy, etc., you can skip down to the conclusion and read that.

This post stems from an investigation of mine, and two recent articles that made me say, “Okay, time to publish the investigation.” ?The investigation in question was over whether yield curves move in parallel shifts or not, thus justifying traditional duration [bond price interest-rate?sensitivity] statistics or not. ?That answer is complicated, and will be explained below. ?Before I go there, here are the two articles that made me decide to publish:

The first article goes over the very basic idea that using ordinary tools like the Fed funds rate, you can’t affect the long end of the yield curve much. ?Here’s a quote from Alan Greenspan:

?We wanted to control the federal funds rate, but ran into trouble because long-term rates did not, as they always had previously, respond to the rise in short-term rates,? Greenspan said in an interview last week. He called this a ?conundrum? during congressional testimony in 2005.

This is partially true, and belies the type intelligence that a sorcerer’s apprentice has. ?The full truth is that long rates have a forecast of short rates baked into them, and reductions in short term interest rates usually cause long-term interest rates to fall, but far less than short rates. ?There are practical limits on the shape of?the yield curve:

1) Interest rates can’t be negative, at least not very negative, and if they are negative, only with the shortest highest quality debts.

2) It is very difficult to get Treasury yield curves to have a positive slope of more than 4% (30Yr – 1Yr) or 2.5% (10Yr – 2Yr).

3) It is very difficult to get Treasury yield curves to have a negative slope of more than -1.5% (30Yr – 1Yr) or -1% (10Yr – 2Yr) in absolute terms (i.e., it’s hard to get more negative than that).

On points 2 and 3, when the yield curve is at extremes, the real economy and fixed income speculators react, putting pressure on the curve to normalize.

Aside from that, on average how much do longer Treasury yields move when the One-year Treasury yield moves?

Maturity	Sensitivity
3-year T	94.64%
5-year T	89.31%
7-year T	85.17%
10-year T	81.14%
20-year T	75.41%
30-year T	72.89%

The answer is that the effect gets weaker the longer the bond is, bottoming out at 73% on 30-year Treasuries. But give Greenspan a little credit — in 2005 the 30-year Treasury yield was barely budging as short rates rose 4%. ?Then take some of the credit away — markets hate being manipulated, so as the Fed uses the Fed funds rate over a long period of time, it gets less powerful. ?In that sense, the Fed and the bond market integrated, as the market began looking past the tightening to the long-term future of US borrowing rates, what happened to short interest rates became less powerful on long yields. ?This is particularly true in an era where China was aggressively buying in US debt, and interest rate derivatives allowed some financial institutions to escape the interest rate boundaries to which they were previously subject.

Also note my graph above. ?I took the Treasury yield curves since 1953, and used an optimization model to estimate 10 representative curves for monthly changes in the yield curve, and the probability of each one occurring. ?If yield curves moving in a parallel direction means the monthly changes at different points in the curve never vary by more than 0.15%, it means that monthly changes in yield curves are parallel roughly 70% of the time.

When do the non-parallel shifts occur? ?When monetary policy moves aggressively, long rates lag, leading the yield curve to flatten or invert on tightening, and get very steep with loosening.

Later, the article hems and haws over whether rising long rates would be a good or a bad thing, ending with the idea that the Fed could sell its long Treasury bonds to raise long yields if needed. ?That brings me to the second article, which says that long interest rates are at record lows, as measured by average Treasury yields on bonds with 10 years or more to mature.

The graph in the second article shows that it takes a long time for inflation to come back after the economy has been in a strongly deflationary mode, where bad debts have to be eliminated one way or another. ?Given the way that monetary policy encouraged the buildup of the bad debts from 1984-2007, it should be little surprise that long rates are still low.

Conclusion

So what should the Fed do? ?If they weren’t willing to try a more radical solution, I would tell them to experiment with selling long Treasuries outright, and not telling the market that it was doing so. ?The reason for this is that it would allow the Fed to separate out the actual effect of more Treasury supply on yields, versus how much the market might panic when it learns?that the long Treasuries might be available for sale. ?The second effect would be like Ben Bernanke mentioning the word “taper” without thinking what the effect would be on the forward curve of interest rates. ?It would be an expensive experiment, but I think it would show that selling the bonds in small amounts would have little impact, while the fear of a flood would have a big but temporary impact.

If the Fed doesn’t want to raise long rates, it could try moving Fed funds up more quickly. ?Historically, long rates would lag more than with a slow rise. (Note: 2004-2007 experience does not validate that idea.)

What do I think the Fed will do? ?I think that eventually they will let all long Treasuries and MBS mature on their own, and?replace them with short Treasuries, should they decide not to shrink the balance sheet of the financial sector as a whole. ?That’s similar to what they did after the 1951 Accord, which restored the Fed’s independence after monetizing some of the debt incurred in WWII. ?Maybe this is the way they eliminate the debt monetization now, if they ever do it.

I think the present Fed will delay taking any significant actions until they feel forced to do so. ?They have no incentive to take any risk of derailing any?recovery, and will live with more inflation should it arrive.

PS –?that?long rates move more slowly than short rates may mean that duration calculations for longer bonds are overstated relative to shorter bonds. ?It might mean that 30-year notes would be 2-3 years shorter relative to one year notes than a parallel shift would indicate.

Book Review: Bad Paper

Posted on 11 November 2014 by David Merkel

This book has two significant types of insights: on people and on market failure.? It does well with both of them, but spends most of its time on the former, because it is more interesting.? That said, the second set is more important, and is buried in a few places in the second half of the book.

With people, this book answers the following questions:

Why does this book largely take place in Buffalo, NY? Because entrepreneurs got started there, and found it easy to acquire talent there.
Why does the industry employ a lot of ex-convicts? There are some crossover benefits to having been through the rough-and-tumble of street life that gives an edge in dealing with desperate people who have bad debts.
Is there an ethical code for debt collectors? Well, yes, sort of.? Kind of like ?the code? from the movie Repo Man ? don?t tell debtors they are in legal trouble, don?t threaten, treat them with kindness, don?t buy debt where you don?t have a clear chain of title, don?t sell lists of debts to collect where the debtors have already been verbally flogged.
Do all debt collectors follow the code? Well, no, and that is one place where the book gets interesting, as various debt collectors look for edges so that they can make money off of debts that creditors have given up on.? There *is* honor among thieves, and be careful if you cross anyone powerful or desperate enough.
Can?t you use the legal system to try to recover money on the debts? Well, only at the end, and even then it is difficult, because if the debtor asks for evidence on the debt that is being collected, the debt collector usually doesn?t have it, and the case will be dismissed.? It is best for collectors to come to settlements out of court.

The book follows around debt collectors and those associated with them, a colorful bunch, who see their see their opportunities flow and ebb as the financial crisis first produces a lot of bad debts to work on, and they mine that ore until the yields get poor.? Some of these people you will gain sympathy for, as they are trying to make a buck ethically.? Others will turn you off with their conduct.

As for market failure issues, you might wonder why the credit card companies and other creditors don?t pursue the debtors themselves.? Why do they sell the right to collect on unsecured debts at such deep discounts to the face value of the debts? [Pennies on the dollar, or less?]

The creditors don?t want to make the effort to dig up the necessary data to make the case in court a slam-dunk.? It would not pay for them to do so in most cases given the large number of cases to pursue, and the relatively small amounts that would be recovered.? That?s why the debts are sold at a discount.

Some debts don?t get removed from databases when payments are made to close them out, and as such some debt collectors try to collect on debts that were once in default, but paid off in a compromise.? This could be remedied if there were a comprehensive database of all debts, but the costs of creating and updating such a database would likely be prohibitive.

Finally, you might ask where the regulators are in all of this.? Between the States and the Feds, they try to clip the worst aspects of debt collection, but they are stretched thin.? This means that for many people, the optimal strategy is not to pay on defaulted unsecured debts, and challenge them if they take you to court.

Quibbles

Lots of foul language, but you?re dealing with the lowest rungs of society, so what do you expect?

Summary / Who Would Benefit from this Book

This is a good book if you want to understand the unsecured debt collection business. ?If you have friends who are troubled by debt collectors, it might be worth a purchase, and lend the book to them. ?If you still want to buy it, you can buy it here:?Bad Paper: Chasing Debt from Wall Street to the Underworld.

Full disclosure:?I?received a?copy from the author?s PR flack.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Stay Calm

Posted on 5 November 2014 by David Merkel

Photo Credit: Moyan Brenn || Relax, you know less than you think... — Photo Credit: Moyan Brenn || Relax, you know less than you think…

So, the Republicans swamped the Democrats in the midterm elections.

Big deal.

The differences between the varying wings of the Purple Party are smaller than you think. ?What’s more, their willingness to magnify those differences and do little as a result is a high probability outcome.

Add in that the Republicans don’t have a coherent set of policies as a group. Will the t-party and Establishment wings of the GOP come to a meeting of the minds? (Democrats may insert easy cheap joke here.) ?Even if they do, who will take the blame when Obama vetoes their bills? ?They aren’t called the “stupid party” for nothing. ?They have a peculiar knack for snatching defeat from the jaws of victory, and letting their less presentable members define them.

Even if in theory, the markets do better from Republicans, in practice the reverse seems to be true. ?But the track record has so few data points that statistical credibility is low.

And, if there is something to the Republicans being in power moving the markets, how would you know if it wasn’t anticipated in the recent run-up of prices? ?Many parties may have bought into the concept of greater prosperity as result of the then-forthcoming elections. ?The time to buy?the rumor is gone. ?The time to sell the news may be here.

The same applies to the presidential cycle. ?Many argue that we are heading into a good time for the markets in the third and fourth year of a presidential term. ?Too many are arguing this in my opinion, and even if there is some real impact from presidential terms, perhaps the market is anticipating this as well. ?After all, the bad part of the presidential cycle looked pretty good this time around.

Add in that again we are working with the law of small numbers — the presidential cycle could just be due to?randomness. ?Some part of the presidential cycle had to look better. ?Is it so much better than any other subset could have been?

The same thing applies to the argument I am seeing trotted around that we are coming into the best six months?of the year. ?Cue the comments on the law of small numbers and randomness. ?Even if there is a structural reason like tax-based selling, might it have been anticipated this time around? ?Markets tend to anticipate. ?Some six month period had to be best… but is it due to randomness?

Going back to politics, I would point out that few significant things change in politics off of party affiliation. ?How many states have their budgets balanced on an accrual basis, taking into account the need to spread out the cost of infrastructure projects, and?pensions funded assuming a realistic 5% earnings assumption on assets, together with fully funded accrual accounts? ?None. ?All of the states put off paying for the accruals of what should be current expenses.

We’ve talked about entitlement reform, but action never happens, except further expansion, as under Bush, Jr. ?Will we see GSE reform, or will Congress continue to use the GSEs for their own ends? ?Will there ever be significant cuts in defense? ?Will we ever see truly balanced budgets on an accrual basis?

Beyond that, consider the Fed, the Supreme Court, and the bureaucracy generally… they don’t change rapidly, if at all. ?Admittedly, the Supreme Court has been more activist over the recent past… so maybe I am wrong there.

And truly, Congress changes only at the edges. ?The grand majority?of the same faces will be there, only the majority and committee assignments shift. ?That may not mean much.

But do we want lots of change? ?Individually, many of us do, but if you add us all together, it often nets to something near zero. ?Perhaps most of us are happy with that, given the alternative that those of us with the opposite views might impose them on the rest of us.

I leave you with this: don’t make too much out of the election results, the presidential cycle, the “sell in May and go away” phenomenon, etc. ?The world is complex, with many people trying to anticipate market reactions. ?Untangling them is close to impossible, so stay calm, and pursue the ordinary strategies that you always do. ?For me, I will continue my value investing.

Redacted Version of the October 2014 FOMC Statement

Posted on 29 October 2014 by David Merkel

September 2014	October 2014	Comments
Information received since the Federal Open Market Committee met in July suggests that economic activity is expanding at a moderate pace.	Information received since the Federal Open Market Committee met in September suggests that economic activity is expanding at a moderate pace.	No change. This is another overestimate by the FOMC.
On balance, labor market conditions improved somewhat further; however, the unemployment rate is little changed and a range of labor market indicators suggests that there remains significant underutilization of labor resources.	Labor market conditions improved somewhat further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources is gradually diminishing.	Shades their view of labor use up.? More people working some amount of time, but many discouraged workers, part-time workers, lower paid positions, etc.
Household spending appears to be rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.	Household spending is rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.	Shades up household spending a little.
Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.		Finally dropped this bogus statement.
Inflation has been running below the Committee’s longer-run objective. Longer-term inflation expectations have remained stable.	Inflation has continued to run below the Committee’s longer-run objective. Market-based measures of inflation compensation have declined somewhat; survey-based measures of longer-term inflation expectations have remained stable.	Shades their forward view of inflation down.? TIPS are showing slightly lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.35%, down 0.18% from September.
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.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators and inflation moving toward levels the Committee judges consistent with its dual mandate.	The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators and inflation moving toward levels the Committee judges consistent with its dual mandate.	No change.? They can?t truly affect the labor markets in any effective way.
The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced and judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year.	The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced. Although inflation in the near term will likely be held down by lower energy prices and other factors, the Committee judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year.	CPI is at 1.7% now, yoy.? They shade up their view down on inflation?s amount and persistence.
The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.	The Committee judges that there has been a substantial improvement in the outlook for the labor market since the inception of its current asset purchase program.	No change.
In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in October, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $5 billion per month rather than $10 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $10 billion per month rather than $15 billion per month.	Moreover, the Committee continues to see sufficient underlying strength in the broader economy to support ongoing progress toward maximum employment in a context of price stability. Accordingly, the Committee decided to conclude its asset purchase program this month.	Finally ends QE, for now.
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.	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.	No change
The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.	This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	Maintains reinvestment of long-term securities, which does little to hold interest rates down, assuming that is a desirable goal.
The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.		Finally ends a useless paragraph.
If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will end its current program of asset purchases at its next meeting.		Deletes sentence
However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.		Deletes sentence
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.? In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, 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 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 developments.	Highly accommodative monetary policy is gone ? but a super-low Fed funds rate remains.? Policy normalizes, sort of, but no real change.
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.	The Committee anticipates, based on its current assessment, that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program this month, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.	No change.? Its standards for raising Fed funds are arbitrary.
	However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.	Tells us what we already knew.
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.	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.	No change.
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.	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.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Narayana Kocherlakota; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo.	Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Loretta J. Mester; Charles I. Plosser; Jerome H. Powell; and Daniel K. Tarullo.	Fisher and Plosser dissent.? Finally some with a little courage.
Voting against the action were Richard W. Fisher and Charles I. Plosser. President Fisher believed that the continued strengthening of the real economy, improved outlook for labor utilization and for general price stability, and continued signs of financial market excess, will likely warrant an earlier reduction in monetary accommodation than is suggested by the Committee’s stated forward guidance. President Plosser objected to the guidance indicating that it likely will be appropriate to maintain the current target range for the federal funds rate for “a considerable time after the asset purchase program ends,” because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee’s goals.	Voting against the action was Narayana Kocherlakota, who believed that, in light of continued sluggishness in the inflation outlook and the recent slide in market-based measures of longer-term inflation expectations, the Committee should commit to keeping the current target range for the federal funds rate at least until the one-to-two-year ahead inflation outlook has returned to 2 percent and should continue the asset purchase program at its current level.	Send Mr. Kocherlakota a chill pill, and ask him to review how badly the FOMC forecasts, and how little effectiveness monetary policy has had for the good in the US.? He just wants to create another bubble, along with the rest of the doves.

Comments

Pretty much a nothing-burger. Few significant changes, if any.? Yes, QE ends, but who didn?t expect that?
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 are down.? 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 FOMC chops some ?dead wood? out of its statement. Brief communication is clear communication.? If a sentence doesn?t change often, remove it.
In the past I have said, ?When [holding down longer-term rates on the highest-quality debt] doesn?t work, what will they do? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.? The Fed is playing with forces bigger than themselves, and it isn?t dawning on them yet.
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.