Public Policy – Page 70 – The Aleph Blog

The Deadly Dozen

Posted on 4 February 2010 by David Merkel

I have been thinking about the the forces distorting the global economy.? In the long run, the distortions don’t matter, because economies are bigger than governments, and eventually economies prevail over governments.? Here are my dozen problems in the global economy.

1) China’s mercantilism — loans and currency.? The biggest distortionary force in the world now is China.? They encourage banks to loan to enterprises in order to force growth.? They keep their currency undervalued to favor exports over imports.? What was phrased to me as a grad student in development economics as a good thing is now malevolent.? The only bright side is that when it blows, it might take the Chinese Communist Party with it.

2) US Deficits, European Deficits — In one sense, this reminds me of the era of the Rothschilds; governments relied on borrowing because other methods of taxation raised little.? Well, this era is different.? Taxes are high, but not high enough for governments that are trying to create the unachievable “permanent prosperity.” In the process they substitute public for private leverage, and in the process add to the leverage of their societies as a whole.

3) The Eurozone is a mess — Greece, Portugal, Spain, etc.? I admit that I got it partially wrong, because I have always thought that political union is necessary in order to have a fiat currency.? I expected inflation to be the problem, and the real problem is deflation.? Will there be bailouts?? Will the troubled nations leave?? Will the untroubled nations leave that are the likely targets for bailout money?

4) Many entities that are affiliated with lending in the US Government, e.g., FDIC, GSEs, FHA are broke.? The government just doesn’t say that, because they can still make payments.

5) The US Government feels it has to “do something” — so it creates more lending programs that further socialize lending, leading to more dumb loans.

6) Residential real estate is still in the tank.? Residential delinquencies are at all-time highs.? Strategic default is rising.? The shadow inventory of homes that will come onto the market is large.? I’m not saying that prices will fall for housing; I am saying that it will be tough to get them to rise.

7) Commercial real estate — there is too much debt supporting commercial real estate, and too little equity.? There will be losses here; the only question is how deep the losses will go.

8 ) I have often thought that analyzing the strength of the states is a better measure for US economic strength, than relying on the statistics of the Federal Government.? The state economies are weak at present.? Part of that comes from the general macroeconomy, and part from the need to fund underfunded benefit plans.? Life is tough when you can’t print your own money.

9) The US, UK, and Japan are force feeding liquidity into their economies.? Thus the low short-term interest rates.? Also note the Federal Reserve owning MBS in bulk, bloating their balance sheet.

10) Yield greed.? The low short term interest rates touched off a competition to bid for risky debt.? The only question is when it will reverse.? Current yield levels do not fairly price likely default losses.

11) Most Western democracies are going into extreme deficits, because they can’t choose between economic stimulus and deficit reduction.? Political deadlock is common, because no one is willing to deliver any real pain to the populace, lest they not be re-elected.

12) Demographics is one of the biggest? pressures, but it is hidden.? Many of the European nations and Japan face shrinking populations.? China will be there also, in a decade.? Nations that shrink are less capable of carrying their debt loads.? In that sense, the US is in good shape, because we don’t discourage immigration.

Fear the Boom and Bust — an Economics Lesson

Posted on 29 January 201031 January 2010 by David Merkel

Ordinarily, I don’t think much of video on the web.? Writing is usually a more concise way to get a view across.? But video can be more effective if it gets past the genre of “talking heads,” in which case, one is usually better off reading a transcript.? Consider the State of the Union message as an example: regardless of who is president, would you rather spend an hour on it, of five minutes?? And, it would be five minutes where you are not distracted by the crowd, and can dissect things rationally.? I pick reading.

There are places where video can be useful, but it has to be well thought out.? I first saw the above video over at “The Big Picture,” which has enough readership to kick up a video’s viewings.? I thought it was clever, representing the economist’s views in a short catchy way, and capturing their philosophies? as well.? The next day, I showed it to three of my boys — they thought it was interesting, and mentioned it the next night at dinner.? My wife, incredulous at the idea of an economics rap video, then watched it the next night with all of the kids, while I cleaned up the dinner dishes.

Then the surprise happened.? “Dad, what are animal spirits?”? “Are animal spirits the bull and the bear?”

Interesting.? The video prompted questions from the children for me to answer.? I’ve written on Animal Spirits before, at least twice.? Animal spirits attributes irrational risk taking and avoidance to businessmen, as if they are irrational animals.

I told my children that businessmen are generally rational, and they make their decisions off of their own balance sheets, and the general willingness of the market to spend, which is related to balance sheets in aggregate.

The contrasts of the video are considerable:

Keynes is known, Hayek is unknown.? Desk clerk immediately knows Keynes.
The two men are hybrid in what they portray.? To some degree they represent the schools of thought that each was a leader of, and to degree the men themselves.
Hayek reaches into the hotel room drawer, and rather than finding the Bible, finds the General Theory. Similarly, Keynes says, “I am the agenda.”? This is a statement of the dominance of Keynesian thought in modern macroeconomics.? Keynes was important, but not as dominant while he lived.
Hayek assumes they will go via the subway.? Keynes hires a limo.? Keynes is worldly wise, having a great time, and Hayek is uncomfortable.? Keynes has alcohol; if Hayek is having alcohol, he is sipping it through a thin straw.
Alcohol is an allusion through the whole piece.? Stimulus is just more of “the hair of the dog that bit you.”? The boom is a good time where we drink freely, and the bust is where we deal with our hangover.? It was no surprise to see that the Bartenders were named “Ben” and “Tim” and that they were serving up alcohol for as long as the patrons would survive.? Even the pyramiding of the glasses had meaning — building up to a stuporous, unsustainable level.
Keynes holds money as he begins his rap, and throws it midway through.? It is an aspect of how incentives from the government or central bank can lead behavior for a time.
Keynes ends his rap with “We’re all Keynesians now.”? Keynes himself did not live to hear that comment uttered by Friedman in the ’70s.
Keynes and Hayek had different views on spending and savings.? On spending, Keynes didn’t think what money was spent on mattered, only that it was spent.? Hayek felt that intelligent spending would grow the economy more.? On savings, Keynes was negative, whereas Hayek said that moderate savings were valuable, and would facilitate future investment.
As for animal spirits, businessmen only get bold when they have sufficient free capital to act.? When interest rates are artificially low some businessmen invest, trusting that good times will continue.? Alas, those good times never last; avoid long commitments when times are good.
There are liquidity traps, but they occur when banking systems are broken due to misregulation.
“In the long run we are all dead.”? Well, Keynes, way to care for our progeny.? You had no kids, for a variety of reasons, but some of us care for how our children, and the nation that we love will do after we have died.

The video portrays a Goliath and David situation.? Keynes is dominant, and totally assured of his position in the world.? Hayek is less certain of himself, but certain in his message.

My wife and my kids have a better understanding of the current economic situation now than they did before the video came out.? I am grateful that the video was made.

Double Down Institutional Investing

Posted on 28 January 2010 by David Merkel

I once wrote a post on university endowment investing that I thought was one of my better ones, but drew little attention.? It helped to inform another piece I wrote that was better received, The Forever Fund.? Okay, two more if you are a glutton for this kind of stuff: Liquidity Management is the First Priority of Risk Management, and The First Priority of Risk Control. (Note: university endowments had a lousy year ending in June of 2009.? Things may be looking better now, but with interest rates so low, university endowments are even more reliant on outperformance of equities and other risky assets.)

The key idea is this: understand what you are trying to fund before you begin investing.? When will the money be needed?? How much?? How realistic is the implied rate of return?? What if everyone with needs like yours tried to do this?? Would it work then?? Is the demand for investments that are optimal for entities with your liability structure greater than the available investments to be had?? Do you have some sustainable competitive advantage that few others have?

When I look at ideas like pension plans employing leverage (also here), I think they don’t know what they are doing.? Anybody remember how New Jersey decided to sell pension bonds and lever up their pension investments in risky assets?

That last article is timely, published today.? What began as borrowing $2.7 billion to plug a gap became a $34 billion gap.? Risky assets, particularly equities, did not perform.? Not only did they not earn enough to earn the actuarial rate needed to fund the defined benefit plan, they also had to pay interest on the pension bonds.

Trying to fill a funding gap via a more aggressive strategy is usually foolish.? If that were the best strategy, you should have been employing it already.

But consider the leverage angle more closely.? A defined benefit plan is by its nature a plan to pay out a stream of benefits over time to beneficiaries.?? Typically they invest some of their assets in bonds that are shorter than the length of the stream of benefits they will have to pay.? Those bonds typically don’t earn enough to cover the actuarial funding rate, so they invest the rest in risky assets that they think that blended with the return on the bonds, will earn the actuarial funding rate or better.

There are at least three problems here:

It would be ideal to invest entirely in super-safe debt instruments that match the expected liability cash flows, but that would require too much in taxes from the citizenry.
But the moment that you move to funding some of the assets into stocks you open up two risks: 1) funding risk — what if the risky assets don’t perform to the degree needed? and, 2) Interest rate risk — the moment you are not matched there are risks if interest rates move against you.? This is usually a risk if rates move down.? It is rare for a defined benefit plan to buy enough long debt such that the value of bonds rises as much or more than the present value of the liabilities rise when interest rates fall.
Pension bonds, or any sort of investments with internal leverage have the potential to increase funding risk, and they increase interest rate risk as well.? Pension bonds add another fixed claim to the existing semi-fixed claim of the benefit stream.

Are we the double-down society as far as investing goes?? It sure seems like it, and if many entities do this as a group the failure of the idea will be spectacular.? Risk premiums are not high now; take a look at Jeremy Grantham’s forecasts on page 4 of this PDF (which has many other useful bits that you can learn from).? Borrowing money to invest when risk premiums are small is playing the exact same game as we were doing with CDOs from 2005 to 2007.? If the spreads are thin, pile on more leverage!? That will get us to our earnings target.

It’s sad to see this phenomenon reappearing.? Don’t we ever learn? 🙁

http://alephblog.com/2009/05/30/the-first-priority-of-risk-control/

Redacted January 2010 FOMC Statement

Posted on 27 January 2010 by David Merkel

December 2009	January 2010	Comments
Information received since the Federal Open Market Committee met in November suggests that economic activity has continued to pick up and that the deterioration in the labor market is abating.	Information received since the Federal Open Market Committee met in December suggests that economic activity has continued to strengthen and that the deterioration in the labor market is abating.	No real change; they shade their views up a bit on economic activity.
The housing sector has shown some signs of improvement over recent months.		Sentence dropped.? Area moved two sections down.
Household spending appears to be expanding at a moderate rate, though it remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit.	Household spending is expanding at a moderate rate but remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit.	No real change, though they shade up their certainty level.
Businesses are still cutting back on fixed investment, though at a slower pace, and remain reluctant to add to payrolls; they continue to make progress in bringing inventory stocks into better alignment with sales.	Business spending on equipment and software appears to be picking up, but investment in structures is still contracting and employers remain reluctant to add to payrolls. Firms have brought inventory stocks into better alignment with sales.	Unemployment unchanged.?? They think they see more business activity in equipment and software.? Housing and CRE markets are getting worse, as opposed to the optimism expressed two sections above.? They think the inventory adjustment is done.
Financial market conditions have become more supportive of economic growth.	While bank lending continues to contract, financial market conditions remain supportive of economic growth.	Banks aren?t lending much, but corporate debt spreads have tightened.
Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.	Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.	Shifts their overall view of economic activity upward. Implies that no further actions are needed on a monetary, fiscal, or market basis in order to keep the recovery going.? So, why no greater change?
With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.	With substantial resource slack continuing to restrain cost pressures and with longer-term inflation expectations stable, inflation is likely to be subdued for some time.	Shades their certainty up on goods and services inflation remaining low.
The Committee will maintain the target range for the federal funds rate at 0 to ? percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	The Committee will maintain the target range for the federal funds rate at 0 to ? ?percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	No change.? This gives you the trigger for when they will raise the Fed Funds rate.? As I said last month, watch capacity utilization, unemployment, inflation trends, and inflation expectations.
To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt.	To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt.	No change.
In order to promote a smooth transition in markets, the Committee is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter of 2010. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.	In order to promote a smooth transition in markets, the Committee is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter. The Committee will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets.	No real change.? The end is in sight for purchases, which will be a new beginning.
In light of ongoing improvements in the functioning of financial markets, the Committee and the Board of Governors anticipate that most of the Federal Reserve?s special liquidity facilities will expire on February 1, 2010, consistent with the Federal Reserve?s announcement of June 25, 2009. These facilities include the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility. The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements by February 1. The Federal Reserve expects that amounts provided under the Term Auction Facility will continue to be scaled back in early 2010. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and March 31, 2010, for loans backed by all other types of collateral.	In light of improved functioning of financial markets, the Federal Reserve will be closing the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility on February 1, as previously announced. In addition, the temporary liquidity swap arrangements between the Federal Reserve and other central banks will expire on February 1. The Federal Reserve is in the process of winding down its Term Auction Facility: $50 billion in 28-day credit will be offered on February 8 and $25 billion in 28-day credit wil be offered at the final auction on March 8. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30 for loans backed by new-issue commercial mortgage-backed securities and March 31 for loans backed by all other types of collateral.	No real change.? This was all known in advance, though not in such detail.
The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth.	The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth.	No change.? A useless sentence.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.	Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh. Voting against the policy action was Thomas M. Hoenig, who believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted.	The regional bank governors change since it is a new year.? Hoenig has the guts to dissent.

Comments

Hoenig?s dissent is interesting, but not significant.? The regional bank presidents have lost a lot of effective authority since unconventional lending came into existence.
As has the Fed funds rate ? so long as the Fed is buying long dated paper such as agency MBS, the Fed funds rate is not the pinnacle of monetary policy.
Watch capacity utilization, unemployment, inflation trends, and inflation expectations.
The FOMC shades up its certainty level on almost everything except real estate, where they seem to express more doubt.
They think the recovery has begun, and they are definite about it.

The Land of the Setting Sun?

Posted on 27 January 2010 by David Merkel

Before I begin, I want to tell all of my friends in Japan that I have a great love for their country.? I have not traveled much, but if I were to travel abroad, Japan would be my first choice.? Plus, I have many friends in Kobe, Japan.

Japan is at the leading edge of the demographic wave where many developed countries have a shrinking population.? But beyond that, Japan has high government budget deficits and a very high government debt.? Consider this graph from Bill Gross’ latest missive:

Japan is in the awkward spot of having high government debt, though much is internally funded, and is still running high government budget deficits.

What a mess.? I happened across a blog I had never seen before today, and it gave a simple formula for when government debts would tend to become unsustainable.? It was analyzing Greece, but I looked at it and said to myself: “What about Japan?”

The main upshot of the equation in the article about Greece is that you don’t want the rate your government finances at to get above the rate of GDP growth.? If so, your debt will increase as a fraction of GDP, even if your deficits drop to zero.

So, what about Japan?? Can we say two lost decades?

Oooch! 0.2%/yr average growth of nominal GDP?!? That stinks.? But here is what is worse.? The Japanese government? finances itself at an average? rate of 0.6%.? The debt is walking backward on them unless GDP growth improves.? No wonder S&P has put Japan on negative outlook.

Japanese interest rates could rise.? Like the US. Japan has an average debt maturity around 5.5 years.? Unlike the US, 23% of its debt reprices every year, which makes them more vulnerable to a run on their creditworthiness.

Here are three more links on the Pimco piece, before I move on:

We can think of central banks as equivalent to a margin desk inside an investment bank in the present situation.? Though I can’t find the data on the web, what I remember from the scandal at Salomon Brothers that led Buffett to take control, there was a brief loss of confidence that led the investment banks margin desk to raise the internal borrowing rate by 3-4% or so. Within a day or so, the trades expected to be less profitable of Salomon were liquidated, and Salomon had more than enough liquidity to meet demands.

But this is the opposite situation: what if the margin desk were to drop the internal lending rate to near zero?? Risk control would be hard to do.? Lines of business and people get used to used to cheap financing fast.? If it were just one firm that had the cheap finance, say, they sold a huge batch of structured notes to some unaware parties, it would be one thing, because after the easy money was used up, the margin rate would revert to normal, and so would business activities.

But let’s expand the paradigm, and think of the Central Bank as a margin desk for the nation as a whole.? Pre-2008, before the Fed moved to less orthodox money market policies, this would have been a more difficult claim to make, but the claim could still be made.

Pre-2008, the Fed controlled only the short end of the yield curve, which, with time, is a pretty powerful tool for making the economy rise and fall.? Short, high-quality interest rates move virtually in tandem with the Fed funds rate, but during good times, with the Fed funds rate falling, economic players seek to clip interest spreads off of longer and lower quality fixed claims, causing their interest rates to fall as well, with an uncertain timing, but it eventually happens.

And when Fed funds are rising, the opposite happens — funding rates for those clipping interest spreads rise, and the expectation of further rises gets built in, leading some to exit their trades into longer and riskier debts, which makes those yields rise as well, with uncertain timing, but eventually it happens.

I like to say that every tightening cycle ends with a crisis.? Let’s see it from an old RealMoney CC post:

		David Merkel
		Gradualism
		1/31/2006 1:38 PM EST

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

Or, these two posts, which you can look at if you want… one suggested that housing was the next bubble (in 2004), and the other critiqued Bernanke’s reasoning on monetary policy.? (Aaron Task has an interesting rejoinder to the latter of these.)

Things are a little different now, because the Fed is not limited to the Fed funds rate any more.? They have a wider array of tools, and the Treasury is in the act as well through the TLG program.? The Fed owns over $1.5 Trillion of longer dated debts, mostly residential MBS.? The Fed as the margin desk has itself become involved in clipping interest spreads, using its cheap short-term funding to buy longer dated paper, directly forcing long rates down.? The Fed may innovate in other ways as well, offering/receiving term financing as well as overnight financing via Fed funds.

But, here’s the rub.? If the Fed brings the margin rate down to near zero and leaves it there, while actively creating expectations that it will stay there “for a considerable period,” and does so in a lesser way for long-dated paper as well, it can manufacture lower interests rates seemingly everywhere for a time.? It’s amazing how fast bond managers can shift from fear to yield lust.? (I leave aside the effects of foreign players for now.)

But as I pointed out in my visit to the US Treasury, you can change the financing rate, but the underlying cash flows don’t change.? The margin desk drops the financing rate, and prior good trades look better, marginal trades look doable, but there are investments that are still losers at a discount rate of zero.? No way to help those.

So what happens when the next crisis arises?? It could be commercial real estate, inflation, a war, a sovereign default (e.g., Greece, Japan, UK, Italy), another wave of corporate defaults, or, a very weak economy, with banks that are willing to clip spreads, but not take any significant financing risks.

Back to Japan.? Two lost decades.? Debt walking backwards on them.? All of the Keynesian remedies they applied.? Government spending and deficits ultrahigh.? Interest rates ultralow.? Start with a government with little debt; end with a government that is the most indebted among developed nations.

This developed world in Bill Gross’s “ring of fire” is pursuing the same strategies that Japan did over the last two decades.? They should expect the same results, until sovereign defaults begin.? Then the game will change — mercantilists like China will see their strategies blow up, and the nations that default will see their living standards decline.

This has gotten too long, but one thing that I will try over the next few days is estimate Nominal GDP growth rates for nations in the “ring of fire,” and their Government’s financing rates.? If I find anything interesting, I will let you know.

Final note: Ben Franklin at the Constitutional convention in 1787 commented that the half-sun on Washington’s chair was a rising sun, not a setting sun.? Though my title plays on a name for Japan, all nations in this predicament may find that their sun is setting as well.? Unwillingness to take short run pain in trading leads to failure in trading — even so, it is the same for nations.

Too Much Leverage Precedes Many Disasters

Posted on 23 January 201024 January 2010 by David Merkel

There seems to be some confusion over what threatened to cause major banks to fail.? Let me go over my list of the risks:

Many relied on AIG to insure their subprime and other structured lending risks.? Note: initially, when an insurer underprices a product dramatically and attracts a lot of business, the sellers of risk chortle, and say, “Sell away to the brain-dead.”? After it has gone on for a long time, a sea change hits, where they think — oh no, we’re the patsies — the industry now relies on the solvency of AIG!? Alas for risk control, and the illusion of the strength of companies merely because they are big.
As an aside, though I have defended the rating agencies in the past, please fault the rating agencies for one thing: the idea that large companies are more creditworthy than small ones.? Big companies may have more liquidity options, but they also take advantage of cheap financing to bloat in bull markets.? When the tide goes out — oh well,? GE Capital might not have survived without the TLGP program.? Another reason why I sold all my GE Capital debt when I was a bond manager.? Big companies can make big mistakes.? Instead, I bought the debt of well-run smaller companies with better balance sheets, lower ratings, and more spread.
Most of the real risks came from badly underwritten home mortgage debt, whether conventional (bye Fannie and Freddie), Alt-A and Jumbo, or subprime.? Underwriting standards slipped everywhere.
Commercial mortgage lending hasn’t yet left its marks — there is a lot of hope that banks can extend maturing loans rather than foreclose and take losses.
In general, banks ran with leverage ratios that were too high.? Risk-based capital formulas did not properly account for added risks from: securitized assets, home equity loans, construction loans, overconcentration in a single area of lending, the possibility that the GSEs could fail, etc.? Beyond that, there was a dearth of true equity, and a surfeit of preferred stock, junior debt, trust preferreds, etc.
The high leverage particularly applies to the investment banks, which asked for a change from the SEC and got it in 2004.? The only bank to not lever up was Goldman; Morgan Stanley did it only a little bit.? Guess who survived?
The Fed encouraged risk-taking by the banks by not allowing recessions to damage them.? They tightened too late, and loosened too early, and that pushed us into a liquidity trap.
Residential mortgage servicers priced their product in a way that could only work if few borrowers were delinquent.
Financial insurers took advantage of loose accounting rules, and insured more than they could afford.
State and local governments came to depend on increased taxes off of inflated asset values.

What I don’t see is problems from private equity or proprietary trading.? These were not big problems in the current crisis, but the Obama Administration is focusing on these as if they are the enemy.

Look, my view is that banks should be able to invest in equity-like investments up to the level of their surplus, and no more.? By this, I mean real common equity, not hybrid equity-debt financing vehicles.

I believe that bank risk-based capital structures need to be strengthened.? I don’t care if it means that lending diminishes for a few years.? Far better tht we have a sound lending base than that we head into a Japanese-style liquidity trap, which Dr. Bernanke is sailing us into.? (He criticized the Japanese, and he does not see that he is doing the same thing.)

President Obama can demagogue all he wants, and make the banks to be villains.? In the long run, what makes economic sense will prevail, not what scores political points.

Blaming Bonuses is Politically Easy but Wrong

Posted on 23 January 2010 by David Merkel

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

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

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

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

Away from that, anyone structuring incentives quickly learns:

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

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

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

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

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

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

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

David

Why Bernanke Doesn’t Matter, So Vote Him Down If You Want

Posted on 23 January 2010 by David Merkel

I am no fan of Ben Bernanke, longtime readers know.? There are many reasons to find fault with him:

His actions on the Fed while Greenspan was Chairman provided the intellectual support for over-providing liquidity to the market.? Dropping the Fed funds rate below 2% was indefensible.? All the economy needs is a small positive slope to the yield curve, and after a few years, the economy will normalize.? Steep yield curves work faster, but they encourage bad investments because when the yield curve is steep, many people will try to clip free income.
Rather than encouraging liquidation of broken financial institutions, he gave money to holding companies in exchange for ownership, with few strings attached.? The Fed should not have power to bail out any financial institutions; that power should belong to Congress or the Treasury directly, so that we can hold them accountable.
He resisted giving information regarding the bailouts by denying FOIA requests.? There is no good reason to avoid those requests.? The insurance industry has to reveal every asset, and material liabilities in aggregate.? The is no reason why the banks could not do the some thing.
He has been intellectually certain that the Great Depression occurred because monetary and fiscal policies were too tight, and a trade war disrupted commerce, rather than the more likely hypothesis that loose monetary policy led to an increase? in debts financing an asset bubble, and the Depression only ended when enough of the debts were extinguished (around 1941).

To any Senator that might be listening (I dream), I would simply say this — it doesn’t matter whether Bernanke is reappointed or not because the greater question is reforming the Fed.? The Fed has a self-perpetuating nature, and resists real change.? The faces change, but it remains business as usual.? Would Congress consider:

adding Governors that are not neoclassical economists?? Bring real diversity of thought to the Fed?
slimming down the Fed so that it does not dominate research on monetary policy?? Employment of economists at the Fed is too big, and not justified by their output.? You could fire half of the people at the Fed, and there would be no effect on its effectiveness.
making the Fed solely responsible for all depositary institutions?? Note: I don’t like the Fed, but I do like accountability.? Let there be one institution responsible for credit, and one institution responsible for creating bubbles.? The Fed has created bubbles, and denies it.? No.? Let the Fed take care of credit, and when they blow it, hold them accountable.? Either fire those that made the bad decisions, or, move back to a commodity/gold standard.? It would constrain our government that attempts to mandate prosperity with out the power to do so and fails.

Senators, if you need to vote down Bernanke for political reasons, there is no reason not to do so.? The American people will not think the worse of you for doing so, and while the markets may blip down, they will recover once a new Chairman is appointed.? Among conventional candidates, I would favor John Taylor, who formulated the Taylor Rule of monetary policy, which Greenspan and Bernanke violated.? Unconventional candidates?? Elizabeth Warren, Sheila Barr, Ron Paul, Barry Ritholtz, jck at Alea, and I could name many more people who understand our crisis better than Bernanke.

PS — the same logic applies to Timothy Geithner; he is dispensable as well.? We think that the institution will change if we change the person at the top, but structural change is needed, refocusing or reducing the institution as a whole.? I could generate another list of complaints against Mr. Geithner, but truly, if he were gone. without structural reform, the Treasury would not change.

My TIPS, Treasuries, and Inflation Model — II

Posted on 19 January 2010 by David Merkel

I spent some time today updating my Treasury yield curve and inflation model.? Anytime a new Treasury note/bond is issued, or we get a new CPI figure, or a coupon payment date passes, the model must be updated.? Though I made some technical improvements to the program at the same time, what impressed me was the change in the forward inflation curve since I last wrote on the topic less than a month ago.

The big change is that inflation expectations rise? continually out to? 2038.? Now the TIPS curve only goes out to 2032, so the extrapolation should be discounted.? But the last time I wrote, inflation expectations peaked in 2022.? That is a significant change.? Investors have bid up the prices of long duration TIPS, to the point where I would be skittish about buying the long end of the TIPS curve.

Okay, let me post the graphs:

Using closing prices, here is my estimate of the coupon-paying yield curve:

And here is the spot curve (estimating where zero coupon bonds would price):

And finally, the forward curve, which estimates the expectations of future short-term rates, inflation, and real rates:

My model uses the whole Treasury and TIPS markets to estimate yields and inflation expectations.? Here is what is notable:

Inflation expectations on the long end have risen considerably over the last month.
I suspect that the US Treasury will be able to issue 30-year TIPS at yields lower than 20-year TIPS.? The new 30-year TIPS issue in February will prove me right or wrong.
Real forward yields are lower than zero 27 years out — that is unlikely.? I would expect nominal forward rates to rise on the long end.

There are at least two ways to view this situation:

1) Investor inflation expectations have overshot, and it is time to sell long TIPS and buy long nominal bonds, as long-term inflation expectations may fall in the future.

2) Time is running out — rapidly rising long-term inflation expectations indicate that the average investor does not trust monetary policy to succeed over the next 20+ years.

What would I do here?? I would hedge my bets, and buy some long Treasury zeroes (not a lot), mostly intermediate-to-long TIPS, and some short nominal Treasuries.? I would bias the portfolio in favor of bonds that are seemingly underpriced.

The hedged position is because I don’t know which direction the US Government and Fed intend to go with policy.? They likely have no idea as well; this is a tough situation.

On the deflationist side there is Hoisington, Gary Shilling, Carpe Diem.

More inflation-oriented are Greg Mankiw, Tim Duy, and Pimco.? But I don’t see anyone of significance screaming for high price inflation in the long-term future. Yes, that is the default view of much of the financial blogosphere, but the US Government had that option in the ’30s.? It would have made things a lot easier if they had done it, but they didn’t do it.? They acted in the interests of the wealthy, rather than the interests of the economy as a whole.

That’s what makes my model interesting.? It shows that there is a lot of demand for long TIPS.? If the US Treasury thinks it can get things under control, the rational thing to do is to stuff the long TIPS buyers with as much product as they can gulp before it becomes obvious that low inflation will continue because the government will soon balance the budget and pay down debt, as they did after WWII.

But if the US Treasury can’t get things under control, the long TIPS buyers will do well, as they have the most sensitivity to rising forward inflation expectations.

Where do we go from here?? My guess is slowly rising inflation with a weak economy.? But so much depends on the rest of the world, that I hold that opinion skeptically.

Full disclosure: I own some of the Vanguard TIPS fund [VIPSX].

Rationality versus Time Horizons

Posted on 16 January 201017 January 2010 by David Merkel

Would that there were one time horizon — a goal to shoot for, similar to the dispensationalists that plague Christianity with an announced date for the return of Christ.? But a major reason that the Chicago School (as well as the Keynesians) is wrong in their view of economics is that there are multiple time horizons that people consider.

Why one time horizon?? It makes the math simple.? It is similar to the foolish Modern Portfolio Theory which has one version of risk which bears no resemblance to risk in the real world.? Modern Portfolio Theory exists so that bright people who can’t interpret the real world can receive salaries and look smart.? What’s that, you say, Modern Portfolio Theory has a fixed time horizon?? Another reason to cast it over the edge.? It is useless.

There have been a series of interviews at The New Yorker with Chicago School economists to try to test them in their allegiance to the free markets.? There is a problem here in that what makes sense in the short run does not always make sense in the long run.

Bubbles develop from short-run thinking.? What has worked in the immediate past? will work even better in the future.? In hindsight, it sounds dumb, but remember that most people are imitative; they imitate the seeming success of others.? People are rational, but not rational in the way that most economists posit.? Imitating your neighbor is a logical move for many actions.? If he is doing something that looks good, it can make a lot of sense to do the same thing — e.g., asking for the recipe for the delicious meal you had at their house, as well as asking where they got a certain obscure ingredient.

Imitation conserves on thinking.? People avoid thinking, because it hurts.? “If it works for my loser brother-in-law, than it certainly will work better for? me,” is the way some think.? There is the implicit appeal to taking an action out of greed or jealousy.? Smart people avoid those temptations, and think for themselves, looking to the long term consequences of any action.

Momentum investors live on the short-term horizon; value investors invest for the long term — if success comes quickly, very good, if slowly, good.? The ability to wait is a plus, because the ability to wait allows for optionality that may produce more value.

Back to bubbles.? They usually exist because financing is too cheap relative to what financing costs on average over a full market cycle.? Lending or equity investing at such times goes on with little thought for what can go wrong.

“This junk bond won’t default.”

“This equity will grow into its valuation, and then some.”

But near the peaks of bubbles, two things happen.? The prices of the assets being financed are so high, that one borrowing to own the asset faces a negative arb — he has to keep paying to keep the asset afloat — the net yield is negative.? The second thing is that chatter becomes uncertain, and the pace of closing deals slows.

These are signs that the cash flows that the assets throw off are less than the cash flows needed to hold the assets.? Such a condition can only exist for a short time during a mania.? When the pace of deals slackens, and the arb is negative it is time to run, not walk to the exits.

If enough economic actors did this, bubbles would self-deflate.? But it hurts to think.? Valuation questions are tough, and it is much easier to mimic the seemingly successful actions of others.

Better it would be if the Fed, which is the main blower of bubbles through easy monetary policy, would pull back on policy when aggregate levels of debt in the economy get above 200% of GDP, or, would allow us to go through recessions where there is significant pain, and liquidation of bad investments.? But no, during the bubble years, Greenspan was lionized for keeping the economy going smoothly — limiting the impact of recessions.? All that time, debts kept building up until the ratio far exceeded that achieved during the Great Depression.? Now Bernanke is lionized for increasing the Debt/GDP ratio while shifting debts from private to public hands.? He has saved us from the final reckoning of debt service.? Now what will the US Government do as its total obligations pass 4x GDP and head toward 5x GDP?? As I have said before, we are in uncharted waters here.

Debt is not neutral.? It creates inflexibility in the economy, because an economy built on fixed commitments has higher bankruptcy risks than one built on equity commitments.? Real reform would force banks to delever.? It would force the US Government to delever.? Real reform would get the government out of the prosperity business (it has never been good at that), and get it to focus on areas where it can make a difference — justice, defense, public health, and other public goods.

One simple solution: phase out the deduction for interest expenses, and phase in a deduction for dividends (preferred dividends would be at 50%).? Disallow trust preferred and hybrid debt structures.? Make finance more transparent by eliminating complex structures, and limiting all derivative transactions such that only hedgers may initiate transactions.? Transactions between two speculators should be regulated as gambling, because that is what it is.

If the government is not willing to take actions that hurt those being regulated, they are not worthy of being called a government.? The government should look out for the best interests of the nation as a whole, regardless of whom it might seem to favor.

Once again, back to bubbles.? Bubbles don’t get popped by the powers that be because the powers that be like bubbles as they are inflating.? Who would be a humbug and stop the sunbeam of prosperity when it is shining with full power?

But when the deflation of the bubble happens, everyone points the finger outward, few point at themselves.? Let Messrs. Greenspan, Paulson, Geithner, and Bernanke, among others, come before the cameras and apologize for their mismanagement of the US economy, and, let them suggest that the government get out of the economy business, because the government has consistently failed there.

To come back to the beginning of this article, the fetish of rationality exists in economics because the math doesn’t work without it.? Many tests of rationality have failed, yet the profession does not give up, because their skills are useless if man is not economically rational.

It is time to unemploy a lot of economists.? Unemploy them at the Fed; if we don’t eliminate the Fed, at least let’s slim it down.? Unemploy them at universities and colleges.? Let the business departments teach practical economics, and close the economics departments themselves.

The failure of Keynesian, Chicago School, and Neoclassical economics in this present crisis is severe.? We need a new economic paradigm to replace the failures that exist within our universities.

Neoclassical economics will fail; I may not live to see it fail, but it will fail.