Public Policy – Page 4 – The Aleph Blog

Redacted Version of the March 2017 FOMC Statement

Posted on 15 March 2017 by David Merkel

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Comments

2% inflation arrives, and the FOMC tightens another notch.
They are probably behind the curve.
The economy is growing well now, and in general, those who want to work can find work.
The change of the FOMC?s view is that inflation is higher. Equities and bonds rise. Commodity prices rise and the dollar weakens.
The FOMC says that any future change to policy is contingent on almost everything.

On the Pursuit of Economic Growth

Posted on 9 March 20179 March 2017 by David Merkel

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I wrote this to summarize my thoughts from a chat session that I was able to participate in at Thompson Reuters Global Markets Forum yesterday.? It was wider ranging than this, but was a very enjoyable time.? Thanks to Manoj Rawal for inviting me.

On the Pursuit of Economic Growth

I think one of the conceits of the modern era is the degree of trust we place in governments.? We want them to do everything for us.? The truth is that their power is limited.? Even if we delegate more power to them, that doesn?t mean the power can/will be used by the government for the purposes intended.

The government is composed of people with their own goals.? It?s not much different than shareholders delegating power of the corporation to a board of directors, who collectively oversee management, should they care to do so.? Often delegated power gets misdirected for the ends of the power- and money-hungry.

Who watches the watchers?? It is one reason why we have ?rule of law? in many republics ? there is law that governs the government, if we have the will to maintain that.? It differs from ?rule by law? which exists more commonly on Earth ? laws exist so that the rulers can maintain their rule over those they rule ? of which China is an excellent example.? Freedom that is good for the interests of the Communist Party is allowed to exist, but not other freedoms.? There are no rights that are God-given, not subject to the dictates of governments.

Sorry for the digression ? my main point is that even the most powerful governments get bogged down, and can?t do nearly what people imagine they can do.? It is akin to what Peter Drucker said on management, that where managers proliferate, it takes progressive more people to manage all of the people ? you might actually be able to get more done with fewer people.

Governments face another constraint ? because people think the government can stimulate the economy, we have had governments stretch past their budgetary limits, borrow a lot of money, and make long-dated promises that they can?t keep.? This is not just a US phenomenon.? This is happening globally.? It is rare, possibly even non-existent to find countries that run balanced budgets, have sound monetary policy, and haven?t overpromised on entitlements.

As such, there isn?t that much that governments can do in terms of discretionary spending.? Even when they do allocate money, most projects of any significance don?t produce immediate results, but take years to start and more years to complete.? China may be able to run roughshod over its citizens, but where rule of law exists, there is necessary delay for most projects.? Obama or Trump can long for ?shovel ready? projects.? They don?t exist, at least not many of them exist that are sizable.

As such, when I look at the plans of Donald Trump, I don?t give them a lot of weight in investment decisions that I make.? The same goes for any US or foreign leader, central banker, or whatever.? Short of starting a war, the amount of truly impactful things he can do is limited, especially for overly indebted governments.

What does matter then?? I think culture matters a lot.? Here are some questions to think about:

What priority do we place on taking risk?
How do you balance the competing needs of creditors and debtors?
How easy is it to start a business?
How do we feel about people using natural resources for profit?
How predictable is government policy, so that people can make long-term plans, and not worry about whether they will be able to see those plans to their fruition or not?
Does the culture protect private property?
Do we encourage men and women to marry, start families, and raise intelligent children?
Do we encourage charitable endeavors, so that effective help can be given to those who genuinely want to escape poverty? (rather than perpetuate it through continual handouts?)
How much do we play favorites across and within industries?
To what degree do we force uneconomic growth objectives through tax incentives, such as owning a home, rather than renting?
How much are we willing to allow technology to eliminate jobs, such that labor is directed away from simple tasks to tasks of higher complexity?

It is my opinion that those are the greater drivers of economic growth, and that the government can do little to foster growth, aside from having simple long-term policies, and letting us get on with being productive.

As such, I don?t see a lot going on right now that should promote higher growth.? Note that high growth is not necessary for a strong stock market, but it is necessary if you want to see ordinary laborers benefit in society.

The Rules, Part LXIII

Posted on 4 March 2017 by David Merkel

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Onto the next rule:

“We pay disclosed compensation. ?We pay undisclosed compensation. ?We don’t pay both?disclosed compensation?and undisclosed compensation.”

I didn’t originate this rule, and I am not sure who did. ?I learned it at Provident Mutual from the Senior Executives of Pension Division when I worked there in the mid-’90s. ?There is a broader rule behind it that I will get to in a moment, but first I want to explain this.

There are many efforts in business, particularly in sales, where some?want to hide what they are truly making, so that they can make an above average income off of the unsuspecting. ?At the Pension Division of Provident Mutual, the sales chain worked like this: our representatives would try to sell our investment products to pension plans, both municipal and corporate. ?We preferred going direct if we could, but often there would be some fellow who had ingratiated himself with the plan sponsor, perhaps by providing other services to the pension plan, and he would become a gateway to the pension plan. ?His recommendation would play a large role in whether we made the sale or not.

Naturally, he wanted a commission. ?That’s where the rule came in, and from what I?remember at the time, many companies similar to us did not play by the rule. ?When the sale was made, the client would see a breakdown of what he was going to be charged. ?If we were paying disclosed compensation to the “gatekeeper,” we would point it out and mention that that was *all* the gatekeeper was making. ?If the compensation was not disclosed, the client would see the bottom line total charge, and he would have to evaluate if that was good or bad deal for plan participants.

Our logic was this: the plan sponsor would have to analyze the total cost anyway for a bundled service against other possible bundled and unbundled services. ?We would bundle or unbundle, depending on what the gatekeeper and client wanted. ?If either wanted everything spelled out we would do it. If neither wanted it spelled out, we would only provide the bottom line.

What we would never do is provide a breakdown that was incomplete, hiding the amount that the gatekeeper was truly earning, such that client would see the disclosed compensation, and think that it was the entire compensation of the gatekeeper.

We were the smallest player in the industry as far as life insurers went, but we were more profitable than our peers, and growing faster also. ?Our business retention was better because compensation surprises did not rise up to bite us, among other reasons.

Here’s the broader rule:

“Don’t be a Pig.”

Some of us?had a saying in the Pension Division, “We’re the good guys. ?We are trying to save the world for a gross margin of 0.25%/year on assets, plus postage and handling.” ?Given that what we did had almost no capital requirements, that was pretty good.

Most scandals over pricing involve some type of hiding. ?Consider the pricing of pharmaceuticals. ?Given the opaqueness is difficult to tell who is making what. ?Here is another?article on the same topic?from the past week.

In situations like this, it is better to take the high road, and make make your pricing more transparent than your competitors, if not totally transparent. ?In this world where so much data is shared, it is only a matter of time before someone connects the dots on what is hidden. ?Or, one farsighted competitor (usually the low cost provider) decides to lay it bare, and begins winning business, cutting into your margins.

I’ll give you an example from my own industry. ?My fees may not be the lowest, but they are totally transparent. ?The only money I make comes from a simple assets under management fee. ?I don’t take soft dollars. ?I make money off of asset management that is?aligned with what I myself own. ?(50%+ of my total assets and 80%+ of my liquid assets are invested exactly the same as my clients.)

Why should I muck that up to make a pittance more? ?It’s a nice model; one that is easy to defend to the regulators, and explain to clients.

We probably would not have the fuss over the fiduciary rule if total and prominent disclosure of fees were done. ?That said, how would the brokers have lived under total transparency? ?How would life insurance salesmen live? ?They would still live, but there would be fewer of them, and they would probably provide more services to justify their compensation.

Even as a bond trader, I learned not to overpress my edge. ?I did not want to do “one amazing trade,” leaving the other side wounded. ?I wanted a stream of “pretty good” trades. ?An occasional tip to a broker that did not know what he was doing would make a “friend for life,” which on Wall Street could last at least a month!

You only get one reputation. ?As Buffett said to the Subcommittee on Telecommunications and Finance of the Energy and Commerce Committee of the U.S. House of Representatives back in 1991 regarding Salomon Brothers:

I want the right words and I want the full range of internal controls. But I also have asked every Salomon employee to be his or her own compliance officer. After they first obey all rules, I then want employees to ask themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper, to be read by their spouses, children, and friends, with the reporting done by an informed and critical reporter. If they follow this test, they need not fear my other message to them: Lose money for the firm, and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless.

This is a smell test much like the Golden Rule. ?As Jesus said, “Therefore, whatever you want men to do to you, do also to them, for this is the Law and the Prophets.” (Matthew 7:12)

That said, Buffett’s rule has more immediate teeth (if the CEO means it, and Buffett did), and will probably get more people to comply than God who only threatens the Last Judgment, which seems so far away. ?But I digress.

Many industries today are having their pricing increasingly disclosed by everything that is revealed on the Internet. ?In many cases, clients are asking for a greater justification of what is charged, or, are looking to do price and quality comparison where they could not do so previously, because they did not have the data.

Whether in financial product prices, healthcare prices, or other places where pricing has been bundled and secretive, the ability to hide is diminishing. ?For those who do hide their pricing, I will offer you one final selfish argument as to why you should change: given present trends, in the long-run, you are fighting a losing battle. ?Better to earn less per sale with happier clients, than to rip off clients now, and lose then forever, together with your reputation.

Two Questions on Returns

Posted on 14 February 2017 by David Merkel

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I recently received two sets of questions from readers. Here we go:

David,

I am a one-time financial professional now running a modest ?home office? operation in the GHI?area.? I have been reading your blog posts for a couple years now, and genuinely appreciate your efforts to bring accessible, thoughtful, and modestly stated insights to a space too often lacking all three characteristics.? If I didn?t enjoy your financial posts so much, I?d request that you bring your approach to the political arena ? but that?s a different discussion altogether?

I am writing today with two questions about your work on the elegant market valuation approach you?ve credited to @Jesse_Livermore.?? I apologize in advance for any naivety evidenced by my lack of statistical background?

I noticed that you constructed a ?homemade? total return index ? perhaps to get you data back to the 1950s.? Do you see any issue using SPXTR index (I see data back to 1986)?? The 10yr return r-squared appears to be above .91 vs. investor allocation variable since that date.

The most current Fed/FRED data is from Q32016.? It appears that the Q42016 data will be released early March (including perhaps ?re-available? data sets for each of required components http://research.stlouisfed.org/fred2/graph/?g=qis ).? While I appreciate that the metric is not necessarily intended as a short-term market timing device, I am curious whether you have any interim device(s) you use to estimate data ? especially as the latest data approaches 6 months in age & the market has moved significantly?

I appreciate your thoughts & especially your continued posts?

JJJ

These questions are about the Estimating Future Stock Returns posts. ?On question 1, I am pulling the data from Shiller’s data. ?I don’t have a better data feed, but that should be the S&P 500 data, or pretty near it. ?It goes all the way back to the start of the Z.1 series, and I would rather keep things consistent, then try to fuse two similar series.

As for question 2, Making adjustments for time elapsed from the end of the quarter is important, because the estimate is stale by 70-165 days or so. ?I treat it like a 10-year zero coupon bond and look at the return since the end of the quarter. ?I could be more exact than this, adjusting for the exact period?and dividends, but the surprise from the unknown change in investor behavior which is larger than any of the adjustment simplifications. ?I take the return since the end of the last reported quarter and divide by ten, and subtract it from my ten year return estimate. ?Simple, understandable, and usable, particularly when the adjustment only has to wait for 3 more months to be refreshed.

PS — don’t suggest that I write on politics. ?I annoy too many people with my comments on that already. 😉

Now for the next question:

I have a quick question. If an investor told you they wanted a 3% real return (i.e., return after inflation) on their investments, do you consider that conservative? Average? Aggressive? I was looking at some data and it seems on the conservative side.

EEE

Perhaps this should go in the “dirty secrets” bin. ?Many analyses get done using real return?statistics. ?I think those are bogus, because inflation and investment returns are weakly related when it comes to risk assets like stocks and any other investment with business risk, even in the long run. ?Cash and high-quality bonds are different. ?So are precious metals and commodities as a whole. ?Individual commodities that are not precious metals have returns that are weakly related to inflation. ?Their returns depend more on their individual pricing cycle than on inflation.

I’m happier projecting inflation and real bond returns, and after that, projecting the nominal returns using my models. ?I typically do scenarios rather than simulation?models because the simulations are too opaque, and I am skeptical that the historical relationships of the past are all that useful without careful handling.

Let’s answer this question to a first approximation, though. ?Start with the 10-year breakeven inflation rate which is around 2.0%. ?Add to that a 10-year average life modification of the Barclays’ Aggregate, which I estimate would yield about 3.0%. ?Then go the the stock model, which at 9/30/16 projected 6.37%/yr returns. ?The market is up 7.4% since then in price terms. ?Divide by ten and subtract, and we now project 5.6%/year returns.

So, stocks forecast 3.6% “real” returns, and bonds 1.0%/year returns over the next 10 years. ?To earn a 3% real return, you would have to invest 77% in stocks and 23% in 10-year high-quality bonds. ?That’s aggressive, but potentially achievable. ?The 3% real return is a point estimate — there is a lot of noise around it. ?Inflation can change sharply upward, or there could be a market panic near the end of the 10-year period. ?You might also need the money in the midst of a drawdown. ?There are many ways that a base scenario could go wrong.

You might say that using stocks and bonds only is too simple. ?I do that because I don’t trust return most risk and return estimates for more complex models, especially the correlation matrices. ?I know of three organizations that I think have good models — T. Rowe Price, Research Affiliates, and GMO. ?They look at asset returns like I do — asking what the non-speculative returns would be off of the underlying assets and starting there. ?I.e. if you bought and held them w/reinvestment of their cash flows, how much would the return be after ten years?

Earning 3% real returns is possible,?and not that absurd, but it is a little on the high side unless you like holding?77% in stocks and 23% in 10-year high-quality bonds, and can bear with the volatility.

That’s all for now.

The Financial Report of the United States Government 2016

Posted on 11 February 201712 February 2017 by David Merkel

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The last time I wrote about this was four years ago. ?I have covered this topic off and on for the last 25 years. ?As usual, the report got released during a relatively dead time, January 12th, where most people were listening to the preparations for the inauguration. ?I’ll give them some credit though — not as much of a dead time as usual; it was in the middle of a work week, AND earlier than usual. ?(It would be nice to know when it’s coming, though.)

I have two main messages to go with my two graphs. ?The first message is one I have been saying before — beware some of the estimates that you hear, should you hear them at all. ?No one wants to talk about this, but what few that do will look at a few headline numbers and leave it there. ?Really you have to look at it for years, and look at the footnotes and other explanatory sections in the back when things seemingly change for no good reason. ?Also, you have to add all the bits up. ?No one will do that for you. ?Even with that, you are relying on the assumptions that the government uses, and they are not biased toward making the estimates sound larger. ?They tend to make them smaller.

Thus you will see two things that adjust the headline figures. ?In 2004, when Medicare part D was created, the Financial Report of the US Government began mentioning the Infinite Horizon Increment. ?Now, that liability always existed, but the actuaries began calculating how solvent is the system as a whole if it were permanent, as opposed to lasting 75 years.

The second is the Alternative Medicare Scenario. ?When the PPACA (Obamacare) was created in 2010, there was considerable chicanery in the cost estimates. ?The biggest part was that they assumed Medicare Part A (HI) would cost a lot less because they would reduce the amount that they would reimburse. ?They legislated away costs by assuming them away, and then each year Congress would restore the funding so that there wouldn’t be a firestorm when doctors stopped taking Medicare. ?But they left it in for budget and forecast purposes, and showed what the projections would be like if these cuts never took place in what they called the?Alternative Medicare Scenario.

So, did the cuts to Medicare part A take place? No.

Graph Credit: The Boards of Trustees of the Federal Hospital Insurance Trust Fund?(page 54)

As you can see they have gone up almost every year since 2010. The liability should not have gone down. If you think the?Alternative Medicare Scenario is conservative enough, the liability has remained relatively constant since 2010, not diminished dramatically.

How is the load relative to GDP? ?It keeps growing, but since 2010 at a less frantic clip. ?The adjusted ratio below includes the?Alternative Medicare Scenario.

Final Notes

Remember that we have had a recovery since 2009. ?The statistics never assume that we will have another recession, much less a full fledged crisis like 2008-9. ?Without adjustment, the Medicare part A trust fund will run out in 2028. ?There is no provision for what the reimbursements will be made if the trust fund runs dry. ?Social Security’s trust fund will run out a few years after that, and instead of getting 12 checks a year, people will only get 9 of that same amount. ?If there is a significant recession, those statistics will move forward by an unknown number of years. ?Without congressional action, because there will be a recession, I would expect that both will run out somewhere in the middle of the 2020s, and then the real political fun will begin.

The tendency has been over time to turn these from entitlements to old age welfare schemes. ?FDR always wanted them to be self funded entitlements with everybody getting roughly the same treatment by formula, because he wanted the program to have widespread legitimacy across all classes, and no sense of stigma for being a poor old person on the dole.

Given the strategies that exist around qualifying for Medicaid, those days are gone, so I would expect that benefits will be limited for those better off, inflation adjustments eliminated, taxes raised to some degree, eligibility ages quickly raised a few more years, with elimination of strategies that allow people to get more out of the system by being clever. ?(As an example, expect the favorable late retirement factors to get reduced, and the early retirement factors to go down even more.)

Does this sound fun? ?Of course not, but remember that cultures are larger than economies, which are larger than governments. ?The cultural need for supporting poor elderly people will lead funding to continue, unless it makes the government, and the culture as a whole fail in the process, and that would never happen, right?

Steeling Themselves For Pension Benefit Cuts

Posted on 9 February 2017 by David Merkel

Photo Credit: Tony Hisgett?|| Only 20 years more and I can retire with a full pension!

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Aside from the bankruptcy of a plan sponsor, the benefits of someone being paid their pension can’t be cut. ?Right?

Well, mostly true. ?With governments in trouble, benefits have been cut, as in Rhode Island, Detroit, and a variety of other places with badly managed finances. ?Usually that’s a big political fight. ?Concessions come partly as a result that you could end up with less if you fight it, and don’t take the deal.

With corporations, the protection of the Pension Benefits Guarantee Corporation [PBGC] has kept pensions safe up to a limit — as of 2016, up to roughly $60K/year for those retiring at age 65 (less for younger retirees) from single-employer plans, and $12,870/year at most for those in multiemployer plans. ?(For some complexities, read more here. ?Also note that the PBGC itself is underfunded and faces antiselection problems as well.)

Multiemployer plans are an inherently weak structure, because?insolvent employers can’t contribute to fund plan deficits, and typically, multiemployer plans arise from collective bargaining arrangements, so that the firms employing the laborers are all in the same industry. ?Insolvency in industries, particularly where there is collective bargaining pushing up costs and limiting work process flexibility, tends to be correlated across firms. ?My poster child for that was the steel industry in 2002, where 20+ firms went insolvent. ?Employer insolvencies in an underfunded multiemployer plan affect all participants, including those working for solvent firms. ?(Note that solvent employers have to pay their pro-rata?share of underfunding in order to exit a multiemployer plan, as I noted for UPS in this article.)

Now in 2014, Congress passed a law called the?Kline-Miller Multiemployer Pension Reform Act of 2014. ?That allowed the PBGC, together with the Departments of Treasury and Labor, to negotiate benefit cuts to the pension plans in order to avoid the plans going insolvent — at which point, all pensioners would be limited to the PBGC limits for their payments. ?Workers in the plan — active, vested, and retired, would have to vote on any deal. ?Majority of those voting wins, so to speak.

The first plan to successfully go through this procedure and cut benefits to participants happened a few weeks ago, in the Iron Workers Local 17 Pension fund. ?Average benefits were cut 20%, with some cut as much as 60%, and some not cut at all. ?The plan was funded to a 24% level, and there are only 632 active employed workers to cover the benefits of 2,042 participants. ?The fund would likely run out of money in 2024. ?Note that only 900+ voted on the cuts, with the cuts passing at roughly 2-1.

There are at least four other multiemployer plans with similar applications to cut benefit payments. ?Prior to this four other multiemployer plans had such applications denied — there were a variety of reasons for the denials: the cuts were done in an inequitable way in some cases, return assumptions were unreasonably high, etc.

My original source for this piece is note by David Gonzales of Moody’s. ?They rate these actions as credit positive because it potentially ends the process where an underfunded multiemployer plan would encourage an employer to default because it can’t afford the liability. ?Somewhat perverse in a way, because the pain has to go somewhere on an underfunded plan — it’s all a question of who gets tapped. ?Note that it also protects the PBGC Multiemployer Trust, which itself is likely to run out of money by 2025. ?After that, those relying on the PBGC for multiemployer pension payments get zero, unless something changes.

For those wanting 30 pages of informative data on scope of the matter, here is a useful piece from the Congressional Research Service.

Final Note

You might think this is an extreme situation, and yes, it is extreme. ?It’s not so extreme that there aren’t other underfunded plans as bad off as this multiemployer plan. ?I would encourage everyone who has a defined benefit plan to take a close look at their funded status. ?I don’t care about what your state constitution says on protecting your pension benefits. ?If the cash gets close to running out, “the?powers that be” will find a way around that. ?After all, what happened with the?Iron Workers Local 17 Pension Fund was illegal prior to 2014. ?Now it is 2017, and benefits were cut.

Because of underfunding, there will be more cuts. ?Depend on that happening for the worst funds, and at least run through the risk analysis of what you would do if your pension benefit were cut by 20% for a municipal plan, or to the PBGC limit for a corporate plan. ?Why? ?Because it could happen.

Redacted Version of the February 2017 FOMC Statement

Posted on 3 February 2017 by David Merkel

Photo Credit: eflon?|| Ask to visit the Medieval dining hall! ?Really!

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Comments

The FOMC holds, but deludes itself that it is still accommodative.
The economy is growing well now, and in general, those who want to work can find work.
Maybe policy should be tighter. The key question to me is whether lower leverage at the banks was a reason for ultra-loose policy.
The change of the FOMC?s view is that inflation is higher. Equities are stable and bonds fall a little. Commodity prices rise and the dollar weakens.
The FOMC says that any future change to policy is contingent on almost everything.

The global economy is growing, inflation is rising globally, the dollar is rising, and the 30-year Treasury has not moved all that much relative to all of that. ?My guess is that the FOMC could get the Fed funds rate up to 2% if they want to invert the yield curve. ?A rising dollar will slow the economy and inflation somewhat.

Aside from that, I am looking for what might blow up. ?Maybe some country borrowing too much in dollars? ?Tightening cycles almost always end with a bang.

On Human Fertility, Part 5

Posted on 27 January 201727 January 2017 by David Merkel

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I write about this every now and then, because human fertility is falling faster then most demographers expect. Using the CIA Factbook for data, the present total fertility rate for the world is 2.407 births per woman that survives childbearing. That is down from 2.425 in 2014, 2.467 in 2012, and 2.489 in 2010.? At this rate, the world will be at replacement rate (2.1), somewhere between 2035 and 2040. That?s a lot earlier than most expect, and it makes me suggest that global population will top out somewhat below 9?Billion in 2050, lower and earlier than most expect.

Have a look at the Total Fertility Rate by group in the graph above. The largest nations for each cell are listed below the graph. Note Asian nations to the left, and African nations to the right.

Africa is so small, that the high birth rates have little global impact. Also, AIDS consumes their population, as do wars, malnutrition, etc.

The Arab world is also slowing in population growth. When Saudi Arabia at?replacement rate (2.11), you can tell that the women are gaining the upper hand there, which is notable given the polygamy is permitted.

In the Developed world, who leads in fertility? Israel at 2.66. Next is France at 2.07 (Arabs), New Zealand at 2.03, Iceland at 2.01, Ireland at 1.98 (up considerably), UK at 1.89, Sweden at 1.88, and the US at 1.87, which is below replacement. The US?still grows from immigration, as does France.

Most of the above is a quick update of my prior pieces, which have some additional crunchy insights. ?When I look at the new data, I wonder if developed nations might not finally be waking up to the birth dearth. ?Take a look at this graph:

Now, the bottom left is a little crammed. ?What if I expand it?

I did the second graph in order to make the point that nations with fertility below 1.76 in 2010 tended to increase their fertility, while those above 1.76 tended to decrease it. ?Not that you should trust any statistical analysis, but if you could, this is statistically significant at a level well above 99%. ?(Note: this is an ordinary least squares regression. ?Every “nation” is weighted equally. ?If I get asked nicely, I could do a weighted least squares regression which gives heavy weight to China, India and the US, and less weight to Somalia, the West Bank, and Tonga. ?I don’t think the result would change much.)

I’m chuckling a little bit as I write this, because this is an interesting result, and one that I never thought I would be writing when I started this project. ?Interesting, huh? ?My guess is that there is a limit to how much you can get people to reduce family sizes before they begin to question the idea. ?Older parents may say, “What was that all about?” but children are usually fun and cute when they are little if they are reasonably disciplined.

One final note: I’ve been running into a lot of demographic articles of late, but this was the one that got me to write this:?The World’s Most Populous Country Is Turning Gray. ?The barbaric “One Child Policy” of China is having its impact; demography is often destiny. ?That said, over the last six years China’s total fertility rate has moved from 1.54 to 1.60.

As it says in the article:

Births in 2016 reached 17.86 million, the most since 2000, rising by 1.91 million from 2015, the National Health and Family Planning Commission said this month. That still falls short of the official projection. Last June, the ministry estimated there would be an increase of 4 million new births every year until 2020. China will continue to implement the two-child policy to promote a balanced population, the plan said.

Fertility doesn’t turn on a dime. ?When women conclude that the rewards of society (money, power, approval of peers) go to those with fewer children, that’s a tough cultural idea to overcome. ?I would conclude that it will take a lot longer than a single five-year plan to turn around birthrates in China… if they can be turned around at all. ?All across Asia, marriages happen at lesser rates, happen later, and produce fewer children. ?China is one of the more notable examples.

PS — Picky note: the two-child policy in China is only available to a husband and wife where at least one is an “only child.” ?It won’t create a balanced population near replacement rate, as everyone else must have only one child (with exceptions).

Trump and Conflicts of Interest

Posted on 13 January 2017 by David Merkel

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I was driving to a meeting of the Baltimore CFA Society, and listening to Bloomberg Radio, which was carrying President-Elect Trump’s Press Conference. I didn’t think too much about what I heard until Sheri Dillon talk about what was being done to eliminate conflicts of interest. Here is an excerpt:

Some have asked questions. Why not divest? Why not just sell everything? Form of blind trust. And I?d like to turn to addressing some of those questions now.

Selling, first and foremost, would not eliminate possibilities of conflicts of interest. In fact, it would exacerbate them. The Trump brand is key to the value of the Trump Organization?s assets. If President-elect Trump sold his brand, he would be entitled to royalties for the use of it, and this would result in the trust retaining an interest in the brand without the ability to assure that it does not exploit the office of the presidency.

[snip]

Some people have suggested that the Trump ? that President-elect Trump could bundle the assets and turn the Trump Organization into a public company. Anyone who has ever gone through this extraordinarily cumbersome and complicated process knows that it is a non-starter. It is not realistic and it would be inappropriate for the Trump Organization.

It went on from there, but I choked on the last paragraph that I quoted above. (Credit: New York Times, not all accounts carried the remarks of Ms. Dillon, a prominent attorney with the firm Morgan Lewis who structured the agreements for Trump) ?As I said before:

Trump to Outline Plans for ?Leaving My Great Business? Dec. 15 https://t.co/iIwweP2LcN Time to IPO and sell off the Trump Organization $$

? David Merkel (@AlephBlog) November 30, 2016

An IPO of the Trump Organization was?realistic. ?I’m not saying it could have been done by the inauguration, but certainly by the end of 2017, and likely a lot earlier. ?I’ve seen insurance companies go through IPO processes that took a matter of months, a few because they had to sell the company to raise liquidity quickly for some reason.

In an IPO, Trump, all of Trump’s children and anyone else with an equity interest would have gotten their proportionate share of the new public company. ?Trump could have provided a lot of shares for the IPO, and instructed the trustee for his assets to sell it off?the remainder over the next year or so.

While difficult, this would not have been impossible or imprudent. ?Trump?might lose some value in the process, but hey, that should be part of the cost for a very wealthy man who becomes President of the US. ?There would be the countervailing advantage that all capital gains are eliminated, and who knows, that might settle his existing negotiations with the IRS.

Ending the counterfactual, though conflict of interest rules don’t apply to the President, Trump had?an opportunity to eliminate all conflicts of interest, and did not take it.

PS — Many major hotels are in the “name licensing” business — I also don’t buy the argument that Trump could not sell off the organization in entire, with no future payments for the rights of using the name. ?A bright businessman could create a new brand easily. ?It’s been done before.

A Failure of Insurance Regulation

Posted on 17 December 2016 by David Merkel

Credit: Bloomberg || Graph of Penn Treaty’s stock price 2002-2009

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I wrote about this last in October 2009 in a piece lovingly entitled:?At Last, Death!?(speaking of the holding company, not the insurance subsidiaries). ?I’m going to quote the whole piece here, because it says most of the things that I wanted to say when I heard the most recent news about Penn Treaty, where the underlying insurance subsidiaries are finally getting liquidated. ?It will be the largest health insurer insolvency ever, and second largest overall behind Executive Life.

Alas, but all good things in the human sphere come to an end.? Penn Treaty is the biggest insurer failure since 2004.? Now, don?t cry too much.? The state guaranty funds will pick up the slack.? The banks are jealous of an industry that has so few insolvencies.? Conservative state regulation works better than federal regulation.

Or does it?? In this case, no.? The state insurance regulator allowed a reinsurance treaty to give reserve credit where no risk was passed.? The GAAP auditor flagged the treaty and did not allow credit on a GAAP basis, because no risk was passed.? No risk passed? No additional surplus; instead it is a loan.? I do not get how the state regulators in Pennsylvania could have done this.? Yes, they want companies to survive, but it is better to take losses early, than let them develop and fester.

A prior employer asked me about this company as a long idea, because it was trading at a significant discount to book.? I told him, ?Gun to the head: I would short this.? Long-term care is not an underwritable contingency.? Those insured have more knowledge over their situation than the insurance company does.?? He did nothing.? He could not see shorting a company that was less than 50% of book value.

It was not as if I did not have some trust in the management team.? I knew the CEO and the Chief Actuary from my days at Provident Mutual.? Working against that was when I called each of them, they did not return my calls.? That made me more skeptical.? It is one thing not to return the call of a buyside analyst, but another thing not to return the call of one who was once a friend.

Aside from Penn Treaty, the only other company that I can think of as being at risk in the long term care arena is Genworth.? Be wary there.? What is worse is that they also underwrite mortgage insurance.? I can?t think of a worse combo: long term care and mortgage insurance.

The troubles at Penn Treaty are indicative of the future for those who fund long term care.? Be wary, because the troubles of the graying of the Baby Boomers will overwhelm those that try to provide long term care.? That includes government institutions.

Note that Genworth is down 60% since I wrote that, against a market that has less than tripled. ?If their acquirer doesn’t follow through, it too may go the way of Penn Treaty. ?(Give GE credit for kicking that “bad boy” out. ?They bring good things to “life.” 😉 )

Okay, enough snark. ?My main point this evening is that Pennsylvania should have had Penn Treaty stop writing new business by 2004 or so. ?As I wrote to a reporter at Crain’s back in 2008:

On your recent article on Penn Treaty, one little known aspect of their treaty with Imagine Re is that it doesn’t pass risk.? Their GAAP auditors objected, but the State of Pennsylvania went along, which is the opposite of how it ordinarily works.
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Now Imagine Re takes advantage of the situation and doesn’t pay, knowing that Penn Treaty is in a weak position and can’t fight back, partially because of the accounting shenanigans.
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It is my opinion that Penn Treaty has been effectively insolvent for the past four years.? I don’t have any economic interest here, but I had to investigate it as an equity analyst one year ago.? Things are playing out as I predicted then.? What I don’t get is why Pennsylvania hasn’t taken them into conservation.

Another matter was that Imagine Re was an Irish reinsurer, and they have weak reserving rules. ?That also should have been a “red flag” to Pennsylvania. ?The deal with Imagine Re was struck in late 2005, leading to upgrades from AM Best that were reversed by mid-2006.

It was as if the state of Pennsylvania did not want to take the company over for some political reason. ?Lesser companies have been taken over over far less. ?Pennsylvania itself had worked out Fidelity Mutual a number of years earlier, so it’s not as if they had never done it before.

Had they acted sooner, the losses would never have been as large. ?I remember looking through the claim tables in the statutory books for Penn Treaty because the GAAP statements weren’t filed, and concluding that the firm was insolvent back in 2005 or so. ?Insurance regulators are supposed to be more conservative than equity analysts, because they don’t want companies to go broke, harming customers, and bringing stress to the industry through the guaranty funds.

The legal troubles post-2009 probably?had a small effect on the eventual outcome — raising premiums might have lowered the eventual shortfall of $2.6 billion a little. ?But raising premiums would make some healthy folks surrender, and those on benefit are not affected. ?It would likely not have much impact. ?Maybe some expenses could have been saved if the companies had been liquidated in 2009, 2012, or 2015 — still, that would not have been much either.

Some policyholders get soaked as well, as most state guaranty funds limit covered payments to $300,000. ?About 10% of all current Penn Treaty policyholders will lose some?benefits as a result.

Regulatory Policy Recommendations

Often regulators only care that premiums not be too high for the insurance, but this is a case where the company clearly undercharged, particularly on the pre-2003 policies. ?For contingencies that are long-lived, where payments could be made for a long time, regulators need to spend time looking at premium adequacy. ?This is especially important where the company is a monoline and in a line of business that is difficult to underwrite, like long-term care.

The regulators also need to review early claim experience in those situations (unusual business in a monoline), and even look at claim files to get some idea as to whether a company is likely to go insolvent if practices continue. ?A review like that might have shut off Penn Treaty’s ability to write business early, maybe prior to 2002. ?Qualitative indicators of underpricing show up in the types of claims that arrive early, and the regulators might have been able to reduce the size of this failure.

But wave goodbye to Penn Treaty, not that it will be missed except by policyholders that don’t get full payment.