Public Policy – Page 80 – The Aleph Blog

The Bump at the end of the Cycle

Posted on 2 June 20092 June 2009 by David Merkel

I haven’t done it recently, but I begin with a bunch of my old CC posts from five years ago:

		David Merkel
		Are There Buyers out There for Long Treasuries?
		5/14/04 8:28 AM?ET
I have been arguing for a while that despite a record short interest in Treasury futures, liquidation of the banks leveraged long positions is a bigger factor in the market. The gentle and slow movements of this market have had an upward bias in yield, lower in price. This can be temporarily self-reinforcing, as a rise in rates causes new players to say that they can’t take the pain, and they liquidate long positions.That said, we should begin to see some relief here; the yield curve has only been this steep twice before in the last 22 years, and this is within 5 basis points of the record-wides over that period (the other times were in 1992 and 2003). I would expect buying interest to materialize below 5.00% on the 10-year Treasury note.The yield curve has already built in 125 basis points of tightening, though when it happens is up for grabs. The ultimate amount of tightening will depend on several factors, notably the level of inflation and the occurence of any macroeconomic catastrophes precipitated by the tightening. (Think of the stock market in 1987, solvency of U.S. banks in 1989, Mexico in 1994, LTCM in 1998 and the Nasdaq in 2001… U.S. housing in 2005?)Unless interrupted by a crisis, the ultimate level of tightening will require the short rate (yield on 90-day T-bills) to be at least 100 basis points less in yield than the long rate (the yield on the current long bond). The yield on the long rate will depend more on the anticipated level of inflation. The short rate chases a moving target.Final note: U.S. dollar-denominated liquidity is getting scarcer. One month ago, the yield on three-month LIBOR broke its 200-day moving average. Typically, this doesn’t bode well for financial equities in the short run. Don’t fight the Fed, at least for the first few tightenings. No stocks mentioned

and…


		David Merkel
		Gradualism means… flexibility?!
		5/20/04 4:14 PM?ET
In Ben Bernanke’s speech, which is going on as I write, he gave three reasons for the Fed to move gradually:1. The Fed does not possess perfect information, so caution is warranted. The Fed learns from the reactions of the real economy and the asset markets, and adjusts its actions. 2. Gradualism gives the Fed greater control over long-term interest rates, and asset prices. 3. Gradualism reduces stress to the financial system. I disagree with his last two points. The Fed does not have much impact on the long end of the yield curve in anything more than the short run. Long rates are affected primarily by the rate of nominal GDP growth in the intermediate term. The Fed reacts to long-term interest rates, and sets the fed funds rate relative to the long rate. Steep curves speed nominal economic activity, and flat curves slow nominal economic activity. As to stress in the financial system, comparisons to the chinese water torture come to mind. While gradualism might be better than drastic moves, gradualism did not prevent the following blowups: bond market (early 87), stock market (late 87), real estate (89-90), Residential MBS and Mexico (94), LTCM and Asia (98), and the Nasdaq (2001-2). Call me a skeptic, but the Fed likes to maximize its own flexibility in applying policy, and gradualism fits that bill. Crises would be better prevented if the Fed stopped trying to fine-tune the economy though over-providing liquidity. Okay, I’m getting off my soap box now… none
		Aaron Task
		Soap Box
		5/20/04 4:36 PM?ET
David, re. this list: bond market (early 87), stock market (late 87), real estate (89-90), Residential MBS and Mexico (94), LTCM and Asia (98), and the Nasdaq (2001-2).Save for the first 2, the rest occurred on Greenspan’s watch. The chairman is often credited for “navigating” us through such crises, but few seem to stop and think about his responsibility (direct or indirect) for their occurrence.Currently, he’s now overseeing a possible housing bubble (and corresponding crash in MBS markets). I can’t wait to see how he “navigates” through that. NOT reassured by his reappointment
		David Merkel
		More on the Bernanke Speech
		5/20/04 4:50 PM?ET
First, a quote from his speech:First, I do agree that the flare-up in inflation in the first quarter is a matter for concern, and that the inflation data bear close watching. Should the rise in inflation show signs of persisting, I am confident that the Federal Open Market Committee will adjust policy as necessary to preserve price stability. As the qualified and probabilistic language of the FOMC’s statement makes clear, the likelihood that the pace of rate normalization will be “measured” represents a forecast about the future evolution of policy, not an unconditional commitment on the part of the Committee. Although I expect policy to follow the usual gradualist pattern, the pace of tightening will of necessity respond to evolving economic conditions, particularly the strength of the ongoing recovery in the labor market and developments on the inflation front.Measured may not be as gradual as one might expect. The fed wants to keep its options open. Though Mr. Bernanke says that he wants Fed policy to be transparent to the markets, the flexibility needed to respond to changing conditions makes the predictability of Fed actions difficult over anything longer than a few months.Bernanke did give us a peek at the neutral Fed funds rate. He believes that it is 2.7% over inflation. If the Fed has an inflation target of 1-2%, that gives a neutral fed funds rate of 3.7-4.7%. He added that the neutral fed funds rate changes with economic conditions, which was another argument for gradualism. If the Fed is eventually aiming at a 4% fed funds rate, and they do 50 basis points each time they tighten (aggressive assumption) that would augur for six tightenings, assuming that a crisis doesn’t interrupt their activities. Who is ready for six tightening moves out to the end of 2005? I think most market participants are expecting less. none
		David Merkel
		At Least the Price of Soap Boxes isn’t Going Up
		5/20/04 5:05 PM?ET
Aaron, I agree with you. In some ways, I think Greenspan was shaped by his initial reaction to the stock market crash in 1987. He threw liquidity at the problem and it went away, or so it seemed. The banks became flush with money to lend, and they lent badly on real estate, which helped to drive the next crisis.Greenspan, having moved far from his earlier Ayn Rand-leanings, and his early devotion to the gold standard, became an inveterate policy tinkerer once in power. Do I blame him? A little; many of us do less well than we would have expected when more power comes into our hands. Greenspan is no exception there.But creating and responding to crises is not unique to Alan Greenspan. At the tight points of monetary policy, crises pop out. Here are a few more from Volcker’s term: Continental Illinois (1984), and third world debt (early 80s). There were other crises correlated with monetary policy before that, but the leverage wasn’t as high, unless you go back to the 1920s. By its very nature, tight monetary policy reveals the places in the economy that have insufficient financial flexibility. The question I have, is where that inflexibility exists today. none

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Well, here we are on the other side of the interest rate cycle.? Rates are not being tightened, but rather, they have been loosened to the point where they are irrelevant.? “Credit Easing” monopolizes liquidity for the favored markets that the Fed wants to heal, while other credit markets go begging.

Monetary policy is loose, and as I have stated before, loose monetary policy typically ends in some excess, whether that excess is goods price inflation, or asset inflation, or perhaps a currency panic, where foreign creditors conclude that they will not get paid back in anything near the terms that they expected when they originally lent.

So, what might be the end of this cycle?? Here are some possibilities:

A slow rise of interest rates in the US, as smaller foreign central banks decide that they have better opportunities elsewhere, and stop buying additional US dollar-denominated liabilities.
A major global war interrupts everything, disrupting global trade and capital flows, and forcing the US to largely self-fund its obligations, all the while spending more on defense.
Goods inflation runs, starting with commodity prices, as the rest of the world, excluding the US and Europe, heals faster.

There are many more variations on the scenarios here, but these give an idea of the forces that may undermine the current quietude.

Thirteen Aspects to our Current Economic Situation

Posted on 27 May 2009 by David Merkel

1) Last night I started out with the concept of a “housing mismatch.”? Today, with a hat tip to Calculated Risk, I can make my case better.? The low end of the market is humming, as new buyers come in.? Makes sense.? Who get the capital together for a downpayment?? New homebuyers for homes on the lower end.? But homeowners that want to upgrade are stuck, because the buying power of the equity of their current home has deflated.? Thus few upgrading buyers, and they are typically a large part of the housing scene.? Good article — helps point out why this cycle in residential real estate may have prices drop below equilibrium levels.? We are close to equilibrium now, but nowhere near reversing.

2) How should bank solvency be regulated?? If sticking with the existing model, the bank examiners must be more rigorous, and they should consider some stressful scenarios, such as we are experiencing now, or worse.? Perhaps a market-based solution would help, such as that which former Fed Governor Poole has proposed.

His objective is the toobig to fail institutions, but he says that all banks would have to issue subordinated debt.? This would be difficult to implement for small banks. Small issue sizes in the debt market are tough to place, and rolling over 1% each year makes the sizes smaller still. The sub debt would have to be at the operating bank subsidiaries, which are smaller than the holding companies.

I like the idea, though. Maybe a market would develop for small bank sub debt? maybe even funds specializing in it. The yields could be significant, and even protected to some degree, given the need to roll it over to stay operating.

That said, loss incidence might be infrequent, but loss severity and correlation would be high. That?s true of losses on unsecured financial debt generally, but it would be worse with sub debt.

This idea is not new, but it is worth a try. The financial analysis of banks by regulators who have little economic incentive to be right, and hampered by politics has not worked well. It would be replaced by profit-seeking analysts who do have an incentive in the health of the bank in question.

3) Given the fall in global trade, export-driven nations are getting hit hard.? Maybe that can help explain why Treasuries are selling off on the long end — aside from excess supply due to the humongous deficit, there is less need to recycle excess dollars by buying Treasuries.

4) Okay, I was wrong about the Indiana Pension System winning in the short run regarding secured Chrysler debt.? Given the time pressures, the suit was rejected.? Maybe they will win on appeal, but how that works out after the deal is done is messy.

5) GM bondholders have rejected a settlement, and so the company will likely go through chapter 11.? I do not get the large amount of financing that the US government is putting up.? What? Do they want to repeat the losses they will experience through AIG?

6) With the shrinkage in market capitalizations, the number of sell side analysts declines.? No surprise here.? The number of sell side analysts is proportional to the money that can be made by investment banks off of underwriting and trading.? As market capitalizations fall, so do revenues for investment banks.

7) Yesterday, I said that if California defaulted, we would face a constitutional crisis.? I still think that is true.? I ran across Felix’s thoughts on the matter today, though they are one month dated.? The upshot to me is that there are no ways of enforcing payment if a state won’t pay on their municipal debts.? This is a hole in the system, and one that could pinch many in the US, not just Californians.

8 ) Federal Reserve Transparency act of 2009?? Bring it on.? Yea, Ron Paul, one of the few economically literate memebers of Congress.? The Fed gets away with a lot because they aren’t purely private or public.? They use their dual status to hide — when it is more useful to be a government institution, they are that.? Vice versa, when being private allows the avoidance of FOIAs.

9) This is one long article.? How sunk are we regarding peak oil/hydrocarbons?? I have revised my estimates of oil production downward, and will buy more energy related stocks at my next rebalancing.

10) Though I am not a dollar bull, there is no easy replacement for the US Dollar on the global scene.? Euro, too experimental.? Yen, too small.? I have not advocated that the Chinese currency could replace the Dollar (as some have), because their economy would have to become far more open.? They aren’t willing to do that.

11) It’s tough being a corporate director. 😉 No, it’s altogether too easy, which leads to complacency.? Consider the situation at the banks, or at the FHLBs.? Years of leverage expansion, where the livin’ was easy, made them lazy, and unwilling to challenge their managements.? No surprise that their reasons for existence are being chalenged now.

12) Though Samuelson misses the point that trust fund exhaustion is not the trouble point, his article is a welcome addition to the discussion.? Time is not on the side of the social insurance programs of the US Government, but as I have stated, that trouble comes when revenues are less than expenses, because the trust funds, invested in Treasuries, are a farce.? The only way the US government can pay off on those is through taxation, borrowing, or inflation.

13) What are implied breakeven levels of inflation implying from TIPS?? That many people fear that inflation will run out of control, given the reckless actions of the Fed and the US Government.

Fifteen Notes on our Current Economic Situation

Posted on 26 May 2009 by David Merkel

1) I don’t think that residential real estate prices are turning in general.? But even if residential housing recovers, and demand returns, there will be a “housing mismatch.”? There will be too many high end homes relative to buyers.? Financing for high end homes is sparse, and too many expensive homes were built during the boom years.

2) Inflation.? What a debate.? In the short-run, deflationary pressures are favored, but what can you expect when so many dollar claims are being created by the Fed?? The output gap may indicate inflation is impossible, but stagflation is possible when monetary policy exceeds the need for dollar claims amid a collapsing economy, as in the 70s.

3) At the time, I suggested that the banks forced to take TARP funds had been coerced because the regulations could be lightly or tightly enforced.? Looks like that was true.? Why does this matter?? The TARP was supposed to be stigma-free because all major banks were taking it.? Coercion should make the government more lenient on payback terms.

4) I never did all that much with the cramdown that the Obama administration did with Chrysler secured creditors.? All that said:

George Will wrote a good piece on the ethics of the situation.
Subordination of secured claims does happen, but not typically with such loans as brought Chrysler out of Daimler.
One of the main parties fighting the case is not a “bunch of speculators,” but the Indiana State Pension funds.? I think they will win their case.

5) Can global trade patterns be changed to avoid the dollar?? Some are trying.? In the long run, if the US is only a capital importer, the US Dollar will lose its reserve status, and weaken considerably.

6) Union jobs are magic.? They provide these incredible benefits, but with one small problem: they kill the companies that are forced into them.? GM may be sold to the government, but unless the burden of total compensation being above productivity is lifted, there will be no substantive change.

7) Dilution.? I was never a fan of McClatchy, but this seals the story on the newspapers.? Sell equity interests cheaply, so that you can survive.? The same is happening with many banks, and it is forcing the share prices of the industry lower.

8 ) Commercial real esate is the final shoe to drop in our credit bust.? Prices are 20% below the peak.? Refinancing will prove tough.? There are no sectors in commercial real estate that are not overbuilt.

9) The PBGC is taking its share? of losses at present.? This is no surprise here, given all I wrote about the PBGC at RealMoney.? The losses on a market value basis are even greater, because firms with underfunded pensions are more likely to default.

10) Residential real estate has not stabilized yet.? The bottom will come after the resets on Alt-A lending.

11) Are there difficulties with lending in the farm belt?? To a greater degree than I expected, yes.

12) Will California survive?? We can only hope.? Given that there is no bankruptcy code for states, California could prompt a Constitutional crisis if it defaults.

13) Should the Fed regulate systemic risk?? Perhaps when it stops creating it.? My position was, and continues to be that the Fed has been incompetent with monetary policy, bringing us to where we are today.? We need to eliminate the Fed and its bureaucracy, which produces little value for the US.? Monetary policy could be conducted with a far smaller staff; it might even be better.? Remember, bureaucries hit economies of scale rather rapidly.? Small is beautiful with bureaucracies.

14) In the recent slowdown, there has been inventory decumulation.? Those at the end of the supply chain have been hit the hardest.? Welcome to the cyclical world when it has to slow down.? The tail always gets it the worst in a game of “crack-the-whip.”

15) Ending with inflation, John Hussmann makes the case that the current economic policy must result in inflation.? If you are reading this, John, given that we live in the same city, perhaps we could have lunch someday?

What is the Sound of One Hand Clapping? What is the Right Price when there is no Market?

Posted on 24 May 2009 by David Merkel

No, this isn’t another discussion of SFAS 157, though there are some similarities.? There has been a bit of a brouhaha over repayment of TARP options.? Isn’t the government getting shortchanged?

Maybe.? Maybe not.? This one is tough to answer, because at least as yet, there is no active market available for really long-dated call options.? Let me give you an example from my own experience.

I used to run a reasonably large options hedging program for a large writer of Equity Indexed Annuities [EIAs].? Much as I did not like the product, still I had to do my job faithfully, and when we were audited by a third party, they commended us having an efficient hedging program.

But here was our problem:? the EIAs lasted for ten years, but paid off in annual installments, based on average returns over each year.? Implied volatility might be low today, and the annual options that we purchased to hedge this year might be cheap, but the product had many years to go.? What if implied volatility rose dramatically, making future annual hedges so expensive that the company would lose a lot of money?

Maybe there could be another way.? What if we purchased the future hedges today?? A few problems with that:

We don’t know how much we need to purchase for the future — the amount needed varies with how much the prior options would finish in the money.
But the bigger problem is once you get outside of three years, the market for options, even on something as liquid as the S&P 500, is decidedly thin.? There’s a reason for that.? The longer-dated the option, the harder it is to hedge.? There are no natural sellers of long dated options, and relatively few Buffetts in the world who are willing to speculate, however intelligently, in selling long-dated options.

There is an odd ending to my story which is tangential to my point, but I may as well share it.? Eventually, the insurance company wanted to make more money, and felt they could do it by hiring an outside manager (a quality firm in my opinion — I liked the outside manager).? But then they told them not to do a total hedge, which was against the insurance regs, given their reserving practices.? Not hedging in full bit them hard, and they lost a lot of money.? Penny wise, pound foolish.

So what about the TARP options?? Did the US Government get taken to the cleaners on Old National Bank?? Is Linus Wilson correct in his allegations and calculations?? Or is jck at Alea correct to be a skeptic?

It all boils down to what the correct long term implied volatility assumption is.? Given that there is is no active market for long-dated implied volatility / long-dated options for something as liquid as the S&P 500, much less a mid-sized bank in southern Indiana, the exercise is problematic.

In quantitative finance, one of the dirty secrets is that common parameters like realized volatility and beta are not the same if calculated? over different intervals.? Also, past is not prologue; just because realized or implied volatility has been high/low does not mean it will remain so.? It tends to revert to mean.? With the S&P 500, implied volatility tends to move 20% of the distance between the current reading and the long term average each month.? That’s pretty strong mean reversion, though admittedly, noise is always stronger in the short run.

Let’s look at a few graphs:

Daily Volatility for ONB:

Or weekly:

or monthly:

or quarterly?

Here’s my quick summary: the longer the time period one chooses, the lower the volatility estimate gets.? Price changes tend to mean revert, so estimates of annualized realized volatility drop as the length of the period rises.? Here’s one more graphic:

I’m not sure I got everything exactly right here, but I did my best to estimate what volatility level would price out the options at the level that the US government bought them.? I had several assumptions more conservative than Mr. Wilson:

In place of a low T-bill rate for the risk-free rate, I used the 10-year Treasury yield.? (Which isn’t conservative enough, I should have used the Feb-19 zero coupon strip, at a yield of 3.79%.)
I set dividends at their current level, and assumed they would increase at 5% per year.
I modeled in the dilution from warrant issuance.

But I was more liberal in one area.? I assumed that ONB would do an equity issuance sufficient to cut the warrants in half.? If the warrants were outstanding, the incentive to raise the capital would be compelling, and it would get done.

The result of my calculation implied that a 21% implied volatility assumption would justify the purchase price of the warrants.? That’s nice, but what’s the right assumption?

There is no right assumption.? Short-frequency estimates are much higher, even assuming mean reversion.? Longer frequency estimates are higher if one takes the present reading, but lower if one looks at the average reading .? After all, Old National is a boring southern Indiana bank.? This is not a growth business.? If it survives, growth will be modest, and the same for price appreciation.

The Solution

It would be a lot better for the US Treasury to get itself out of the warrant pricing business, and into the auction business, where it can be a neutral third party.? Let them auction off their warrants to the highest bidder, allowing banks to bid on their own warrants.? I’ll give the Treasury a tweak that will make them more money: give the warrants to the winning bidder at the second place price.

By now you are telling me that I am nuts — giving it to the winner at the second place price will reduce proceeds, not increase them.? Wrong!? We tell the bidders that we want aggressive bids, and that they will get some of it back if they win.? I’ve done it many times before — it makes them overbid.

So, with no market for these warrants, I am suggesting that the Treasury creates their own market for the warrants in order to realize fair value.? Is it more work?? Yeah, you bet it is more work, but it will realize better value, and indeed, it will be more fair.

Book Review: Financial Shock

Posted on 22 May 2009 by David Merkel

Note to readers: for this review, I read the first chapter, and skimmed the rest of the book. (full disclosure)? I usually read the entirety of every book I review, but I did not this time.? Why?? Chapter 1 is the backbone of the book, and tells the whole story in a nutshell.? The remaining chapters flesh out Chapter 1.? Most of my writings over the past five years shadow what Mr. Zandi has written, and he has created an integrated description that covers every major area of the crisis, with particular attention to mortgages, and the huge effect that the speculative mania in real estate had on the financial economy.

This is a serious book, one that explains the roots of our crisis.? If you haven’t understood it in a systematic way from reading my blog, or those that I recommend, this book will give you a coherent explanation of how we got here.

I do have some quibbles with the book.? When he describes residential mortgage securitization on page 117, the mezzanine and subordinated tranches are too large, even for subprime.? Also, his recommendations in the last chapter — I can agree with most of them, but not with mark-to-market, and the uptick rule.

This edition of the book takes us up to the first quarter of 2009, allowing Zandi to comment on the initial actions of the Obama administration.

All in all a very good book.? If you have a relative that doesn’t understand the crisis, this will explain it to him in a simple way.? If you want to buy it, you can buy it here:

Financial Shock (Updated Edition), (Paperback): Global Panic and Government Bailouts–How We Got Here and What Must Be Done to Fix It

As with all of my reviews, if you buy something through Amazon after entering through my site, I get a small commission, and you don’t pay anything more.? Don’t buy anything that you don’t want to buy on my account, though.

One Dozen More Notes on the Economic Scene

Posted on 20 May 200920 May 2009 by David Merkel

1) I may as well start out the evening with some predictions. I’m not an expert on this, but Chapter 9 of the bankruptcy code applies to municipalities, but not states. Given the problems with state & municipal pensions, we will probably see chapter 9 modified over the next two decades to allows states to default. There will also be some modification to retirement funding laws as applied to municipalities, states, and maybe the US Government, to allow for retroactive negotiation of pensions and healthcare benefits for an insolvent government.

2) California will lead the parade of states in trouble.? They want the US to guarantee their municipal debt.? Schwartzenegger did all he could to try to pass the referenda that might partially close the budget gap, but from what I see now, it looks like most of the important ones have failed.? Having been a California resident for seven years, I went though my share of referenda; the referendum process makes the politicians of California lazy… they pass the tough stuff off to the electorate, who then get to decide off of voters’ guides and soundbites.

3) California is an exaggerated version of the troubles that other states are having.? Social program spending rises, while taxes on wages, corporate profits, real estate, real estate transfers, etc., all fall.? If you can’t print your own money, and must balance your budget, life is tough, kind of like it is for most Americans.

4) Another municipal issue — can financial guarantors split in two?? I have argued “no,” but who cares what I think?? We do care about those that use the courts, and banks are suing to prevent the MBIA split.? It is a simple issue of fraudulent conveyance.

5) One last municipal issue: pension placement agents.? This is very similar to what I experienced in Pennsylvania regarding municipal pensions there.? Pension consultants would gain business through campaign contributions, and the Democratic and Republican consultants would collaborate and share to control the profits jointly.? Insurance companies providing pension services would pay? compensation to the consultants in exchange for business.? It’s a dirty business, and when I raised ethical objections to it, I was told that I was naive.? Perhaps I have more company now.

Anytime you have opaqueness of compensation, politics, and uncertainty of results (investing), there is always room for corruption.

6) Asset allocation.? The belief in a large equity premium led many to overweight stocks.? I have argued against that.? Now there are many who are finding the they have to start over, after bad equity returns.? There is no magic in any asset class.? Yes, equities do better than bonds in the long run, but only by 1-2%/yr, not 5-7%.

As for the arguments of Ayres and Nalebuff, only the most emotionally dead investors can live with levering up 1.9 times perpetually.? Most people panic.? They can barely deal with the volatility of the S&P 500, much less double that.

7) Mmmm… is it time to take on Bill Miller again?? Yeh.? Overweighting financial stocks?? That is quite a bet, and probably irresponsible again.? Here is my free advice — analyze your estimates of intrinsic value with commercial real estate prices 30% lower than today.? Aside from short-tail insurers, I don’t think you want to be overweight financials.

8 ) On the same note, many small and intermediate-sized banks face troubles under stress, particularly from commercial real estate lending.

9) I think we are in the second inning for declines in prices for commercial real estate, but perhaps the seventh inning for residential real estate.? So long as residential properties sell for less than their mortgages there is downward pressure on prices, because negative events lead to foreclosures, not sales.

10) How will derivatives be regulated?? That is the question.? Will it be as transparent as TRACE?? I doubt it.? The market is not that liquid.

11) Will the US Government likely get full value back on TARP buyouts? No, because they lack expertise at analyzing these situations.? They don’t know what a warrant is worth.

12) Will low-rate mortgages rescue the economy?? No, but many middle class people with equity will breathe easier after they refinance.? Also, some will buy homes, but who will have the downpayment necessary to qualify now that underwriting has tightened?? Not many.

So What?s a Year Worth? (2)

Posted on 19 May 200919 May 2009 by David Merkel

This completes the piece I wrote last week on the entitlements crisis.? Look at the following graph and table.

Those are trillions of dollars that we are looking at, and a 14% growth rate over the last eight years, significantly outpacing GDP growth.? Why did I not like Bush Jr., and why is Obama likely worse?? There is no concern for the long run effects of current policies.? Does it matter that current policy is unsustainable?? This does not count in state defined benefit pension plans and retiree healthcare.? Even without that, the deficit on an accrual basis is 3.5x GDP.? Another way to think of this is that we are at least ten years behind in tax collections.

We are viewing the slow failure of the US Government.? It may not be for years or decades, but the lack of willingness of the current administration to address the growing shortfall shows that they are more similar? to the Bush, Jr., administration, than different from it.? After all, who ran the biggest deficits?? Obama, by a long shot.

Selling Hartford, Buying Canadian National

Posted on 16 May 2009 by David Merkel

Since the last time I wrote about my portfolio, things have been volatile.? Here are my actions since then:

New Buys

National Western Life Insurance
Canadian National Railway

New Sells — Hartford Financial

Rebalancing Buys:

Assurant (brnging it up to a double-weight)
Dorel Industries

Rebalancing Sells:

Allstate (2)
Assurant
Companhia De Saneamento Basico
General Dynamics Crp
Genuine Parts
Hartford Finl Svcs Group Inc (3)
Industrias Bachoco SA (2)
Ishares Inc MSCI Brazil Index Fund
Noble Corporation
Safety Ins Group Inc
Shoe Carnival Inc
Vishay Intertech Inc (3)

Comments

After the plunge, and the run, I scaled out of Hartford three times, and then sold because of the high odds that they will take the TARP money.? Taking TARP money has led to underperformance in the past, and though it looks like cheap capital, it can be a very expensive set of handcuffs to cut off.

If Allstate takes the TARP money, I will sell them as well, and buy a certain P&C reinsurer.? I suspect that they won’t take it — only the desperate take TARP money.

I replaced Hartford with National Western Life.? Little company, and illiquid.? If you follow me here, limit orders only.? It is a basic life an annuity company.? No debt.? Trades for half of book value.? Currently profitable, but future profits are uncertain.? One controlling investor, R. L. Moody, and the rest of the shareholder’s list reads like a “Who’s Who” of small cap value investing.? I have not reviewed the accounting in detail, but when I reviewed it in detail six years ago, I thought the accounting was more conservative than most insurance companies.

With all of the cash building up from rebalancing sales, I needed to add another name with a strong balance sheet.? I chose Canadian National.? Unlike US railroads, they go coast-to-coast — less need for loading and unloading.? Second, the valuation is not much higher than peers.? Third, the balance sheet is stronger than all peers.? Not that I think that any of the major North American railroads is at risk of failure, but it is unlikely that Canadian National will come under significant stress.

That’s all for now.? So far, it’s been a good year for me.? I’m running with cash at my upper 20% limit, so I am looking for safe and cheap ideas that would not get hit that badly in another pullback.

Full disclosure: long NWLI CNI DIIB.PK? AIZ ALL SBS GD GPC IBA EWZ NE SAFT SCVL VSH

Book Review: Street Fighters

Posted on 16 May 200916 May 2009 by David Merkel

This week, amid everything else I was doing, I read the entirety of the newly released book, “Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street,”? written by Kate Kelly, Wall Street Journal reporter who covered Securities firms like Bear Stearns, and wrote three major articles as it declined.

Here is how the book works: it takes you from Thursday evening to Sunday evening during the crisis.? When a new topic or person is brought in in an important way, Kate Kelly does a flashback to give readers the needed background.? It detracts from the urgency of the rest of the story, but does flesh out how Bear Stearns came to this ugly situation.

Culture matters in an organization.? A well-run organization, such as existed under Ace Greenberg developed pride in the organization, because it worked so well.? But pride, once engendered, is a fickle mistress.? Under James Cayne, once he stopped checking the details, and even major issues like exposure to the mortgage markets, pride was destructive.? Alan Schwartz believed that Bear Stearns was a great institution, and it blinded him regarding raising capital.? They couldn’t need additional liquidity, until it was too late to raise it.

Kate Kelly interviewed many people extensively for her book, and includes footnotes where parties don’t agree with her renderings.? She does make? the? last 72 hours live, with all of the uncertainty and fear of the situation.? I liked the book, and would recommend it.? That said, there are other books out on Bear Stearns, and I have not read them.

It’s a Small World After All

Now, what are the odds that a kid I used to stand with at the bus stop to go to kindergarten would end up in this book that I am reviewing?? To an actuary, it boggles the mind.? There is a “bit player” who appears twice in the book, my old friend Pat Lewis.? He lived three doors down from me, and was the popular, tall athlete, while I was a short nerd who tried my best in athletics.? We were both long distance runners, but he was my better by far.

After many years, I came back into contact with him in 2000 or so, when he had gotten a job in risk control at Bear Stearns.? I met him for lunch during an actuarial conference in midtown Manhattan — what a place to meet for two guys from the Milwaukee suburbs.? We caught up on each other lives and careers.? Me, married with seven children (then — eventually eight) — he, unmarried, but still more handsome than me.? Both of us are risk managers — he at Bear, me at F&G Life.? As the book records, Pat and those working with him try to create mathematical models that will highlight the risks of Bear.? James Cayne, not understanding the value of them, kills the project.

There are other references to him in the book, but this is a tale where those more powerful would not listen to reason.? Pat Lewis is a standup guy, and stated what he believed, even when things were chaotic.

Lessons

Though the book gives its own set of lessons, I want to give a few of my own.

Love beats fear… we need friends

Bear might have felt like a big swinging dick after LTCM, where they stiffed the rest of the securities industry by refusing to pony up capital, but that cemented the view of the rest of the industry: Bear was not a team player.? That cost them when their disaster hit.? My conclusion: love beats arrogance in the long run.? Better to have friends than to suffer alone.

Don’t take your eye off the ball

Cayne clearly took his eye off the ball thinking that the business would do fine without close attention — he could go off and play bridge and smoke pot.? Inattention destroys businesses.

Risk control wins in the long run.

Cayne ignored risk control.? He was happy with a high ROE, and did not look closely to see how it was generated.

Liquidity is lifeblood — consider the BONY box.

Goldman is the only securities firm to come through this crisis almost unscathed.? Rather than pressing it to the limit, they would add assets during good times to the BONY box.? That is, they would save safe assets to protect themselves in the long run.? What a wise strategy.? No wonder that they run our government.

Summary

This is a good book that deserves to be read by those that want a clear view of how Bear Stearns went down.? It is engaging and informative.

As For Me

Here are some posts that I wrote during the crises:

If you want to buy the book you can buy it through the link in my leftbar. ?? Or, you can buy it here:

Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street

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So What’s a Year Worth?

Posted on 14 May 2009 by David Merkel

When I heard the announcement on Tuesday about Social Security and Medicare, I emoted something between a grin and a grimace, and said, “A pity that I have been right on this.”? I’ve always felt that Social Security and Medicare? have had optimistic economic assumptions.? It does not surprise me that the year that Social Security revenues are exceeded by expenses has moved in by one year, from 2017 to 2016.? Medicare, we are already exceeding revenues in 2008 and now.

Many focus on when the trust funds will run out — now 2017 for Medicare, and 2037 for Social Security.? Consider this, the trust funds are invested in nonmarketable US Treasury Notes.? That’s safe, right?? Safe, yes, as safe as the US government.? They will pay with the dollars that they print via their stepchild, the Fed.

This is my advice to all who read me.? Given that these social insurance programs invest only in US government debt, on an accounting basis, it makes sense to unify their balance sheets with that of the US government.? Once we unify the balance sheets, it is easy to realize that the negative consequences will come when expenses exceed revenues, not when the funds go to zero. When expenses exceed revenues, the US government will either need to tax or borrow more in order to make ends meet.? The US Government bonds held are a convenient accounting fiction to show that the taxes paid have been spent for other purposes.? There are no “Trust Funds,” only nonmarketable bit of US debt, that will get repaid through higher taxes, or further borrowings.? China and OPEC, ready to fund US retirements in style? 😉

As for the economic assumptions that Social Security uses, I think they are still optimistic.? One thing I have learned about cash flow modeling is that though the averages matter, the early years matter the most.? There is more time for their results to compound with interest.

We could have two more bad years (flat/down GDP on average), and then face the total system revenue breakeven in 2013.? Even if their assumptions prove correct, total system breakeven will come in 2014-2015.

And the markets will react ahead of that, because it will be so well known.? The need for tax revenues will be significant, and more so as we proceed into the 2020s.? This will lead to the need for solutions — with Medicare, much sooner than Social Security.

Medicare

Possible solutions (and their liabilities):

Nationalize the healthcare system and Medicare goes away.? (Medicare is solved, at the expense of creating a bigger problem.? Other cultures may fit nationalized healthcare, but American will chafe at it.)
Create a second parallel healthcare reimursement system that only serves Medicare clients with limited services to those that are terminally ill.? Ease the pain, but nothing radical and expensive.? (I like this one, so it can’t be a good idea.)
Raise taxes.? (lower the reasons to employ labor)
Raise eligibility ages, and quickly. (Listen to the screams.)
Lower reimbursement rates. (Also won’t work because fewer doctors will do Medicare medicine… and quality drops as well.)
Mandate that doctors must take Medicare clients at Medicare rates.? (Nasty.? But once rights of contract get violated in one place, they get violated in others.)
Eliminate plan D, the drug prescription benefit.? It’s young and too complicated, so just kill it.
Means-test eligibility for reimbursement.? (It would lose political legitimacy.)
Terminate the system, such that children born after 1/1/2010 don’t pay in, and would not receive benefits. (Doesn’t really solve the funding problem, unless mixed with some of the above.)

Social Security

Possible solutions (and their liabilities):

Means-test eligibility for reimbursement.? (It would lose political legitimacy.)
Raise taxes.? (lower the reasons to employ labor)
Raise eligibility ages, and quickly. (Listen to the screams.)
Lower benefit payments. (More screams.)
Remove the cost of living adjustments, and inflate the currency.? (At least this rates the problem back to the Baby Boomers, who would get hurt the worst over this… a generation that failed to save and produce enough kids.)
Terminate the system, such that children born after 1/1/2010 don’t pay in, and would not receive benefits. (Doesn’t really solve the funding problem, unless mixed with someof the above.)

“I’ll Gladly Pay You Tuesday for a Hamburger Today.”

The nature of the US government, the lower Federal governments, many of its corporations, and some of its people has been to promise/borrow today, and pay it off later, because tomorrow will be, much, much, better than today.? With the the debt overhang and the looming pension crises, we are beginning to see that much American prosperity was a debt-fueled illusion.? We are presently in stage 1 of dealing with the grief of this shattered illusion — denial.

If the Federal Social Insurance schemes (Social Security, Medicare, Veterans Pensions, Old Federal Employee Pensions) and most State Pensions and Elderly Medical Care are going to pay off, taxes will have to be raised significantly.? That will be one nasty political fight, which might result in the death of certain sacrosanct laws governing the inviolability of pension promises to state employees, and perhaps Federal employees.? Also note, you can raise tax rates, but if it harms the economy, you will get less taxes.

The Federal Government will try to borrow its way out of the problem, until foreign creditors finally rebel, realizing they are throwing good money after bad.? After that, taxes will have to be raised, or promises abandoned/reduced.

For underfunded private defined benefit and retiree healthcare plans, they will likely be terminated, and lesser benefits paid.? All three of the legs of the modern retirement tripod (social insurance, savings, and pensions) are under threat as the era of debt deflation progresses.

Now, realize that though I talk about the US, most of the rest of the developed world is in worse shape as the demographic crisis affects pensions and elderly healthcare globally — they had even fewer kids than in the US, which is close to replacement rate, and so the ratio of workers to those supported will fall even more than in the US, setting up many nasty political fights — all the more nasty, because the governments are much more heavily involved already.? Don’t even think about China, which will come to regret the one child policy that led to so many abortions, and so many beautiful Chinese girls coming to the US to be adopted.

So What’s a Year Worth?

A year can teach us a lot.? 2008 showed us the limitations of our economy.? Future years will show us the limitations of the power of our governments.? Conditions for prosperity can be created, but prosperity can never created by governments.? That is up to the culture of those governed.

This has gotten a bit long, so I will do a follow-up piece within a few days.? Here are a few good articles to consider: