Public Policy – Page 77 – The Aleph Blog

Questions and Answers

Posted on 25 August 200925 August 2009 by David Merkel

This may become a series, but I’m going to post some questions I have been asked, and the answers that I gave.? Anyway, here goes:

Has anyone prepared a summary of US Treasury bonds, say five years ago and now and looked at average maturity, etc.

GE was taken to task by the investment community in 2002-03 for using very short term money to fund long term lending/capital needs.? Was the investment community right?

Where is the US government right now ? Are they playing the short end of the maturity ladder, if so what could be the reasons why and what are the implications for the investment community?

Thanks for all of your insight.

This is a graph of the average maturity in months of the marketable portion of US Government debt.? Reagan really lengthened the debt, and Bush, Jr. shortened it.? (Just another bad legacy for that economic liberal, Bush, Jr.)? The most notable aspect of that was the elimination of the 30-year bond in 2001, and its subsequent reappearance in 2006.? The Obama Administration is not a known quantity in these matters yet.

The sharp drop from June 2008 to September 2008 I believe is due to the creation of a lot of short-dated debt that was given to the Fed to allow it to grow its balance sheet.

With respect to GE, yes, the lending community was right.? Prudent borrowers match assets and liabilities.? I recently criticized GE for borrowing with too much short-term debt for their finance arm.? As it is, GE has had a wild ride in its stock price, dipping below six this year.? Without the TLGP, who knows?? GE might have had to send GE Capital into insolvency.

In general, I have been an advocate of lengthening the maturity structure of the US government’s debts.? Governments are supposed to try to be permanent; thus they should finance long.? Governments like the generally lower cost of short debt, and so they sometimes finance shorter than they ought to in an effort to save money.? Governments that don’t finance long enough can be subject to runs, such as Mexico in 1994.

I hope the US government takes the opportunity to finance long while it is still cheap to do so.? My guess is that the opportunity gets wasted; not that the average maturity shrinks a lot, but that it doesn’t grow much.

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What does your husband say about this? Small investors don’t bother?

> http://money.cnn.com/2009/07/29/pf/steve_lehman_federated_investors.fortune/index.htm

This one came to my wife for me.? Quoting from the article, my response was:

>>So what’s a retail investor to do? Lehman’s answer: Leave it to the pros. “It’s never been more difficult [to invest],” he says, “and it will remain more challenging than ever. Unless someone really has a flare for investing and enjoys doing it, I would say don’t waste your time.”<<

Small investors should probably use low cost index funds and vanilla Exchange Traded Funds.? That will lower their costs, which will raise their returns.? It is rare for outperformance to persist in funds management, particularly as the funds under management for any manager grows.? There are some value managers that are worthy of being invested in over the long haul for equities, and if you want a list, I will provide one.

David

PS — to the editors at Money — “flare” s/b “flair”

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We have a certificate of deposit that we are cashing out and are wondering if buying some gold would be a better way to protect our savings? Considering the way the government is spending money, it seems the only way to be safe from the inflation that is coming.

This is a tough one. A lot depends on whether the government inflates their way out of this or not. I almost think they have to, but they could have done it in the Great Depression/WWII, and did not. They raised taxes, and the best investment was government bonds for a long while.

This situation is probably different. Gold will preserve purchasing power over the long haul, but it rarely does more than that. Sometimes, that’s the best you can do.

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I don’t have a good place to post this last bit, so here it goes: here is a recent audio interview of me. I only wish we had focused more on investing topics. For those interested, I had my notes in front of me, which cited a number of my articles.

Full disclosure: I don’t own any gold, aside from my wedding band.

Three Notes on the Federal Reserve and Financial Services Reform

Posted on 25 August 2009 by David Merkel

As I have said before, it doesn’t matter who the next Fed Chairman is, because all of the candidates are basically the same when it comes to monetary policy.? There are no hard money candidates.? So, with the announcement that the reappointment of Ben Bernanke is likely, we can all breathe a sigh of relief because Larry Summers won’t be there (ego kills), and, Ben Bernanke is a known quantity.

On another front, a Federal judge ruled that the Fed would have to turn over data requested by Bloomberg, LP, regarding the emergency lending programs that the Fed has entered into.? Good thing, as I have said before, there is no reason why banks can’t disclose their asset books as insurers do.

Finally, Paul Volcker wants to regulate money market funds like single purpose banks.? Interesting idea, but money market funds have suffered far fewer losses than regulated banks.? I would pass on this idea, and look for more substantive ways to modify the financial system — as an example, make banks as transparent and complete in their regulatory filings as insurance companies.? Now, that would be real reform.

Nine Notes on Residential Real Estate

Posted on 15 August 200916 August 2009 by David Merkel

I don’t really have one unified article type when I write here.? Sometimes I have a really strong conviction about something, and then it flows.? At other times, I gather data, do an analysis, and come up with a way of motivating it.? Then there are the Seven, Eight, Ten, Twelve, Fifteen, Twenty Points/Notes/Comments articles.? Tonight’s piece is one of those.

(An aside — the numbers stem from a comment from an editor of a Canadian business publication — he told me that certain numbers grab people’s attention more.? True?? Not sure.? I do know that one of my editors at RealMoney felt that some of my quirky titles lost readership.? Even today, my editor at SA freely revises my titles, sometimes making something an emphasis that I had not intended.? Whatever; she titles better than me.? What intrigues me is that other sites sometimes pick up her title, not mine, even when they link directly to my blog.)

I don’t do linkfests.? I don’t do them not because they are not valuable, but because others do them better then me, like Abnormal Returns.? So, I do something different.? As I troll the web each day, I tag articles for future comment.? I then wait until I have a critical mass of articles on a given topic, and then I publish one of the “XX Points” articles.? This enables a greater range of facets on a given issue.? I also allows me to give more of an integrated explanation of how I think it all fits together.? Now, the price is that some of the articles are dated.? I think they are fresh enough to highlight trends.

Enough explaining.? On to tonight’s topic, real estate and its effect on the real and financial economies.

1)? Principal forgiveness — it is what underwater homeowners want, and what they are unlikely to get.? Principal forgiveness means that a loss has to be taken by someone now.? Adjust the rate, adjust the term, adjust the amortization — it is all tinkering, even if it lowers the payment slightly, because the owner is still inverted on his mortgage.

Ideas like lowering the principal, but giving the bank a large chunk of the price appreciation at sale, or say 30 years out, would be cute, but still, the bank (or juniormost MBS certificate holder, who usually directs the servicer) would take a loss now.

So, I’m not surprised when I read articles like these:

Governments have power, but it is very difficult to fight the economics of the situation.? One further note, as is mentioned by a few of the above articles, is that the most profitable situation for the lenders/servicers, is that the property teeters on the edge of solvency, not only paying the mortgage slowly, but pays additional fees in the process.

2)? Will there be a second foreclosure wave?? Maybe.? First American CoreLogic argues that it will be the existing wave continuing.? I tend to agree with CoreLogic for the following reason: when you have enough of the mortgaged homes of the country underwater, it is difficult to slow the rate of foreclosure, because foreclosures happen to properties that underwater where one of the following occurs:

Death
Divorce
Unemployment
Disability
Disaster
Strategic default (buy a nicer home cheaper, and stop paying off this overpriced garbage)
Debt reset/recast

3)? The GSEs, despite the rally, are still in lousy shape.?? Fannie lost $14.8 Billion, and tapped the Treasury for liquidity.? Freddie earned less than $1 billion, but only because they revalued assets $5 billion higher.? Their regulator believes that they won’t be able to repay all aid that the US has granted them.? My verdict: the common of each company is an eventual zero.? Stay away.? Thrillseekers that like zero shorts, don’t do it; the odds are good for a zero, but the payoff is asymmetric.

4)? What percentage of homeowners are or will be upside-down or underwater?

24 or 32% (now and soon)
30% (Zillow — soon)
32% (First American CoreLogic — now)
48% (Deutsche Bank — in two years, challenged by Lawler)

I favor the estimates of First American CoreLogic.? First, they have great data.? Second, my view is that properties with greater than 90% LTVs are likely upside-down in a sale due to closing costs.? The inflection point in mortgagee behavior occurs between 90-100% LTVs, not at 100%+.

That’s why we are in such deep trouble.? With 32% of all mortgages inverted, there will be many more foreclosures, and prices should still head downward, even on the low end.

5)? But maybe things aren’t so bad, at least on the low end.

Home inventories fell in July.
In some markets, on the low end, foreclosures are selling fast.
New home sales increased in June.
Bottoms are longer than we would like to expect.

6)? All that said, the high end isn’t seeing much action, and prices continue to sag.? There aren’t many move-up buyers.

7)? What characterizes the underwater borrower?? Cash-out refinancing, and home equity loans.? The home as an ATM always relied on the “greater fool” theory implicitly — that there would always be a greater fool willing to buy out the home at a greater price than the new amount of leverage.? On the home equity loans — banks are doing all that they can to avoid recognizing losses.? With home equity loans, losses are usually total.? The only thing that surprises me here is that it has taken this long to get to realizing the losses.

8 ) So you want appraisers to be honest, but not yet?? Appraisers, auditors, etc. — third party evaluators are conflicted — he who pays the piper calls the tune, and no one is willing to have the buyer pay for the appraisal.? So now the appraisers try to be honest and business can’t get done?!? Those who hire appraisers, make up your minds; do you want a few short term deals, or do you want reliable long term business?

9)? On the dark side, many option ARMs will default before the payments recast.? That means the recast wave will be more gradual, but it won’t be any less troublesom in aggregate.

That’s all for this evening.? Absent something else pressing, I will write about commercial real estate on Monday night.

Ten Unsolved Problems in the Global Economy

Posted on 15 August 2009 by David Merkel

There are many celebrating the recovery as if it were already here.? This is a brief post to outline my main remaining concerns for recovery of the global economy.

1)? China is overstimulating its economy, and forcing its banks to make bad loans.? This pushes up commodity prices, and makes it look like China is growing, but little of the investments made are truly needed by the rest of the global economy.

2)? Western European banks have lent too much to Eastern European nations in Euros.? The Eastern Europeans can’t afford it, and widespread defaults are a possibility.

3)? The average maturity of bonds held by foreign investors in US Treasuries is falling.? Runs on currencies happen when countries can no longer roll over their debts easily, which is facilitated by having a lot of debt to refinance at once.

4)? On a mark-to-market basis, market values for commercial real estate have fallen dramatically.? Neither REIT stocks nor carrying values for loans on the books of banks reflect this yet.? Many banks are insolvent at market-clearing prices for commercial real estate.

5)? We still have yet to feel the effects from pay-option ARMs resetting and recasting.? Most of the pain in residential housing is done, but on the high end, there is still more pain to come, and the pay-option ARMs will reinforce that.

6)? The rally in corporate debt and loans was too early and fast.? Conditions are not back to normal for creditworthiness.? There should be a pullback in corporate credit.

7)? We had global overbuilding is cyclical sectors 2002-2007.? We overshot the demand for large boats as an example.? We overdeveloped energy supplies (that will be short-lived), metals, and other commodities.? It will take a while to grow into the extra capacity.

8 )? The US consumer is still over-levered.? It will be a while before he can resume his profligate ways, assuming a new frugality does not overcome the US.? (Not likely by historical standards.)

9)? The Federal Reserve will have a hard time removing their nonstandard policy accommodation.

10)? We still have the pensions/retiree healthcare crisis in front of us globally.

That’s all.? To my readers, if you can think of large unsolved problems in the global economy, forward them on to me here in the comments.? If I agree, I will incorporate them in future articles.

Twenty Notes on Current Risks in the Markets

Posted on 14 August 2009 by David Merkel

1)? A modest proposal: The government announces that they will refinance all debtors.? Not only that, but they will buy out existing debt at par, and allow people and firms to finance all obligations at the same rate that the government does for whatever term is necessary to assure profitability or the ability to make all payments.? The US Treasury/Fed will become “The Bank.”? No need for the lesser institutions, The Bank will eat them up and dissolve their losses, taking over and refinancing their obligations.? Hey, if we want a single-payer plan in healthcare, why not in finance?? Being healthy is no good if you can’t make your payments. 😉

This scenario extends the US Government’s behavior to its logical absurd.? The US Government would never be large enough to achieve this, but what they can’t do on the whole, they do in part for political favorites.? They should never have bailed out anyone, because of the favoritism/unfairness of it.? Better to have a crash and rebuild on firmer ground, than to muddle through in a Japan-style malaise.? That is where we are heading at present.? (That’s the optimistic scenario.)

2)? I have exited junk bonds, and even low investment-grade corporates.? Consider what Loomis Sayles is doing with junk.? Yield = Poison, to me right now, which echoes a very early post in this blog.? There are times when every avenue in bonds is overpriced — that is not quite now, because of senior CMBS, carefully chosen.? All the same, it makes me bearish on the US Dollar, and bullish on foreign bonds.? This is a time for capital preservation.

3) High real yields are driving the sales of US Government debt.? Is that a positive or a negative?? I can’t tell, but there is always a tradeoff for indebted governments, because they can usually reduce interest expense by financing short.? When their average debt maturity gets too short, they have a crisis rolling over the debt.? We are not there yet, but we are proceeding on that road.

4)? I have a bias in favor of buyside analysts, after all I was one.? But this research makes me question my bias.? Perhaps sellside analysts are less constrained than buyside analysts?

5) Debtor-in-possession lending is diminishing, reflecting the likelihood of loss.? In some cases that may mean more insolvencies go into liquidation.? Interesting to be seeing this in the midst of a junk bond rally.

6)? Short-selling isn’t dead yet.? Would that they would take my view that a “hard locate” is needed; one can’t short unless there is a hard commitment of shares to borrow.

7) Should we let managers compete free of the constraints imposed by manager consultants?? You bet, it would demonstrate the ability to add value clearly.? I face that? problem myself, in that I limit myself to anything traded on US equity exchanges.? As such, I have beaten most US equity managers (and the indexes) over the last nine years, but no one wants to consider me because I don’t fit the paradigms of most manager consultants.

8 )? Is there a fallacy in the “fallacy of composition?”? I think so.? Yes, if everyone does the same thing same time, the system will be unstable.? But if society adopts a new baseline for saving/spending, the system will adjust after a number of years, and there will be a new normal to work from.? That new normal might be higher savings and investment, in this case, leading to a better place eventually than the old normal.

9)? Anyway, as I have said before, stability of a capitalist system is not normal.? Instability is normal, and is one of the beauties of a capitalist system, because it adjusts to conditions better than anything else.

10)? Corporate treasurers are increasingly engaged in a negative arbitrage where they borrow long and hold cash so that the company will be secure.? How will this work out?? Will this turn into buybacks when things are safe?? Or will it just be a drag on earnings, waiting for an eventual debt buyback?

11)? Does debt doom the recovery?? Maybe.? I depends on where the debt is held, and how is affects consumption spending.? Personally, I think that consumers and small businesses are under a lot of stress now, and it won’t lift easily.

12)? So things are looking better with junk bond defaults.? Perhaps it was an overestimate, or that it would not all come in 2009.? We will see.

13)? Junk bonds do well; junk stocks do better.? In a junk rally, everything flies.? All the more to hope that this isn’t a bear market rally; if so, the correction will be vicious.

14)? Eddy, pal.? Guys who criticize data-mining are near and dear to me.? Now the paper in question has a funny definition of exact.? I don’t know how to describe it, except that it seems to mean progressively more accurate.? I didn’t think the paper was serious at first, but given the relaxed meaning of “exact,” it data-mines for demographic influences on the stock market.? Hint: if you have lots of friends when you are nine, ask for stock as a birthday present.

15)? I’m increaisngly skeptical about China, and this doesn’t help.? I sense that the global recession is intesifying, amid the current positive signs in the US.

16)? Do firms with female board members do worse than companies with only male board members?? No, but they get lower valuations, according to this study.? I started a study on female CEOs in the US, and I got the same result, but it is imcomplete at present — perhaps new data will invalidate my earlier findings.? Why does this happen, if true?? Men seem to be better at managing single investments, while women are better at managing portfolios.

17)? Do we have more pain coming from the banks?? I think so.? Residential real estate problems have not reconciled, and Commercial real estate problems are just beginning.? If we mark loans to market, many large banks are insolvent, and this is not an issue that will easily be healed with time.

18)? As a nation, I like Japan, and would like to visit it someday.? What I don’t want is for the US to imitate its economic stagnation, but maybe that could be the best of all possible worlds for the US.

19)? I am de-risking my equity and bond portfolios at present.? I do not think that the present market levels fairly reflect the risks involved.? I am reducing risk in bonds, and looking for strong sustainable equity yields in equities.

20)? Echoing point 17, we face real problems on bank balance sheets from commercial real estate lending.? There is more pain to come.? The time to de-risk is now.

Living with Excluded Views

Posted on 12 August 2009 by David Merkel

1)? As I’ve said before, I don’t care whether Bernanke is reappointed or not, because who will be appointed that has a materially different theory of central banking than Bernanke?? I don’t see Ron Paul getting appointed.

But to reappoint Bernanke because a bunch of economists think it is a good idea is dumb.? The neoclassical economists were blind going into this crisis, and only a few outside the mainstream saw the debt building up, and said this would not work out well.

And, if I were in Bernanke’s shoes, I would not want endorsements from economists.? Oh wait, he is one.? Alas, I am one too, though rogue. Outside of economists, are politicians the only ones who trust economists?? Yet, the politicians use the economists as a useful shield.? “We only did what the economists suggested would bring prosperity.? We cannot be blamed if the experts are dunces.”

I think Bernanke will be reappointed.? I only hope he is there long enough to see him either struggle with stagflation, or with a Japan-style malaise, or both.? As I have said since 2004 at RealMoney, “This will not work out well.”

2)? Barack Obama is a bright guy.? He may be the brightest president since… um, I’m not sure, he might be the brightest of them all.? That does not mean that I agree with his ideas, because a bright man starting from bad postulates ends up in a bad place quicker.? That said, there seems to be some restraint on his part, as noted in this WSJ article:

In early July, the president ordered a briefing on derivatives — financial contracts that track the return on stocks, bonds, currencies or other benchmarks. Critics had been raising questions about administration proposals to regulate certain derivatives, such as credit-default swaps, which many blame in part for the financial crisis. With advisers gathered round on the Oval Office’s twin sofas, Mr. Obama said he was concerned that the administration hadn’t struck the right balance.

Its proposal called for standard derivatives to be traded on an exchange, bringing them into the open. Critics were calling the proposal too timid because it also would allow “customized” derivatives to continue trading privately. “What is to assure that this won’t drive all derivatives off the exchange?” the president asked, according to Mr. Emanuel.

He says Mr. Obama was frustrated his team wasn’t offering up a full range of views on how to approach derivatives regulation. “Get me some other people’s opinions on this,” Mr. Emanuel recalls the president as saying. “I want more than what’s in this room.”

In the end, the administration tweaked its position on derivatives. In legislative language drafted this week, it is seeking to require financial firms that offer customized derivatives to maintain higher capital cushions.

And so goes the proposed legislation.? It only tweaks at the edges the existing derivative setup, and does not question the troubles that the financial markets wreak on the cash markets when they are allowed to become gambling markets, where speculators trade with speculators, and the tail begins to wag the dog.? Synthetic markets must be smaller than the real markets, if we want to have longer-term stability.? Hedgers must lead the markets, not speculators.

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That’s all for now.? I don’t have much hope in the legislation on derivatives, or who leads the Fed.? Given where the terms of debate are, the debate excludes my views.

Beyond Co-ops: National Healthcare Mutual

Posted on 11 August 2009 by David Merkel

I’m not a healthcare actuary; I am a life & investment actuary.? I did pass my health exam on the actuarial syllabus with a high score, but that was almost 20 years ago.? So, take what I say not as expert opinion, but as reasonably well-informed opinion (I hope).

I general, I believe the US needs to move away from insurance with respect to healthcare.? Let people pay directly for healthcare services, and if they must have insurance, let it be with a high deductible, like $5000/year.? If the government then wants to help the poor, let them pay on the deductible.

Wait.? That’s a non-starter.? First-dollar coverage is the holy grail.? Expensive as anything, but that is the perverted goal.

Rationing takes place in any economic/political system, it is merely a question of how the goods and services get rationed.? Price?? Time?? Need (however defined)?

So, the politicians look to cover everyone, and yet control costs in the medical system.? Covering everyone is very expensive, because for the most part, the worst risks aren’t insured.? Those that would pay the highest premiums on a actuarially fair basis don’t buy/get insurance.

Controlling costs means reducing access, limiting doctor freedom, limiting choices, delaying treatment, etc.? Preventive care is a nice concept, but the gains are negligible.

I say let people be free, and get the government out of the picture.? No corporate deduction for healthcare costs.? No HSAs or other tax-preferred benefits (I have one of those).? Scale back Medicare; it is way too expensive relative to the GDP of the US.? Finally, inculcate a culture that recognizes that we are all going to die, and that certain care for the elderly will not be available unless they can pay for it privately.? We don’t want to prolong an expensive death at taxpayer expense.

An Idea

But with all that, let me propose one idea that might help.? I once proposed a program to improve the banking system of the US through the creation of mutual banks.? I thought, why not try the same idea with health insurers?

So, I started reading the news on the healthcare proposals, and I was surprised to find the idea of co-ops being discussed (also).? Some co-ops have been successful in managing costs and access, others not, as many co-ops have failed.

My thought was this: mutual banks could work versus the big? banks, because scale is not much of an advantage in banking.? Big banks have expense advantages, but they take dumb risks.? With healthcare there is a real advantage to size.? Small co-ops can’t compete against major health insurers.? But maybe a big mutual entity could do so.

Instead of a bunch of medical co-ops, better to sponsor/seed one mutual health insurance company that can cover the whole USA, and challenge the big private insurers.? The new entity would be charged with the tasks of reducing the uninsured, and lowering healthcare costs.? Much better than the co-ops idea.

But, nothing is perfect; we haven’t reached Solla Sollew yet.? If the mutual insurer is supposed to subsidize care, how should they do it?? Many of those that are uninsured are bad risks.? Others who might want to use the mutual company might look for policyholder dividends, particularly if they did not use the healthcare system much.

In the life insurance industry, the best mutuals imitate stock insurers, but adopt a longer-term view of their business.? I would assume that it would be true of a mutual health insurer as well.? So, what benefit would come from a large mutual health insurer?

Competition against the large managed care providers, lowering prices, kind of like what Southwest Airlines does…
Skimming the cream of those who are basically healthy, but can’t easily find insurance.
Congress would gain insight into how difficult it is to lower medical expenses, and how difficult it is to cover the uninsured.

The main reason that Congress is having large problems with this issue is that they are trying to do too much.? They are aiming for costless solutions to a costly problem.? They are looking to restrain access to healthcare to a culture that wants its problems solved now.

This is all a fool’s bargain to me, so let Congress charter National Healthcare Mutual, and see how much good it can do, before it returns to them hat in hand.

Ten Notes on the Current Markets

Posted on 6 August 2009 by David Merkel

1)? Great minds think alike.? Fools seldom differ.? Remember my post on AIG’s subsidiaries?? Well, now in the New York Times, much of the same.

2)? Fed Independence! (spit, spit)? Come on, Bernanke, you argue against the Fed being audited because it might compromise Fed independence, and yet you regularly have lunch with leaders of the Executive branch.? You compromise the independence of the Fed more than any audit could by acting cooperatively with the Treasury.? If you were really independent, you would do what is best for your explicit mandate — fighting inflation and unemployment, rather than tinkering with non-bank credit markets, and rescuing companies.

3) Manus manum lavat. One hand washes the other.? Banks that have been bailed out are buying more Treasuries.? Some of that is lower spreads — lack of lending opportunities.? The rest is implicitly paying back the government.

4) The government may be increasing its sales of TIPS.?? I’ve been less bullish on TIPS of late, and this does not encourage me to change.? Further, farmland values may be falling.? Given growth in demand for food in the world, that should not be so, but maybe that is wrong.? Maybe depressionary conditions are that strong.? I also offer up the piece from UBS, via FT Alphaville, that suggests that deflation is more likely to minimize the total cost of debt to the US government.

All of this depends on the current length of US government debt.? If all of it were nominal (not inflation-indexed) 30-year debt, the US Government would gladly inflate.? Their financing is locked in.? But if it were all short-dated, the US government would have to manage the powder keg.? After all that was Mexico in 1994 — the government was financed in the short-term interest rate markets.

Thus, governments that have not been prudent, and have financed short-term can face a run on the currency.? The US government finances to an average of 4-5 years, so it is not apparent whether they could face a run or not.

The more TIPS that are issued as a fraction of the total debt, the less valuable the inflation guarantee becomes.? If China, or any other creditor thinks that TIPS are the solution to loss of value on US debt claims, let them realize this:

Yes, if the US inflates its currency, there will be protection.
No, if the US defaults on its obligations, you won’t be materially better off.
If the US decided to selectively default on foreigners, paying them back in a different US dollar than the domestic one, TIPS won’t help you much.

5)? Bye, bye, Fannie and Freddie?? Sending them into runoff was my proposed solution when the crisis hit.? Now that the reality of the humongous losses from mortgage lending and guarantees has become apparent, the government faces reality, and may wind them down.? As it is now, we know that F&F are unlikely to pay back their aid from the government in full.? In my opinion, better that the government would have let the companies go into Chapter 11 without interference. Instead, the taxpayers bail out much of the capital structure that did not deserve a bailout.

6)? Should Ben Bernanke be reappointed as Fed Chairman?? It doesn’t matter.? There is no significant variation in ideas among likely candidates that would make a significant difference in how the Fed behaves.? I don’t think Ben should be reappointed, but I don’t see any worthy replacements.? Ron Paul is out of the question, sadly.

These articles argue that Ben Bernanke should not be reappointed, and they make some good arguments:

All that said, what is the option?? Is there someone stunningly good standing in the wings, with a materially different view of monetary policy from Bernanke, who would be acceptable to the activist Obama administration?? I don’t see one available, so perhaps the devil you know is better than the devil you don’t.

7)? The corporate bond market has been on fire of late, with higher prices, tightening spreads and greater issuance.? We had several episodes like that in 2002, before facing reversals.? The first time is not the charm, and I would expect more of a backup in prices because corporate loss rates have not peaked yet.

8)? Let me just point out that “cash for clunkers” is another version of the “broken window fallacy.”

9)? As for AIG, I don’t expect the government to be paid back in full.? Sales of AIG subsidiaries have gone at cheap prices, and only the simple subsidiaries have been able to be sold.? Investment banks will make money on the deal, though.

10)? Even if GDP shrinkage is slowing due to government spending, that still means that the private sector is weak.? GDP ex-government growth will be a statistic to watch in the future.

Avoiding the Tail Wagging the Dog

Posted on 4 August 2009 by David Merkel

I’ve written a number of pieces where I have discussed limits on derivatives.? These have seemingly been among my least popular pieces, partly because I seem to argue against the free market.? I’m not arguing against the free market, per se, but arguing that there are some types of contracts that should not be valid on a public policy basis.? This piece is meant to integrate my thoughts on:

Having a hard locate with shorting — (shares that have not been previously lent are located and confirmed to be borrowed).
Insurable interest with respect to credit default swaps [CDS].? Only hedgers can initiate transactions, and if the hedger sells, he must first collapse the CDS transaction.
Insurable interest should apply across all derivative markets, and should become a regular part of insuring systemic stability.? Regulators of the various exchanges would require hedgers to divulge the assets or liabilities in question that they are hedging.? The hedgers would then be allowed to buy and sell contracts up the hedging need, and no more.? Speculators would bid for the right to trade with the hedgers, but could not trade with other speculators.? Every transaction must have a hedger.

One of my core reasons for this is to shrink derivative activity so that it is smaller than the underlying markets.? This will keep “the tail from wagging the dog.”? After all, if you need to do a transaction, why not buy/sell the underlying, on a forward basis if necessary?? Also, let the regulators understand their clients more closely, so that they can better prevent insolvencies.

My second core reason is that speculators dealing with speculators is gambling, and should be regulated that way, because there is no transactional tie to the real economy.? Now, some will say,”Doesn’t all investment involve gambling?”? My answer is no.? All investment involves risk-taking, but there is a difference between risk-taking and gambling.

Every business/businessman takes risks.? Many of those risks get externalized in public security markets because the equity and debt of the company trade on secondary markets.? The prices of the shares and bonds reflect marginal perceived risk of the business.? That risk is necessary risk.? Unnecessary risk is two unrelated parties with no economic interest betting on whether the company can survive or not; such a bet should be regulated as gambling.

Most people buying/shorting a stock have some reason why they think they will make money.? Even if they are wrong, they don’t think their actions are as uncertain as a coin flip.? Few pick tickers randomly, and decide positions (buy/short) randomly.

My third core reason is to reduce regulatory and taxation arbitrage.? Many derivative transactions are done to escape regulations and taxation existing in the underlying markets.? Let these parties abide by the rules of their regulators, and let them pay the taxes that they owe.

There are legitimate reasons for wanting to lay off short-term risk, without selling a long term asset.? But on the whole, speculative markets should not exceed the demand for hedging.? Similarly, markets for shorting should not exceed the amount of underlying available to be borrowed.

That’s my position.? Separate investment and gambling through a requirement of hedging in synthetic transactions.? If some want to gamble on companies, let them go to Vegas; the margin requirments will be tighter.

I know this article won’t be popular, but I do want financial markets to have real legitimacy over the long term.? Gambling, even if legal,? never has moral legitimacy.? Better to have smaller markets that are viewed by most to be legitimate, than to have large markets that have the legitimacy of a casino.

Book Review: Mr. Market Miscalculates

Posted on 29 July 200920 June 2017 by David Merkel

Since the first time I read him, I have been a fan of James Grant.? He helped to sharpen my focus on how money and credit work in the long run, and how they affect the economy as a whole.? Reading one of his early books, Minding Mr. Market: Ten Years on Wall Street With Grant’s Interest Rate Observer, I gained perspective on the increasingly complex financial world that we were moving into.

But not all have shared the opinion of Mr. Grant’s wisdom.? When I worked for Provident Mutual, the Chief Portfolio Manager (at that time new to me, but eventually a dear colleague) said to me, “feel free to borrow any of the publications we receive.”? For a guy who likes to read, and learn about investments, I was jazzed. But, when I came back and asked whether we subscribed to Grant’s Interest Rate Observer, I got the look that said, “You poor fool; what next, conspiracy theories?” while she said, “Uh, noooo. We don’t have any interest in that.”

Now the next two firms I worked for did subscribe, and I enjoyed reading it from 1998 to 2007. But now the question: why buy a book that repeats articles written over the last fifteen years?

I once reviewed the book Just What I Said: Bloomberg Economics Columnist Takes on Bonds, Banks, Budgets, and Bubbles, by another acquaintance of mine, the equally bright (compared to James Grant) Caroline Baum.? This book followed the same format, reprinting the best of old columns, with modest commentary.? In my review, I cited Grant’s earlier book as a comparison, Minding Mr. Market.

As an investor, why read books that will not give an immediate idea of where to invest now?? Isn’t that a waste of time? That depends.? Are we looking to become discoverers of investment/economic ideas, or recipients of those ideas?? Books like those of Grant and Baum will help you learn to think, which is more valuable than a hot tip.

Here are topics that the book will help one to understand:

How does monetary policy affect the financial economy?
Why throwing liquidity at every financial crisis eventually creates a bigger crisis.
Why do value (and other) investors need to be extra careful when investing in leveraged firms?
What is risk?? Variation of total return or likelihood of loss and its severity?
Why financial systems eventually fail at compounding returns at rates of growth significantly above the growth rate of GDP.
Why great technologies may make lousy investments.
Why does neoclassical economics fail us when trying to understand the financial economy?
How does one recognize a speculative mania?
And more…

The largest criticism that can be leveled at James Grant was that he saw that he would happen in this crisis far sooner than most others.? Being too early means you eventually get disregarded.? The error that the “earlies” made, and I knew quite a few of them, was not recognizing how much debt could be crammed into the financial economy in order to juice returns on fixed income assets with yields lower than likely default losses.? That’s a mouthful, but the financial economy had not enough good loans to make relative to the amount of loans needed to maintain the earnings growth expectations of the shareholders of financial companies. Thus, the credit bubble, facilitated by the Fed and the banking regulators.? You can read all about it in its many facets in James Grant’s book.

You can buy the book here: Mr. Market Miscalculates: The Bubble Years and Beyond.

Who would benefit from the book?

Those that have assumed that neoclassical economics adequately explains the way our economy works.
Those that want to understand how monetary policy really works, or doesn’t.
Those that want to learn about equity or fixed income value investing from a quirky but accurate viewpoint.
Those that want to be entertained by intelligent commentary that proved right in the past.

As with other James Grant books, this does not so much deal with current problems, as much as educate us on how to view the problems that face us, through the prism of how past problems developed.

Full disclosure: If you buy anything through the links to Amazon at my blog, I get a small commission,? but your costs don’t go up.?? Also, thanks to Axios Press for the free review copy.? I read the whole thing, and enjoyed it all.