Public Policy – Page 3 – The Aleph Blog

What Caused the Financial Crisis?

Posted on 15 September 201816 September 2018 by David Merkel

Photo Credit: Alane Golden || Sad but true — the crisis was all about bad monetary policy, a housing bubble, and poor bank risk management======================

There are a lot of opinions being trotted around ten years after the financial crisis.? A lot of them are self-serving, to deflect blame from areas that they want to protect.? What you are going to read here are my opinions.? You can fault me for this: I will defend my opinions here, which haven?t changed much since the financial crisis.? That said, I will simplify my opinions down to a few categories to make it simpler to remember, because there were a LOT of causes for the crisis.

Thus, here are the causes:

1) The Federal Reserve and the People?s Bank of China

For different reasons, these two central banks kept interest rates too low, touching off a boom in risk assets in the USA.? The Fed kept interest rates too low for too long 2001-2004. The Fed explicitly wanted to juice the economy via the housing sector after the dot-com bust, and the withdrawal of liquidity post-Y2K.? Also, the slow, predictable way that they tightened rates did little to end speculation, because long rates did not rise, and in some cases even fell.

The Chinese Central Bank had a different agenda.? It wanted to keep the Yuan cheap to continue growing via exporting to the US.? In order to do that, it needed to buy US assets, typically US Treasuries, which balanced the books ? trading US bonds for Chinese goods ? and kept longer US interest rates lower.

Both of these supported the:

2) Housing Bubble

This is the place where there are many culprits.? You needed lower mortgage underwriting standards. This happened through many routes:

US policy pushing home ownership at all costs, including tax-deductibility of mortgage interest.
GSEs guaranteeing increasingly marginal loans, and buying lower-rated tranches of subprime RMBS. They ran on such a thin capital base that it was astounding.? Don?t forget the FHLBs as well.
Politicians and regulators refused to rein in banks when they had the power and tools to do so.
Securitization of private loans separated origination from risk-bearing, allowing underwriting standards to deteriorate. Volume was rewarded, not quality.
Mortgage insurers and home equity loans allow people to borrow a far greater percentage of the value of the home than before, for conforming loans.
Appraisers went along with the game, as did regulators, which could have stopped the banks from lowering credit standards. Part of the fault for the regulatory mess was due to the Bush Administration downplaying financial regulation.
The Rating Agencies gave far too favorable ratings to untried asset classes, like ABS and private RMBS securitizations. This is for two reasons: financial regulators required that the companies they oversaw must use ratings for assessing capital needed to cover credit risk, and did not rule out asset classes that were unproven, as prior regulators had done.? Second, CDOs and similar structures needed the assets they bought to have ratings for the same reason.
There was a bid for yieldy assets on the part of US Hedge funds and foreign financial firms. Without the yield hogs who bid for CDO paper, and other yieldy assets, the bubble would not have grown so big.
Financial guarantors insured mortgage paper without having good models to understand the real risk.
People were stupid enough to borrow too much, assuming that somehow they would be able to handle it.? As with most bubbles, there were stupid writers pushing the idea that investing in housing was “free money.”

3) Bank Asset-liability management [ALM] for large commercial and investment banks was deeply flawed. ?It resulted in liquid liabilities funding illiquid assets.? The difference in liquidity was twofold: duration and credit.? As for duration, the assets purchased were longer than the bank?s funding structures.? Some of that was hidden in repo transactions, where long assets were financed overnight, and it was counted as a short-term asset, rather than a short-term loan collateralized by a long-term asset.

Also, portfolio margining was another weak spot, because as derivative positions moved against the banks, some banks did not have enough free assets to cover the demands for security on the loans extended.

As for credit, many of the assets were not easily saleable, because of the degree of research needed to understand them.? They may have possessed investment grade credit ratings, but that was not enough; it was impossible to tell if they were ?money good.?? Would the principal and interest eventually be paid in full?

The regulatory standards let the banks take too much credit risk, and ignored the possibility that short-term lending, like repos and portfolio margining could lead to a ?run on the bank.?

4) Accounting standards were not adequate to show the risks of repo lending, securitizations, or derivatives.? Auditors signed off on statements that they did not understand.

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That?s all, I wanted to keep this simple.? I do want to say that Money Market Funds were not a major cause of the crisis.? The reaction to the failure of Reserve Primary was overdone.? Because of how short the loans in money market funds are, the losses from money market funds as a whole would have been less than two cents on the dollar, and probably a lot smaller.

Also, bailing out the banks sent the wrong message, which will lead to more risk later.? No bailouts were needed.? Deposits were protected, and there is no reason to protect bank stock or bondholders.? As it was, the bailouts were the worst possible, protecting the assets of the rich, while not protecting the poor, who still needed to pay on their loans.? Better that the bailouts should have gone to reduce the principal of loans of those less-well-off, rather than protect the rich.? It is no surprise that we have the politics? we have today as a result.? Fairness is more important than aggregate prosperity.

PS — the worst of all worlds is where the government regulates and gives you the illusion of protecting you when it does not protect you much at all.? That tricks people into taking risks that they should not take, and leaves individuals to hold the bag when bad economic and regulatory policies fail.

Why I Watch the Thirty

Posted on 19 April 2018 by David Merkel

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I like long bonds.? I am not saying that I like them as an investment.? I like them because they tell me about the economy.

Though I argued to the Obama Administration that they should issue Fifties, Centuries and Perpetuals, the Thirty-year bond remains the longest bond issued.? I think its yield tells us a lot about the economy.

How fast is nominal growth?? Look at the Thirty; it is highly correlated with that.

What should the Fed use for its monetary policy?? Look at the Thirty, and don’t let the Five-year note get a higher yield than it.? Also, don’t let the spread of the Two-year versus the Thirty get higher than 1.5%.? When things are bad, stimulus is fine, but it is better to wait at a high spread than goose the spread higher. Excesses in loose policy tend to beget excesses in tight policy.? Better to avoid the extremes, and genuinely mute the boom-bust cycle, rather than trying to prove that you are a genius/maestro when you are not.? Extreme monetary policy does not get rewarded.? Don’t let the yield curve get too steep; don’t invert.

Finally, the Thirty is a proxy for the cost of capital.? It’s long enough that it is a leap of faith that you will be paid back.? Better still for the cost of capital is the Moody’s Baa average, which tracks the bold bet of lending to low investment grade corporations for 20-30 years.

That said, the Thirty with its cousin, the long Treasury Inflation Protected Security [TIPS] gives you an idea of how long term inflation expectations and real rates are doing.? The thing that kills stocks is higher long term real interest rates, not inflation expectations.? The main reason for this is that when inflation rises, usually earnings do also, at least at cyclical companies.? But there is no reason why earnings should rise when real rates rise.

This is why I pay more attention to the Thirty rather than the more commonly followed Ten.? I know that more debt gets issued at a maturity of ten years.? Granted.? But the Thirty tells me more about the economy as a whole, and about its corporations.? That’s why I carefully watch the Thirty.

Notes on the Fed Announcements

Posted on 22 March 2018 by David Merkel

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Listening to the Fed Chair’s press conference, there was one thing where I disagreed with what Powell was saying.? He said a few times that they only made one decision at the FOMC meeting, that of raising the Fed Funds rate and the reverse repo rate by 0.25%.? They made another decision as well.?The decided to raise the rate of quantitative tightening [QT] by increasing the rate of Treasury, MBS and agency bonds rolloff by $10B/month starting in April. They did that by increasing the rate of reduction of MBS and agency bonds from $8B to $12B/month, and Treasuries from $12B to $18B/month. The total rate of QT goes from $20B to $30B/month.? This may raise rates on the longer end, because the Fed will no longer buy so much debt.

There was also a little concern over people overinterpreting the opinions of the Fed Governors, especially over the “dot plot,” which shows their opinions over real GDP growth, the unemployment rate, PCE inflation, and the Fed funds rate.? My point of view is simple.? If you don’t want people to misinterpret something, you need to defend it or remove it.

Personally, I think the FOMC invites trouble by doing the forecasts.? First, the Fed isn’t that good at forecasting — both the staff economists and the Fed Governors themselves.? Truly, few are good at it — people tend to either follow trends, or call for turns too soon.? Rare is the person that can pick the turning point.

Let me give you the charts for their predictions, starting with GDP:

The Fed Governors have raised their GDP estimates; they raised the estimates the most for 2018, then 2019, then 2020, but they did not raise them for the longer run.? I seems that they think that the existing stimulus, fiscal and monetary, will wear off, and then growth will return to 1.8%/year.? Note that even they don’t think that GDP will exceed 3%/year, and generally the Fed Governors are paid to be optimists.? Wonder if Trump notices this?

Then there is the unemployment rate.? This graph is the least controversial.? The short take is that?unemployment rate estimates by the Fed governors keep coming down, bottoming in 2019, and rising after that.

Then there is PCE Inflation.? Estimates by the Fed Governors are rising, and in 2019 and 2020 they exceed 2%.? In the long run the view of the Fed Governors is that they can achieve 2% PCE inflation.? Flying in the face of that is that they haven’t been able to do that for the duration of this experiment, so should we believe in their power to do so?

Finally, there is the Fed Funds forecast of the Fed Governors — the only variable they can actually control. Estimates rose a touch for 2018, more for 2019, more for 2020, and FELL for the long run. Are they thinking of overshooting on Fed Funds to reduce future inflation?

Monetary policy works with long and variable lags, as it is commonly said.? That is why I said, “Just Don?t Invert the Yield Curve.”? Powell was asked about inverting the yield curve at his press conference, and he hemmed and hawed over it, saying the evidence isn’t clear.? I will tell you now that if the Fed Funds rate follows that path, the Fed will blow something up, and then start to loosen again.? If they stop and wait when 10-year Treasury Note yields exceed 2-year yields by 0.25%, they might be able to do something amazing, where monetary policy hits the balancing point.? Then, just move Fed funds to keep the yield curve slope near that 0.25% slope.

There would be enough slope to allow prudent lending to go on, but not enough to go nuts.? Much better than the present policy that amplifies the booms and busts.? The banks would hate it initially, and regulators would have to watch for imprudent lending, because there would be no more easy money to be made.? Eventually the economy and banks would adjust to it, and monetary policy would become boring, but predictably good.

Just Don’t Invert the Yield Curve

Posted on 21 March 2018 by David Merkel

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Jerome Powell is not an economist, and as such, has the potential to try to remake the way the Fed does monetary policy.? Rather than hold onto outmoded ideas ideas like the Phillips Curve, which may have made sense when the US was a more insular economy, there are better ways to think of monetary policy from a structural standpoint of how financial firms work.

(Note: the Phillips Curve relies on a very simple assumption that goods and services price inflation stems from wage inflation, and that wage inflation occurs when domestic unemployment is low.? In a global economy, those relationships are broken when labor can be easily added from sources outside of the US.)

Financial firms tend to grow rapidly when the yield curve is steeply sloped.? Borrowing short and lending long is profitable, at least in the short-run.? This provides a lot of credit to the economy, which in the short-run, encourages growth, as businesses borrow to build supply, and consumers borrow, which temporarily boosts demand.

Financial firms tend to shrink?when the yield curve is flattish and certainly when negatively sloped.? Borrowing short and lending long is unprofitable, at least in the short-run.? This reduces credit to the economy, which in the short-run discourages growth, as businesses don’t borrow to build supply, and consumers borrow less, which temporarily reduces demand.

If there are misfinanced (too much short-term borrowing) or over-indebted areas of the economy, there can be considerable economic failure with a flat or inverted yield curve.? As I have said before, when the FOMC tightens without thinking about the financial economy, they keep tightening until something blows up, and then they loosen too much, starting the next cycle of over-borrowing.? I said this at RealMoney in 2006:

One more note: I believe gradualism is almost required in?Fed?tightening cycles in the present environment ? a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

2000 ??Nasdaq

1997-98 ? Asia/Russia/LTCM, though that was a small move for the Fed

1994 ? Mortgages/Mexico

1989 ? Banks/Commercial Real Estate

1987 ? Stock Market

1984 ? Continental Illinois

Early ?80s ? LDC debt crisis

So it moves in baby steps, wondering if the next straw will break some camel?s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.

But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can?t afford it.

Position:?None

I also commented that housing was likely to be the next blowup in a number of posts from that era.? Sadly, they are mostly lost because of a change in the way theStreet.com managed its file system.

As such, it behooves the Fed to avoid overly flattening the yield curve.? In late 2005, I wrote at RealMoney.com that the Fed should stop at 4%, and let the excess of the economy work themselves out.? By mid -2006, they raised the Fed Funds rate to 5.25%, flattening to invert the yield curve, which collapsed the leverage in the economy in a disorderly way.

It would have been better to stop at 4%, and watch for a while.? Housing prices had peaked, and I wrote about that at RealMoney.com as well.? The Fed could have been more gradual at that point.? There really wasn’t that much inflation, and the economy was not that strong.? Bernanke may have felt that he needed to prove that he wasn’t a dove on inflation.? Who knows?? The error was unforced, and stemmed from prior bad practices.

In this case, the Fed does have an alternative to crashing the economy again.? I would encourage the FOMC to not raise rates over 2.5%.? When they get to 2.5%, they should start selling the longest bonds in their portfolio (note: I would encourage them to end balance sheet disclosure before they do this, after all, the Fed suffers from too much communication not too little.? The Fed was better managed under Volcker and Martin.)

This would test the resilience of the economic expansion, and if the economy keeps growing as long bonds rise in yield, then match the rises in long yields with rises in the Fed Funds rate.? This is a neo-Wicksellian method of managing monetary policy that could match the ideas of Jerome Powell, who was more skeptical than most Fed Governors about about Quantitative Easing [QE].

The eventual goal is to manage monetary policy aiming for a yield curve that has a low positive slope, allowing the banks to make a little money, but not a lot.? The economy would expand moderately, and not be as prone to booms and busts.

My summary advice for the FOMC would be this: before you flatten/invert the yield curve, start selling all of the long MBS and Treasury bonds with average maturities longer than 10 years.? That will slow down the economy more effectively than flattening the yield curve, and it is not as likely to lead to a crisis.

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I have no illusions — the odds of the FOMC doing this is remote.? But given past failures, isn’t a new idea worthy of consideration?

PS — there is another factor here.? What happens to the financing costs of the profligate US government?

Surprise! Return to RT Boom/Bust

Posted on 1 March 2018 by David Merkel

After almost three years, I returned to RT Boom/Bust on Tuesday.? There are many changes at RT.? Many new people, and a growing effort to put together an alternative channel that covers the world rather than just the US or just the developed world.? They are bursting at the seams, and their funding has doubled, so I was told.

I get surprised by who watches RT and sees me.? My? congregation is pretty conservative in every way, but I have some friends working in intelligence come up to me and say, “Hey, saw you on RT Boom/Bust.”? And then there is my friend from Central Africa who says, “The CIA has you on their list.? Watch out!”? He’s funny, hard-working, but very earnest.

I’ve never seen anything in what I have done where there is any hint of editorial control.? Maybe it is there, but I think I would be smart enough to see it.

Anyway, the topic at hand was alternative monetary systems, and the thing that kicked it off was the Vollgelt in Switzerland, where they are trying to create a monetary system where the banks can’t lend against deposits.? Here were my notes for the show, with a little more to fill in:

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Mr. Merkel, what exactly is a sovereign money system?

The banks can?t lend against deposits.? Deposits are segregated, and wait for the depositor to use them.? The deposits no longer can be used by the bank but only the depositor.? There would be no need for deposit insurance, because deposits are off of the bank?s balance sheet.

What is the difference between a sovereign system and the way banks handle your money now?

You would have to pay for your transactional account, because the bank can?t make money off of lending against the deposits. Banks would no longer do ?maturity transformation? by lending long against short-term deposits.? Long-term lending would have to be other entities in the economy, such as insurance companies, pension funds, endowments, private individuals, foreign lenders, mortgage REITs, and banks funded by matching sources like CDs, bonds, and equity.

Switzerland is poised to vote on a sovereign money system, or Vollgeld in German. How likely is this vote to pass?

Not likely for three reasons.? First, the Swiss turned down a proposal to back the Swiss Franc with 20% gold.? Not one canton voted for it.? Only 22% of the electorate voted for it.? Second, things aren?t that bad now, and the financial system isn?t that levered.? ?If it ain?t broke, don?t fix it.?? Third, this is a total experiment with no real world precedents.? Many criticize economists for imagining what the world should be like and then proposing policy off their unrealistic idealized models.? This is another example of that.? We don?t know what the unintended consequences might be.

Some unintended consequences might be:

Transition would be difficult
Recession during the transition, because middle and small market lending would likely suffer
Pay for transactional accounts ? no interest even if inflation is high.
Increase in savings accounts, which might be short-dated enough to be transactional
Gives a lot of power to the SNB, which might be halfhearted about implementation (Regulators dislike change, and risk).
Could be subverted if Government becomes dependent on free money, leading to inflation
Moves monetary policy from rate targeting to permanent quantitative monetary adjustment. Unclear how the SNB would tighten policy; maybe issue central bank bonds to reduce money supply?

Could something like this rein in credit bubbles? Are we facing another credit bubble?

Yes, it could.? Most credit bubbles result from short-term lending funding long-term assets.? This would rein it in, in the short-run, but who could tell whether it might come back in another unintended way?? If some new class of lender became dominant, the threat could reappear.

We aren?t facing a credit bubble now, because the last crisis wiped away a lot of private debt, and replaced it with public debt.? Perhaps some weak nations with debts not in their own currency could be at risk, but right now, there aren?t any categories of private debt big enough and misfinanced enough to create a crisis.? That said, watch margin loans, student loans, and auto loans in the US.

Are there any modern day equivalents we can compare Vollgeld to?

None that are currently being used.? There are a lot of theoretical ideas still being tossed around, like 100% reserving, lowering bank leverage, strict asset-liability matching, disallowing banks from lending to financial companies, etc.? These ideas get a lot of press after crises, but fade away afterward.? Most of them would work, but all of them lower bank profits.? Concentrated interests tend to win against general interests, except in crises.

You mentioned there is a similar concept for derivatives that no one is talking about. How exactly would that work?

Derivatives are functionally equivalent to insurance contracts, but they are not regulated.? I believe they should be regulated like insurance contracts, and require that those seeking insurance have an ?insurable interest? that they are trying to hedge.? Only direct hedgers could initiate derivative transactions, and financial guaranty insurers would compete to fill the need.

This would prevent the unintended consequences of having multiples of protection written on a given risk, where a weak party like AIG is incapable of making good on all of the derivative contracts that they have written, which could lead to its own systemic risk if other derivative counterparties can?t absorb the losses.

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I know that is over-simplified, but I read through the papers of both sides in the debate, and I thought both overstated their cases significantly.

I know fiat money has its problems, and so does fractional reserve banking, but if you are going to propose a solution, perhaps one that fits the basics of how a well-run bank at low leverage would work would be a good place to start.

On Finding a Job in Finance

Posted on 19 December 2017 by David Merkel

I was approached by a younger friend for advice.? This is my response to his questions below:

Thank you for agreeing to do this for me. I would love to have an actual conversation with you but unfortunately, I think that between all of the classes, exams, and group project meetings I have this week it would prove to be too much of a hassle for both of us to try to set up a time.

1. What professional and soft skills do you need to be successful in this career and why?
2. What advice would you give to someone considering working in this field?
3. What are some values/ethics that have been important to you throughout your career?
4. I understand that you currently run a solo operation, but are there any leadership skills you have needed previously in your career? Any examples?
5. What made you decide to make the switch to running your own business?

Thanks again,

ZZZ

What professional and soft skills do you need to be successful in this career and why?

I’ve written at least two articles on this:

How Do I Find a Job in Finance?

How Do I Find a Job in Finance? (Part 2)

Let me answer the question more directly.? You need to understand the basics of how businesses operate.? How do they make money?? How do they control risk?

Now, the academics will show you their models, and you should know those models.? What is more important is understanding the weaknesses of those models because they may weakly explain how stocks in aggregate are priced, but they are little good at understanding how corporations operate.? The real world is not as ideal as the academic economists posit.

It is useful to read broadly.? It is useful to dig into a variety of financial reports from smaller firms.? Why smaller firms?? They are simpler to understand, and there is more variation in how they do.? ?Learn to read through the main financial statements well.? Understand how the income statement, balance sheet, and cash flow statement interact.? Look at the footnotes and try to understand what they mean.? Pick an industry and compare all of the companies.? I did that with trucking in 1994 and learned a boatload.? This aids in picking up practical accounting knowledge, which is more powerful when you can compare across industries.

As for soft skills, the ability to deal with people on a firm and fair basis is huge.? Keeping your word is big as well.? When I was a bond trader, I ate losses when I made promises on trades that went wrong.? In the present era, I have compensated clients for losses from mistaken trades.

Here’s another “soft” skill worth considering.? Many employers are aghast at the lousy writing skills of young people coming out of college, and rightly so.? Make sure that your ability to communicate in a written form is at a strong level.

Oral communication is also important.? If you have difficulty speaking to groups, you might try something like Toastmasters.

Many of these things come only with practice on the job, so don’t think that you have to have everything together in order to do well — the important thing is to improve over time.? Young people are not expected to be as polished as their older colleagues.

What advice would you give to someone considering working in this field?

It’s a little crowded in finance.? That is partially because it attracts a lot of people who think it will be easy money.? If you are really good, the crowding shouldn’t be much of a hurdle.? But if you don’t think that you are in the top quartile, there are some alternatives to help you grow and develop.

Consider developing your skills at a small bank or insurer.? You will be forced to be a generalist, which sets you up well for future jobs.? It also forces you to confront how difficult the economics of smaller firms are, and how costly/difficult it is to change strategy.? For a clever person, it offers a lot of running room if you work for a firm that is more entrepreneurial
Or, consider working in the finance area of an industrial firm.? Finance is not only about selling financial products — it is about the buyers as well.
Work for a government or quasi-governmental entity in their finance area.? If you can show some competence there, it would be notable.? The inefficiencies might give you good ideas for what could be a good business.

What are some values/ethics that have been important to you throughout your career?

Here are some:

Be honest
Follow laws and regulations
Work hard for your employer
Keep building your skills; at 57, I am still building my skills.
Don’t let work rob you of other facets of life — family, friends, etc.? Many become well-paid slaves of their organization, but never get to benefit personally outside of work.
Avoid being envious; just focus on promoting the good of the entity that you work for.
Try to analyze the culture of a firm before you join it.? Culture is the most important aspect that will affect how happy you are working there.

I understand that you currently run a solo operation, but are there any leadership skills you have needed previously in your career? Any examples?

This is a cute story:?Learning Leadership.? I have also written three series of articles on how I grew in the firms that I worked for:

There’s a lot in these articles.? They are some of my best stories, and they help to illustrate corporate life.? Here’s one more:?My 9/11 Experience.? What do you do under pressure?? What I did on 9/11 was a good example of that.

I know I have a lot more articles on the topic on this, but those are the easiest to find.

What made you decide to make the switch to running your own business?

I did very well in my own investing from 2000-2010, and wanted to try out my investing theories as a business.? That said, from 2011-2017, it worked out less well than I would have liked as value investing underperformed the market as a whole.

That said, I proceed from principle, and continue to follow my investment discipline.? It follows from good business management principles, and so I continue, waiting for the turn in the market cycle, and improving my ability to analyze corporations.

Nonetheless, my business does well, just not as well as I would like.

I hope you do well in your career.? Let me know how you do as you progress, and feel free to ask more questions.

Notes from an Unwelcome Future, Part 1

Posted on 28 November 2017 by David Merkel

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Dear Readers, this is another one of my occasional experiments, so please be measured in your comments.? The following was written as a ten-year retrospective article in 2042.

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It was indeed an ugly surprise to many when the payments from Social Security in February 2032 did not come.? Indeed, the phones in Congress rang off the hook, and the scroll rate on incoming emails broke all records.? But as with most things in DC in the 21st century, there was no stomach to deal with the problem, as gridlock continued to make Congress a internally hostile but essentially passive institution.

Part of that gridlock stemmed from earlier Congressional reforms that looked good at the time, but reduced the power of parties to discipline members who would not go along with the leadership.? Part also stemmed from changes in media, which were developing in the 1980s because the media was increasingly out of sync with the views of average Americans, but came to full fruition after the internet became the dominant channel for news flow, allowing people to tune out voices unpleasant to them.? Gerrymandering certainly did not help, as virtually all House seats were noncompetitive.? Finally, the size of the?debt, and large continuing deficits limited the ability of the government to do anything.? The Fed was already letting inflation run at rates higher than intermediate interest rates, so they were out of play as well.

Despite occasional warnings in the media that began five years earlier after the Chief Actuary of the Social Security Administration suggested in his 2027 year-end report that this was likely to happen in 4-6 years, most media and people tuned it out because it was impossible in their eyes, and face it, actuaries are deadly dull people.? Only a few bloggers kept up a drumbeat on the topic, but they were ignored as Johnny One-Note Disasterniks.

Shortly thereafter, the obligatory hearings began in Congress, and?the new Chief Actuary of the Social Security Administration was first on the list to testify.? First he explained that when the Social Security was developed, this safeguard was added in case the income and assets of the trust were inadequate to make the next payment, that payment would be skipped.? He added that by law, skipped payments would not be made up later.? After all, Social Security is an earned right, but mainly a statutory right and not a constitutional right.? Then he commented that without changes, a payment would likely be skipped in 2033 and 2034, two skips each in 2035 and 2036, and by 2037 three skips would be the “new normal” until demographics normalized, but that would likely take a generation to achieve, as childbearing was out of favor.

There were many other people who testified that day from AARP, its relatively new but strong foe AAWP (w -> Working), and various conservative and liberal think tanks, but no one said anything valuable that the Chief Actuary didn’t already say: without changes to benefits or taxes (contributions, haha), payment skipping would become regular.? It was a darkly amusing sidelight that members of the House of Representatives managed to trot out every “urban myth” about Social Security as true during their hearings, including the bogus idea that everyone has their contributions stored in the own little accounts.

The eventual compromise was not a pretty one:

Cost-of-living adjustments were ended.
Benefits were means-tested.
Late retirement adjustment factors were decreased.
All the games where benefits could be maximized were eliminated.
Immigration restrictions were loosened for well-off immigrants.
The normal retirement age was raised to 72, and
“Contributions” would now be assessed on income of all types, with no upper limit.? That said, the rate did not rise.

That ended the payment skipping, though it is possible that a skip could happen in the future.? As it is, much of the current political climate is marked by intergenerational conflict, with Social Security viewed derisively as an old-age welfare plan.? A visitor to the grave of FDR did not find him doing 2000 RPM, but did note the skunk cabbage that someone helpfully planted there.? As it was, quiet euthanasia, some voluntary, some not, took place among the elderly Baby Boomers, tired of being labelled sponges on society, or picked off by annoyed caretakers.

It should be noted that as benefits were cut in real terms, friends and families of the some elderly and disabled helped out, but many elderly people led lives of poverty.? Perhaps if they had expected this, they would have prepared, but they trusted the malleable promises of the US Government.

The open question at present is whether it was wise for society to promote collective security schemes.? As it is, with seven states in pseudo-bankruptcy, many municipalities in similar straits if not real bankruptcy, and many countries suffering with worse demographic problems than the US, the problems of these arrangements are apparent:

Breaking the link between childbearing and support in old age discouraged childbearing.
Every succeeding generation of participants got a worse deal than those that came before.
Politicians learned to prioritize the present over the future, and use monies that should have been put to some productive future use into the benefit of those who would consume currently.
Complexity encouraged gaming of the system, whether it was maxing benefits, or faking disability.
Retirement ages that were too low made the burden too heavy to the workers supporting retirees.

Future articles in this retrospective series will touch on some of the other problems we have recently faced, as many involuntary collective security measures have hit troubled times, and the unintended effects of too much debt, both governmental and private are still with us.

The Crisis Lending Fund

Posted on 18 November 2017 by David Merkel

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Last week, there was an article in Barron’s describing how many mutual fund families take advantage of a provision in the law allowing them to have funds lend to one another.? Quoting from the article:

Under normal circumstances the Securities and Exchange Commission bars funds from making ?affiliated transactions,? but there?s a loophole in the Investment Company Act of 1940 for funds to apply for an exemption to make such ?interfund loans.? Until recently, few fund families applied for this exemption. None had before 1990. From 2006 to 2016, the SEC approved just 18 interfund lending applications. But since January 2016, the agency has approved 26. Most major fund families?BlackRock, Vanguard, Fidelity, Allianz?now can make such loans. Stiffer regulations of banks, which are now less willing to offer funds credit lines, partly explain the application surge.

I’m here tonight to suggest making a virtue out of necessity, because one day this practice will be banned after another crisis if something goes afoul.? Let the mutual fund companies that do this set up a special “crisis lending fund,” and put in place the following provisions:

The various funds that can borrow from the crisis lending fund must pay a commitment fee for the capital that could be lent.? Make it similar to what a bank provides on a revolving credit line.
When funds are not lent, it is invested in Treasury securities, or something of very high quality, in a five-year ladder.
When funds are lent, they receive a rate similar to rates current on single-B junk bonds.
The lending to other funds is secured, such that if the loans are collateralized by less than 200%, the loans must be paid down.? I.e., if the fund has $200 million of net asset value, there can be at most $100 million of loans, from all parties lending to the fund.

This would be an attractive, somewhat countercyclical asset for people to invest in.? Who wouldn’t want a fund that made additional money during a crisis, and was safe the rest of the time as well?

Just a stray thought.? As with many of my ideas, this would help create a stable private-sector solution where the government might otherwise intrude.

Redacted Version of the September 2017 FOMC Statement

Posted on 20 September 2017 by David Merkel

Comments

Labor conditions can?t get much better. GDP is meandering.
The yield curve is flattening, with short rates rising more than long rates.
Stocks, bonds and gold fall a little. Though the statement doesn?t say it, many conclude that tightening will continue.
I think the Fed is too optimistic about the economy. I also think that they won?t get far into letting securities mature before they resume reinvestment.

The Crisis at the Tipping Point

Posted on 9 August 20179 August 2017 by David Merkel

Photo Credit: Fabio Tinelli Roncalli || Alas, there were so many signs that the avalanche was coming…

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Ten years ago, things were mostly quiet. ?The crisis was staring us in the face, with a little more than a year before the effects of growing leverage and sloppy credit underwriting would hit in full. ?But when there is a boom, almost no one wants to spoil the party. ?Yes a few bears and financial writers may do so, but they get ignored by the broader media, the politicians, the regulators, the bulls, etc.

It’s not as if there weren’t some hints before this. ?There were losses from subprime mortgages at HSBC. ?New Century was bankrupt. ?Two hedge funds at Bear Stearns, filled with some of the worst exposures to CDOs and subprime lending were wiped out.

And, for those watching the subprime lending markets the losses had been rising since late 2006. ?I was following it for a firm that was considering doing the “big short” but could not figure out an effective way to do it in a way consistent with the culture and personnel of the firm. ?We had discussions with a number of investment banks, and it seemed obvious that those on the short side of the trade would eventually win. ?I even wrote an article on it at RealMoney in November 2006, but it is lost in the bowels of theStreet.com’s file system.

Some of the building blocks of the crisis were evident then:

European banks in search of any AAA-rated structured product bonds that had spreads over LIBOR. ?They were even engaged in a variety of leverage schemes including leveraged AAA CMBS, and CPDOs. ?When you don’t have to put up any capital against AAA assets, it is astounding the lengths that market players will go through to create and swallow such assets. ?The European bank yield hogs were a main facilitator of the crisis that was to come, followed by the investment banks, and bullish mortgage hedge funds. ?As Gary Gorton would later point out, real disasters happen when safe assets fail.
Speculation was rampant almost everywhere. (not just subprime)
Regulators were unwilling to clamp down on bad underwriting, and they had the power to do so, but were unwilling, as banks could choose their regulators, and the Fed didn’t care, and may have actively inhibited scrutiny.
Not only were subprime loans low in credit quality, but they had a second embedded risk in them, as they had a reset date where the interest rate would rise dramatically, that made the loans far shorter than the houses that they financed, meaning that the loans would disproportionately default near their reset dates.
The illiquidity of the securitized Subprime Residential Mortgage ABS highlighted the slowness of pricing signals, as matrix pricing was slow to pick up the decay in value, given the sparseness of trades.
By August 2007, it was obvious that residential real estate prices were falling across the US. ?(I flagged the peak at RealMoney in October 2005, but this also is lost…)
Amid all of this, the “big short” was not a sure thing as those that entered into it had to feed the trade before it succeeded. ?For many, if the crisis had delayed one more year, many taking on the “big short” would have lost.
A variety of levered market-neutral equity hedge funds were running into trouble in August 2007 as they all pursued similar Value plus Momentum strategies, and as some fund liquidated, a self reinforcing panic ensued.
Fannie and Freddie were too levered, and could not survive a continued fall in housing prices. ?Same for AIG, and most investment banks.
Jumbo lending, Alt-A lending and traditional mortgage lending had the same problems as subprime, just in a smaller way — but there was so much more of them.
Oh, and don’t forget hidden leverage at the banks through ABCP conduits that were off balance sheet.
Dare we mention the Fed inverting the yield curve?

So by the time that BNP Paribas announced that three of their funds that bought?Subprime Residential Mortgage ABS had pricing issues, and briefly closed off redemptions, and Countrywide announced that it had to “shore up its funding,” there were many things in play that would eventually lead to the crisis that happened.

Some of us saw it in part, and hoped that things would be better. ?Fewer of us saw a lot of it, and took modest actions for protection. ?I was in that bucket; I never thought it would be as large as it turned out. ?Almost no one saw the whole thing coming, and those that did could not dream of the response of the central banks that would take much of the losses out of the pockets of savers, leaving bad lending institutions intact.

All in all, the crisis had a lot of red lights flashing in advance of its occurrence. ?Though many things have been repaired, there are a lot of people whose lives were practically ruined by their own greed, and the greed of others. ?It’s a sad story, but one that will hopefully make us more careful in the future when private leverage rises, creating an asset bubble.

But if I know mankind, the lesson will not be learned.

PS — this is what I wrote one decade ago. ?You can see what I knew at the time — a lot of the above, but could not see how bad it would be.

July 2017	September 2017	Comments
Information received since the Federal Open Market Committee met in June indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year.	Information received since the Federal Open Market Committee met in July indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year.	No change.? Feels like GDP is slowing, though.
Job gains have been solid, on average, since the beginning of the year, and the unemployment rate has declined.	Job gains have remained solid in recent months, and the unemployment rate has stayed low.	Shades labor conditions down, as improvement has seemingly stopped.
Household spending and business fixed investment have continued to expand.	Household spending has been expanding at a moderate rate, and growth in business fixed investment has picked up in recent quarters.	Shades business fixed investment up.? Does that matter as much in an intangible economy?
On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined and are running below 2 percent.	On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined this year and are running below 2 percent.	Small change of timing.? It?s not much below 2%…
Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.	Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.	No change
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.	The Dual Mandate is the perfect shield to hide behind.? The Fed can be wrong, but it can never be blamed.
The Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term.	Hurricanes Harvey, Irma, and Maria have devastated many communities, inflicting severe hardship. Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term. Consequently, the Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Higher prices for gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily; apart from that effect, inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term.	Mentions the transitory effects of hurricanes.? Aside from that, they think they are on track.
Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.	Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.	No change.? Note the unbalanced language, though ? they are only monitoring inflation closely.
In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent.	In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent.	No change.
The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.	The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.	No change, but monetary policy is no longer accommodative.? The short end of the forward curve continues to rise, and the curve flattens.
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.	In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.	No change
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.	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.? If you don?t know what will drive decision-making, i.e., it could be anything, just say that.
The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.	The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.	No change. Symmetric: we can?t let inflation get too low, because we don?t regulate banks properly.
The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.	The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.	No change
However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.	However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.	No change
For the time being, 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.		Deleted; QE is over (for now).
The Committee expects to begin implementing its balance sheet normalization program relatively soon, provided that the economy evolves broadly as anticipated; this program is described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.	In October, the Committee will initiate the balance sheet normalization program described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.	Promises the very slow end of QE, as they may start to let securities mature.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Neel Kashkari; and Jerome H. Powell.	Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Neel Kashkari; and Jerome H. Powell.	No dissents; it?s relatively easy to agree with doing nothing.