Public Policy – Page 82 – The Aleph Blog

Ancient and Modern: The Retirement Tripod

Posted on 16 April 2009 by David Merkel

Note to readers — I have fallen behind.? Sigh.? I want to write more, but business, church and friends dig into my time.? My apologies for not having written much recently.? Does it help that I may have saved organizations/businesses in the process? 😉

I have always viewed the modern retirement tripod with skepticism.? What makes modern man so different from his ancient great-great-grandfathers?? There are a few things:

We live longer.? Most of this is due to improvements in sanitation and nutrition, and some of it due to health care improvements, particularly with the young and the old.
We marry less frequently (not counting marriages after divorce), and have fewer children in marriage.? That said, a greater percentage of children survive to adulthood, balancing out the fewer children.? (Note: this might be true in the US, but not in Europe and Japan.)
The government is a larger factor in the economy.? Say what you will about democracy, it tends to produce a bigger government than the old days of having Kings.
Currency debasement is easier.? The treasury of the King no longer has to file and clip coins in order to steal value from the masses; now it can be done by computer.
Global trade is a much larger portion of total economic activity than ever.? If the global division of labor breaks down through trade wars, it could get really ugly, especially for deficit nations like the US.

But what is similar?

Those that are old and cannot work largely rely on those that can work to survive.? Perhaps they greet at WalMart today — it’s not much different from watching the little ones while everyone else is out in the fields.
The pressure to produce and save during the most productive years is still there, with the tension that exists in the middle years between producing, training children to become productive, and caring for the elderly.
With saving, there is the question of what will produce value over the long run.? In ancient times, land or an animal could be useful.? Today, stocks and bonds… there are no guarantees.
When times are good, everyone benefits.? Vice-versa when things are bad.? The boom-bust cycle is a constant in human affairs.

The modern retirement tripod is Social Security, pensions, and private savings.? Let’s call it government prudence, employer prudence, and personal prudence.? Given the shift from defined benefit to defined contribution plans, even pensions boil down for many to personal prudence.

What of government prudence?? The US government is running huge deficits at a time that it should be retiring debt (or even saving) to enable it to meet the promises made for Medicare and Social Security.? There is no prudence here, only politicians playing for advantage in the short run.

Personal prudence?? Well, we are saving now in the US, but only out of fear.? The US has always been a debtor-friendly place.? Perhaps 5% of the US has truly prepared for retirement, given the faulty assumption that portfolios can grow much faster than nominal GDP growth plus 2%.? Ask your financial planner to run his asset earnings projections at 6%, with inflation at 4%.? If you can retire on that assumption, you are in decent shape.

Corporate prudence?? Corporations have been terminating defined benefit plans (as I predicted 15 years ago) because they can’t afford them.? Now, blame the IRS for a large part of this, because they didn’t let companies prefund in the good years, because? it cut down on their tax take.? That said, many corporations could have made contributions, but did not, because it would have hurt earnings.

Okay, so we haven’t been very prudent.? What’s the alternative?? The alternative is the ancient retirement tripod: continued work at a slower pace, help from children, and savings/assets.

The only commonality is the savings/assets component.? The types of assets vary, but the idea is the same — what can produce income annually.

Continued work at a slower pace is? a good thing for many people.? Not only does it give them money; it gives them a purpose in life.? Older people are often more thoughtful than younger people, and are willing to spend more time on customer problems.? There is real value in being connected to the current problems of the day, rather than the idleness of “retirement.”

Children are problematic.? Some succeed, some don’t.? Some are loyal; some aren’t.? In general in the US, we encourage individualism, not loyalty to parents.? That makes any aid in old age problematic; the consumer ethic is selfish, versus an ethic that cares for those that have cared for you.? All that said, those with more children are likely to do better, even if it is only that you will have advocates in old age.? Health care systems can be cruel to old folks that have no one watching out for them.

What if we go through an era where government systems fail, and people? must rely on local resources?? I suspect that will happen; there is no way that the US can support its obligations in current purchasing power terms.

Those with strong social arrangements (often, loyal children) will survive well, as will those that have saved/invested well.? Additional help will come from continued work — personally, I hope to be doing investments until I die and go to be with Jesus.? But work is a benefit to anyone; it connects us with the realities of our world.

A final note, and one that is slightly controversial: you can tell that I favor the ancient retirement tripod.? But why?? The modern tripod stemmed from an unusual demographic bulge which made it easy for oldsters to ride on the backs of the Baby Boomers.? The Baby Boomers will have no such help.

Here’s my easy prescription: raise the retirement age to 75.? Now.? Shatter the idea that in old age you can have an easy time of it, while one is still relatively healthy.? Instill an idea that says work is valuable, and those that do not work are sponging of of society.

In a time where government intervention is growing, it is all the more important to tell people that they can’t rely on the government.? The government is broke.? So will be those that exclusively rely on it.

Not All Bubbles Lead to Depressions

Posted on 7 April 2009 by David Merkel

I enjoyed the opinion piece in yesterday’s WSJ, From Bubble to Depression? I want to clear up a few of their misconceptions.? Key quote:

Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

They almost get it in their later paragraphs, but the answer is simple.? In the first “crash,” the losses were mainly equity-based, so there were no knock-on effects on other entities.? No additional dominoes fell.? With housing in the late 2000s, a loss of $3 billion happened on assets that were usually levered with debt at 5x to 30x, probably averaging 10x.? And, these mortgages were held by leveraged banks that had borrowed in many other places in the overall financial system, and sometimes by even more leveraged speculators using CDOs.

Let me say it again — Bubbles are financing phenomena; depressions are financing phenomena.? They are opposite sides of the same coin.? The severity of bubbles differs with the amount of debt employed and the pervasiveness of the sectors of the economy affected.? The tech bubble did not have much debt, and it was contained.? The real estate bubble was the opposite.

The thing is, the amount of debt we have racked up as a fraction of GDP exceeds that of the Great Depression.? My view is that many debts will have to be liquidated before the US economy grows robustly again, whether through payoff, compromise or inflation.

Now, we had Michael Mayo today offering his opinions on the banks, (two, three) which are not all that much different than mine.? In an era of debt deflation, coming off record debt-to-GDP ratios, it is next to impossible for the US Government to make any significant difference against the deflation.? Better not to try at all.? An action big enough for the US Government to absorb the necessary amount of bad debt will kill the Dollar.

This last bubble has led to a depression, because of the debts incurred.? We must liquidate debts, but in the process, the economy will suffer.? I’m sorry, I like prosperity too, but there is no way out of this period of debt liquidation.? Just as the period of debt growth pushed asset prices up, so the period of debt deflation will push asset prices down.

My advice?? Avoid almost all banks, and other financial companies sensitive to the stock market or real estate, in terms of both equity and bond investments.

Replace the Car or Repair It?

Posted on 4 April 20095 April 2009 by David Merkel

It is a tough practical decision — when do you replace a car versus repairing it?? There isn’t an easy answer, but the intelligent way to approach it is to estimate the present value of the cost of continually repairing the old car versus the cost of buying a new one, net of the sales proceeds of the old car.

It’s a tough decision, with many squishy variables.? Nonetheless, it is the right way to frame the question.? It is also the right paradigm for a number of other questions.

When will the US give up on bailing out AIG (or any other firm)?
When will the US Government default, or decide to inflate massively?
When will China and the Arabs decide that “sunk costs are sunk” and abandon the US and the US Dollar?

After investing in an investment that proves to be bad, the question crops up, “Should I buy more?? If I liked it at 25, don’t I love it at 15?”? The same thing with govenment decisions, except that they are writ larger.

Eventually, there is a tipping point where the investor realizes that things are so bad, that it is better not to invest any more, because it would be throwing good money after bad.? Replace the car, repairing it will cost too much.

In this uncertain environment, that is what we are facing now:

What will the US do with marginal firms?? AIG or Lehman treatment?…
When would the US give up on issuing more debt?
When will foreigners give up on buying US debt?

None of these are necessarily second quarter 2009 issues.? Neither is a car replacement; I can just repair it for now.

My advice is to start thing ahead, and ask when parties that you rely on are likely abandon ship.? Then change your investment processes to avoid the likely path of disaster.? This is messy, but it is the best way to operate.

The Bonus Canard in Financials

Posted on 4 April 2009 by David Merkel

It was 2000 when I received my first significant bonus check working for a financial company as part of an investment department.? Now don’t get me wrong, as an investment actuary at prior firms, I took on complex projects that no one else could do, and I did them not for any bonus that I might receive, but just to do my best.? My bonuses were maybe 3-5% of my pay, and I was happy with them.? That the NPV I created for the company was 5,000x that did not bother me.? I work to do my best.? I have turned down higher paying jobs that would hurt my family, but I love intellectual challenges, whatever they pay.? (I tell this story in greater detail to younger people in investments, in order to show them that we do our work to do our best, regardless of the compensation.)

Now, in 2000, when my boss gave me the check, I looked at it and thought there must be an error.? He told me that he was very happy with my work, and that we had all hit the top of the scale in our bonus formulas.? He told me to invest it wisely.? (How I invested it is another story, and one worth telling later.)? I thanked him, and then called my wife, telling her that I had a check for 105% of my salary.? We were amazed.

I didn’t get it, so I went back to my boss several days later, and asked him why the bonus was so large.? We had a good relationship, and at the time, I didn’t realize that I was slowly becoming his main assistant.? He told me, “The St. Paul wants its investment managers to focus on safety, not short-term returns.? But they compete for investment talent among other investment firm that do swing for the fences.? They want smart people, but they don’t want them to take undue risks.? That’s why they make the bonuses easy to get, unless we lose a lot of money.”

That made sense, but it made me think that my real pay was double what I signed up for.? Wow.? I did not realize what a good deal I had.? Double my pay to make money for the company, but keep it safe.? That’s a challenge I could love.

When we merged into another firm that had the opposite philosophy, my pay went up, but my bonus went down in percentage terms.? I would make more money if I took more risk, but I maintained the same behavior, because I serve a higher power than money.

At my next firm, my bonus was not predictable.? Whether I did well or badly, I could not figure out how I would receive a bonus.

My main point here is that there is no one correct bonus formula.? We can bonus for performance and/or safety, over short and/or longer horizons.? It is easy politically to criticize the bonuses at AIG, because why whould a losing firm give bonuses, but perhaps employees did the right thing in their area of the company, while other areas failed.? Some reward should come to those that did it well.

Legal Complexities as the Automakers Restructure

Posted on 1 April 2009 by David Merkel

When I became a corporate bond manager in 2001, one of the first things I began to do was sell away all of my automaker bonds.? A big bet I knew, even though I was a neophyte, but I thought it was the right thing to do.? I reduced my exposure from $100 million to $10 million.? ( I could not get a decent bid for bonds from Ford’s Dutch subsidiary.)? My view was that their fixed cost structures were too high, and they would lose to lower cost automakers.

In writing for RealMoney, I always took the tack of selling the automakers’ stocks.? I made an exception for their securitized auto loan receiveables, which had me on the other side of Cramer.? I always try to draw distinctions for what constitutes reasonable investments with respect to equities or debt; the question is not always the same.? But with the automakers, the distinction was somewhat moot, so I encouraged readers to sell all unsecured debts of the automakers maturing in less than three years.

Now, we are nearing the endgame, where GM and Chrysler stocks go to zero, and Ford may as well, as it comes under knock-on stress.

But is it Legal?

I am dismayed at the enthusiasm that many display for giving the US Treasury draconian powers, allowing them to effectively destroy contract law.? I don’t care if the Treasury saves the economy or not, what will our society be like when it is done?? I have already laid out a simpler proposal where change is incremental, Add a New Chapter to the Bankruptcy Code, which leaves most of the powers in the hands of the courts.

We don’t need to get it done quickly, if the government added a “too big to fail” section to the bankruptcy code.? Obligations would be honored, and the courts could sort through an equitable division of the property, or cram it down, if agreement is not rapidly reached.

Even if Congress passes a law allowing the Treasury Department to have incredible discretion in reorganizing financial companies, that does not mean that the actions are exempt from judicial review.? The Supreme Court could rule that the infringement on the rights of bondholders constitute an illegal “taking.”? I’m no lawyer, so I write this with some trepidation.

My main point is that the US government does not have the power to eliminate the basics of contract law, without making the government itself lose legitimacy.? Contract law is basic to all civilized societies, and is a major component of the wealth, which relies on stability.

Beyond that, any plan that creates a good company / bad company should be doomed, because it essentially becomes government sponsored fraudulent conveyance, where valuable assets that the bondholders were relying on disappear.

Don’t get me wrong, I think the bondholders should take a sizable hit here.? I just believe that the result should come through the courts, not through the US Treasury.? The courts do well at this sort of thing.

It is dangerous to tamper with contract law in such ways.? Bond financing for other entities that are anywhere near the bankruptcy cliff will dry up, pushing other firms into insolvency.? The Treasury could well save some firms through these powers, should they get them, but at a cost of destroying many others.

The rush should not be this big.? Let the government temporarily be a DIP-lender to “too big to fail” firms, but then let the court handle it.? They were designed for questions of equity, and they have worked well at that for several centuries.? Discretion on the part of bureaucrats at the Treasury will be far less competent (as we have seen so far) and far less fair (ditto).

Of Course not at Par; That’s Par for the Course

Posted on 31 March 2009 by David Merkel

There are several truths well-known to educated investors that have been glossed over in all of the discussions of mark-to-market accounting, or SFAS 157.? (Really SFAS 133, but SFAS 157 clarified it.)

Accounting rules have little impact on stock prices.? Almost every academic study on accounting rules supports that idea.? Why?? Investors attempt to estimate the stream of free cash flows that an asset will throw off.? Accounting rules can help or hinder that.? Because SFAS 157 attempts to calculate a present value of cash flows for level 2 and 3 assets, it aids in that estimation.
Parties involved confuse regulatory with financial accounting.? Mainly due to the laziness of financial corporations in the boom phase of our markets, they looked to minimize effort, and make the accounting the same for regulatory and financial purposes.? This was foolish, because there is no one accounting method that is ultimate.? Every financial statement answers one main question.? For GAAP, the balance sheet asks “What is the net worth?”? Regulatory accounting would ask “Is net worth positive under conditions of moderate stress, including the possibility that markets go illiquid, and we have to rely on cash flows to pay off the liabilities?”
There are always two ways to do accounting.? You can do mark-to-market, or you can do book value accounting with impairment.? Darkness encourages skepticism.? In a period where there are few credit risks, book value? accounting will be well-received.? In an era where credit risks are significant, book value accounting will be no help, investors will distrust book value, and the effect might be less than where fair value estimates are provided. ? Regardless, the cash flows will still flow.
Equity-like investments deserve equity-like accounting.? They should be market to market, as equities are.? With derivatives, this is the reason that we mark them to market, their values are so variable.? So we should mark speculative mortgage investments: estimate the future cash flows, and discount them at a high, but not equity-like interest rate.
But what of assets that are seemingly money good, but the few trades that have happened indicate a value at 60% of par, possibly because of The Bane of Broken Balance Sheets, or Time Horizon Compression.? Here’s the problem: we have a lot of people alleging that those values can’t be right.? Let them stand up and start buying to prove it all wrong.? Part with precious liquidity to gain uncertain yield.? It is quite possible that we are in a depression, and as such, there are too many assets relative to the ability to fund them — asset values must fall.? Don’t immediately assume that the few trades in the market are ridiculous because they are lower than your current marks.
Some argue that there is an inconsistency between loans and bonds.? Bonds get marked to market, while loans are marked at book.? There is no inconsistency.? The loans are held to maturity, unless sold.? The bonds could be held to maturity as well, in which case they are at book value, and only changed if there is a need for a writedown, the same as the loans.? Most companies have not chosen that option, largely because they want the right to sell assets if they want to.? But that locks in their accounting; if they want the ability to sell, they must accept balance sheet volatility.
We have to differentiate SFAS 157 from misapplications of SFAS 157, which might be driven by the auditors.? SFAS 157 does not mean last trade.? In thin markets, companies are free to use discounted cash flow and other analyses to estimate fair value.
Now all of this said, practically, SFAS 157 leads to overestimating the value of assets.? In the consulting work I have done, companies are not willing to mark their volatile assets down to levels near their fair value, much less last trade, which is worse.? They are hoping for some huge return of risk-taking to appear, and revalue their assets. What if present conditions persist for five to ten years, where there are too many debts relative to the wilingness to fund them, as in the Great Depression?? In that situation, SFAS 157 would prove to be too flexible, with banks marking assets higher than warranted.

The anti-SFAS 157 arguments rely on an assumption that things aren’t so bad — that mean-reversion is right around the corner.? We are in a situation where marginal cash flows to purchase dud assets aren’t there.? Mean reversion is a long way off, and the valuations of financial assets reflect that consistently.? Try selling a bunch of whole loans held at par.? See what the offers are.? Why aren’t banks doing that to raise liquidity?? Because the prices don’t justify it.

You can’t fight cash flows.? Accounting exists to partition cash flows into periods, so that analysis of businesses can be done, and debt financing can be secured.? In the end, cash flows win out, regardless of the accounting methods.

Thus my opinion: SFAS 157 is a good standard, and I am no fan of the FASB generally.? There are misapplications of SFAS 157, forced by auditors, I believe.? SFAS 157 already offers decent flexibility to management teams — let them use that flexibility, but no more.? After that, let the regulators set their own solvency rules.

-==-=-=–==–=-=-=-==–=-==-=-=-

PS — What foes of SFAS 157 are unwilling to admit, is that lenders lent money near the peak of an amazing bull market, and now the collateral values lent against are far less than imagined at the time of lending.

It’s like the FRAM oil filter ad — “you can pay me now or pay me later.”? There is a great deal of hubris involved in arguing that the market as a whole is out-of-whack.? (Much as I had hubris toward the end of the bull phase… let me stab myself.)? In ordinary bear markets, there is some strength somewhere to support asset values.? That is not true now.? We are dealing with something not normal over the last 70 years, and overall market values are reflecting that.? Eventually accounting values will get there, as they did in the thirties.

The Great Omission

Posted on 27 March 200927 March 2009 by David Merkel

This seems to be the era for dusting off old articles of mine.? This one is one year old, I wrote it on April Fools’ Day — Federal Office for Oversight of Leverage [FOOL].? (Today I would simplify it to: Federal Office Overseeing Leverage.) I would recommend a re-read of that article, and encourage those at the Treasury to realize the enormity of what it is trying to do.

Well, now the Treasury ain’t foolin’ around.? They think they can harness systemic risk.? Check out the speech of Mr. Geithner, and his proposed policy outline.? What are the main points of the policy outline?

1) A Single Independent Regulator With Responsibility Over Systemically Important Firms and Critical Payment and Settlement Systems

Defining a Systemically Important Firm
Focusing On What Companies Do, Not the Form They Take
Clarifying Regulatory Authority Over Payment and Settlement Activities

2) Higher Standards on Capital and Risk Management for Systemically Important Firms

Setting More Robust Capital Requirements
Imposing Stricter Liquidity, Counterparty and Credit Risk Management Requirements
Creating Prompt-Corrective Action Regime

3) Registration of All Hedge Fund Advisers With Assets Under Management Above a Moderate Threshold

Requiring Registration of All Hedge Funds
Mandating Investor and Counterparty Disclosure
Providing Information Necessary to Assess Threats to Financial Stability
Sharing Reports With Systemic Risk Regulator

4) A Comprehensive Framework of Oversight, Protections and Disclosure for the OTC Derivatives Market

Regulating Credit Default Swaps and Over-the-Counter Derivatives for the First Time
Instituting a Strong Regulatory and Supervisory Regime
Clearing All Contracts Through Designated Central Counterparties
Requiring Non-Standardized Derivatives to Be Subject to Robust Standards
Making Aggregate Data on Trading Volumes and Positions Available
Applying Robust Eligibility Requirements to All Market Participants

5) New Requirements for Money Market Funds to Reduce the Risk of Rapid Withdrawals

6) A Stronger Resolution Authority to Protect Against the Failure of Complex Institutions

Covering Financial Institutions That May Pose Systemic Risks

i. A Triggering Determination

ii. Choice Between Financial Assistance or Conservatorship/Receivership

Options for Financial Assistance

Options for Conservatorship/Receivership

iii. Taking Advantage of FDIC/FHFA Models:

Requiring Covered Institutions to Fund the Resolution Authority

(As an aside, did anyone else notice that point 6 didn’t make it into the introductory outline?)

The Great Omission

There’s a bias among Americans for action.? That is one of our greatest strengths, and one of our greatest weaknesses, and I share in that weakness.? Whenever a crisis strikes, or an egregious crime is committed, or a manifestly unfair scandal develops, the klaxon sounds, and “Something must be done!? This must never, never, NEVER happen again!”

So, instead of merely having a broad-based law against theft/fraud, and allowing the judges discretion for aggravating/extenuating circumstances, we create lots of little theft/fraud laws to fit each situation, fighting the last war.? Oddly, because of specificity of many statutory laws, it weakens the effect of the more general theft/fraud laws.

The Treasury will fight the last war, as they always do, but there is a great omission in their fight, even to fight the last war.

Why did they ignore the Fed?? Why did they ignore that many of the existing laws and regulations were simply not enforced?? For much but not all of this crisis, it was not a failure of laws but a failure of men to do their jobs faithfully.

Consider this opinion piece from the Wall Street Journal today.? There is some disagreement, which helps to flesh out opinions.? I think a majority of them concur with the idea that the greatest creator of systemic risk, particularly since 2001, was easy credit from the Federal Reserve.? It’s been my opinion for a long time.? For example, consider this old (somewhat prescient) CC post from RealMoney:


		David Merkel
		The Fed Vs. GSEs: Which Is Most Threatening to the Economy?
		2/24/04 1:35 PM?ET
I found Dr. Greenspan’s comments about Fannie and Freddie this morning a little funny. I agree with him that the government-sponsored entities, or GSEs, have to be reined in; they are creating too much implied leverage on the Treasury’s balance sheet. They may prove to be a threat to capital market stability if they get into trouble; they are huge. Well, look to your own house, Dr. Greenspan. As it stands presently, the incremental liquidity that the Fed is producing is going into housing and financial assets. The increase in liquidity has led to low yields, high P/E ratios and subsidized issuance of debt. All of this has led to stimulus for the economy and the equity and bond markets, but at what eventual cost? The Fed has far more systemic risk to the economy than the GSEs. No stocks mentioned

Since then, the GSEs have failed, and the Federal Reserve is trying to clean up the mess they created in creating the conditions that allowed for too much leverage to build up.? Now they are fighting deleveraging by bringing certain preferred types of private leverage onto the balance sheet of the Fed/Treasury/FDIC.

The first commenter in the WSJ piece makes some comments about monetary aggregates, suggesting that the Fed had nothing to do with the housing bubble.? Consider this graph, then:

Outpacing M2 (yellow) for two decades, MZM (green), the monetary base (orange) and my M3 proxy, the total liabilities of banks in the Federal Reserve really began to take off in the mid-90s, and accelerated further as monetary policy eased starting in 2001.

This brings up the other part of the omission: bank and S&L exams were once tougher, but became perfunctory.? The standards did not shift, enforcement of the standards did.? Together with increased use of securitization, and to some extent derivatives, this allowed the banks to lever up a lot more, creating the systemic risk that we face today.

There are other problems (and praises) that I have with (for) the Treasury’s proposals, and I will list them in the addendum below.? But the most serious thing is what was not said.? The government can create as many rules and regulations as it likes, but rules and regulations are only as good as how they are executed.? The Government and the Fed did not use its existing powers well.? Why should we expect things to be better this time?

Addendum

Praises

A single regulator for large complex firms is probably a good idea.? Perhaps it would be better to limit the total assets of any single financial firm, such that any firm requiring more than a certain level risk based capital would be required to break up.
Higher risk-based capital is a good idea, but be careful phasing it in, lest more problems be caused.
With derivatives, most of the proposal is good, but the devil is in the details of dealing with nonstandard contracts.

Problems

Risk based capital should higher for securitized assets versus unsecuritized assets in a given ratings class, because of potentially higher loss severities.
You can’t tame the boom/bust cycle.? You can’t eliminate or tame systemic risk.? It is foolish to even try it, because it makes people complacent, leading to bigger bubbles and busts.
Hedge funds are a sideshow to all of this.? Regulating them is just wasted effort.
With Money Market funds, my proposal is much simpler and more effective.
Do you really know what it would take to create a macro-FDIC, big enough to deal with a systemic risk crisis like this?? (The FDIC, much as it is pointed out be an example, is woefully small compared to the losses it faces, and it is not even taking on the large banks.)? It would cost a ton to implement, and I think that large financial services firms would dig in their heels to fight that.? Also, there would be moral hazard implications — insured behavior is almost always more risky than uninsured behavior.
Very vague proposal with a lot of high-sounding themes.? (late addition after the initial publishing, but that was my first thought when I read it.)

Translation: We Really, REALLY, Hate You Guys!!

Posted on 24 March 200924 March 2009 by David Merkel

From an earlier post, point 4:

?We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.? [emphasis mine]

So said Mr. Luo, a director-general at the China Banking Regulatory Commission.? I?ve been saying for a long time that China is stuck, and that we are their problem, and not vice-versa.? There may come a point where they stop buying US Dollar-denominated debt, and let existing debt mature, but that will come after a shift in their own economy where they are no longer driven bythe promotion of their exports.? There aren?t many large good alternatives to US debt for parking the proceeds from exporting aggressively.

So today, we get another volley from China as they realize that they are stuck holding US Dollar denominated assets that they are more certain than ever will depreciate.? They see injustice in having bought too many dollars in exchange for the exports they paid to promote to the US.? Excerpting from the article:

People’s Bank of China Governor Zhou Xiaochuan said he wants to replace the dollar, installed as the reserve currencyWorld War II, with a different standard run by the International Monetary Fund (IMF). after

China, the top holder of US Treasury bonds with 739.6 billion dollars as of January, according to American figures, earlier expressed concern over its investment as the world’s largest economy battles a deep recession.

“The outbreak of the crisis and its spillover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system,” Zhou wrote in an essay posted on the bank’s website Monday.

Zhou’s comments come ahead of the G20 summit from April 2 in London, where world leaders and international organisations including the IMF are to discuss reforming the financial system.

He suggested the IMF’s Special Drawing Rights, or SDR, could serve as a super-sovereign reserve currency as it would not be easily influenced by the policies of individual countries.

Russia has also proposed the summit discuss creating a supranational reserve currency. The IMF created the SDR as an international reserve asset in 1969, but it is only used by governments and international institutions.

“The reform should be guided by a grand vision and start with specific deliverables,” Zhou wrote. “It should be a gradual process that yields win-win results for all.”

However, China’s proposal was unlikely to lead anywhere because the SDR is not a currency system backed up by a government, independent Shanghai-based economist Andy Xie said.

Xie said the proposal was probably a protest aimed at Washington’s plan to buy one trillion dollars of its own debt, diluting the value of China’s dollar reserves and raising fears of inflation.

“It’s a sad situation: China is America’s banker. America owes so much to China, but it’s not afraid of China,” he said. “China is America’s hostage. It’s not the other way around.” [emphasis mine]

As the world’s main reserve currency, US dollars account for most governments’ foreign exchange reserves and are used to set international market prices for oil, gold and other currencies.

As the issuer of the reserve currency, the US pays less for products and borrows more easily.

Strategic Drawing Rights are a cute idea, but it would be too small? to support global trade.? Like the Euro, it is a political construct, but one with less dedicated political and economic support.

As I commented in my piece, It is Good to be the World?s Reserve Currency, there’s no good alternative to the US Dollar yet. Like the mercantilists of old, who bought gold dear, and sold it cheaply, so will it be for China — they bought US Dollar claims dear, but will sell them more cheaply.?? This is the price of forced industrialization.

There will come a time when the US Dollar is no longer the world’s reserve currency, but there needs to be a worthy competitor, or a willingness to do without a single clearing unit.? This is an age of computers, so there does not need to be a single dominant unit of exchange, but habits die hard.? It will probably take some disaster to dislodge the US Dollar, and force the changeover.? Whether that comes through inflation, default, partial default, or war remains to be seen.

Liquidity and the Current Proposal by the US Treasury

Posted on 24 March 2009 by David Merkel

One of the earliest pieces at this blog was What is Liquidity?, followed by What is Liquidity? (Part II).? I’ve written a bunch of pieces on liquidity (after doing a Google search and being surprised at the result), largely because people, even sophisticated investors and unsophisticated politicians and regulators misunderstand it.? Let’s start with one very simple premise:

Many markets are not supposed to be liquid.

Why?

Small markets are illiquid because they are small.? Big sophisticated players can’t play there without overwhelming the market, making volatility high.
Securitization takes illiquid small loans and transforms them into a bigger security(if it were left as a passthrough), which then gets tranched into smaller illiquid securities which are more difficult to analyze.? Any analysis begins with analyzing the underlying loan collateral, and then the risks of cashflow timing and default.? There is an investment of time and effort that must go into each analysis of each unique security, and is it worth it when the available amount to invest in is small?
Buy-and-hold investors dominate some markets, so the amount available for sale is a small portion of the total outstanding.
Some assets are opaque, where the entity is private, and does not publish regular financial statements.? An? example would be lending to a subsidiary of a corporation without a guarantee from the parent company.? They would never let and important subsidiary go under, right?? 😉
The value of other assets can be contingent on lawsuits or other exogenous events such as natural disasters and credit defaults.? As the degree of uncertainty about the present value of free cash flows rises, the liquidity of the security falls.

When is a securitization most liquid?? On day one.? Big firms do their due diligence, and put in orders for the various tranches, and then they receive their security allocations.? For most of the small tranches, that’s the last time they trade.? They are buy-and-hold securities by design, meant to be held by institutions that have the balance sheet capacity to buy-and-hold.

When are most securitizations issued?? During the boom phase of the market.? During that time, liquidity is ample, and many financial firms believe that the ability to buy-and-hold is large.? Thus thin slices of a securitization get gobbled down during boom times.

As an aside, I remember talking to a lady at a CMBS conference in 2000 who was the CMBS manager for Principal Financial.? She commented that they always bought as much of the AA, single-A and BBB tranches that they could when they liked the deals, because the yield over the AAA tranches was “free yield.”? Losses would never be that great.? Privately, I asked her how the securitizations would fare if we had another era like 1989-92 in the commercial property markets.? She said that the market was too rational to have that happen again.? I kept buying AAA securities; I could not see the reason for giving up liquidity and safety for 10, 20, or 40 basis points, respectively.

Typically, only the big AAA tranches have any liquidity.? Small slices of securitizations (whether credit-sensitive or not) trade by appointment even in the boom times.? In the bust times, they are not only not liquid, they are permafrost.? In boom times, who wants to waste analytical time on an old deal when there are a lot of new deals coming to market with a lot more information and transparency?

So, how do managers keep track of these securities as they age?? Typically, they don’t track them individually.? There are pricing grids or formulas constructed by the investment banks, and other third-party pricing services.? During the boom phase, tight spread relationships show good prices, and an illusion of liquidity.? Liquidity follows quality in the long run, but in the short run, the willingness of investors to take additional credit risk supports the prices calculated by the formulas.? The formulas price the market as a whole.

But what of the bust phase, where time horizons are trimmed, balance sheets are mismatched, and there is considerable uncertainty over the timing and likelihood of cash flows?? All of a sudden those pricing grids and formulas seem wrong.? They have to be based on transactional data.? There are few new deals, and few trades in the secondary market.? Those trades dominate pricing, and are they too high, too low, or just right?? Most people think the trades are too low, because they are driven by parties needing liquidity or tax losses.

Then the assets get marked too low?? Well, not necessarily.? SFAS 157 is more flexible than most give it credit for, if the auditors don’t become “last trade” Nazis, or if managements don’t give into them.? More often than not, financial firms with a bunch of illiquid level 3 assets act as if they eating elephants.? How do you eat an elephant?? One bite at a time.? They write it down to 80, because that’s what they can afford to do.? The model provides the backing and filling.? Next year they plan on writing it down to 60, and hopefully it doesn’t become an obvious default before then.? Of course, this is all subject to limits on income, and needed writedowns on other assets.? I have seen this firsthand with a number of banks.

So, relative to where the banks or other financials have them marked, the market clearing price may be significantly below where they are currently marked, even though that market clearing price might be above what the pricing formulas suggest.

The US Treasury Proposal

The basics of the recent US Treasury proposal is this:

Banks and other financial institutions gather up loans and bonds that they want to sell.
Qualified bidders receive information on and bid for these assets.
High bid wins, subject to the price being high enough for the seller.
The government lends anywhere from 50-84% of the purchase price, depending on the quality and class of assets purchased.? (I am assuming that 1:1 leverage is the minimum.? 6:1 leverage is definitely the maximum.)? The assets collateralize the debt.
The FDIC backs the debt issued to acquire the assets, there is a maximum 10 year term, extendable at the option of the Treasury.
The US Treasury and the winning private investor put in equal amounts, 7-25% each, to complete the funding through equity.
The assets are managed by the buyers, who can sell as they wish.
If the deal goes well, the winning private investors receive cash flows in excess of their financing costs, and/or sell the asset for a higher price.? The government wins along with the private investor, and maybe a bit more, if the warrants (ill-defined at present) kick in.
If the deal goes badly, the winning private investors receive cash flows in lower than their financing costs, and/or sell the asset for a lower price.? The government may lose more than the private investor if the assets are not adequate to pay off the debt.

I suspect that once we get a TLGP [Treasury Liquidity Guaranty Program] yield curve extending past 3 years, that spreads on the TLGP debt will exceed 1% over Treasuries on the long end.? Why?? The spreads are in the 50-150 basis point region now for TLGP borrowers at 3 years, and if it were regarded to be as solid as the US Treasury, the spread would just be a small one for illiquidity.? (Note: the guarantee is “full faith and credit” of the US Government, but it is not widely trusted.? Personally, I would hold TLGP debt in lieu of short Treasuries and Agencies — if one doesn’t trust the TLGP guarantee, one shouldn’t trust a Treasury note — the guarantees are the same.)

One thing I am unclear on with respect to the financing on asset disposition: does the TLGP bondholder get his money back then and there when an asset is sold?? If so, the cashflow uncertainty will push the TLGP spread over Treasuries higher.

Thinking About it as an Asset Manager

There are a number of things to consider:

Sweet financing rates — 1-2% over Treasuries. Maybe a little higher with the TLGP fees to pay.? Not bad.
Auction?? Does the winner suffer the winner’s curse?? Some might not play if there are too many bidders — the odds of being wrong go up with the number of bidders.
What sorts of assets will be auctioned?? [Originally rated AAA Residential and Commercial MBS] How good are the models there versus competitors?? Where have the models failed in the past?
There will certainly be positive carry (interest margins) on these transactions initially, but what will eventual losses be?

The asset managers would have to consider that they are a new buyer in what is a thin market.? The leverage that the FDIC will provide will have a tendency to make some of the bidders overpay, because they will factor some of the positive carry into the bid price.

I personally have seen this in other thin market situations.? Thin markets take patience and delicate handling; I stick to my levels and wait for the market to see it my way.? I give one broker the trade, and let him beat the bushes.? If nothing comes, nothing comes.

But when a new buyer comes into a thin market waving money, pricing terms change dramatically after a few trades get done.? He can only pick off a few ignorant owners initially, and then the rest raise their prices, because the new buyer is there.? He then becomes a part of the market ecosystem, with a position that is hard to liquidate in any short order.

Thinking About it as a Bank

More to consider:

What to sell?
What is marked lower than what the bank thinks the market is, or at least not much higher?
Where does the bank know more about a given set of assets than any bidder, but looks innocuous enough to be presumed to be? a generic risk?
Loss tolerances — where to set reservation prices?
Does participating in the program amount to an admission of weakness?? What happens to the stock price?

Management might conclude that they are better off holding on, and just keep eating tasty elephant.? Price discovery from the auctions might force them to write up or down securities, subject to the defense that prices from the auctions are one-off, and not realistic relative to the long term value.? Also, there is option value in holding on to the assets; the bank management might as well play for time, realizing that the worst they can be is insolvent.? Better to delay and keep the paychecks coming in.

Thinking about it as the Government and as Taxpayers

Still more to consider:

Will the action process lead to overpriced assets, and we take losses?? Still, the banks will be better off.
Will any significant amount of assets be offered, or will this be another dud program?? Quite possibly a dud.
Will the program expand to take down rasty crud like CDOs, or lower rated RMBSand CMBS?? Possibly, and the banks might look more kindly on that idea.
Will the taxpayers be happy if some asset managers make a lot of money?? Probably, because then the government and taxpayers win.

Summary

This program is not a magic bullet.? There is no guarantee that assets will be offered, or that bids for illiquid assets will be good guides to price discovery.? There is no guarantee that investors and the government might? not get hosed.? Personally, I don’t think the banks will offer many assets, so the program could be a dud.? But this has some chance of success in my opinion, and so is worth a try.? If they follow my advice from my article Conducting Reverse Auctions for the US Treasury, I think the odds of success would go up, but this is one murky situation where anything could happen.? Just don’t the markets to magically reliquefy because a new well-heeled buyer shows up.

Add a New Chapter to the Bankruptcy Code, Redux

Posted on 24 March 2009 by David Merkel

Given the news of the morning, I thought I would dust off my four-month old proposal Add a New Chapter to the Bankruptcy Code.? Until we limit our dear government’s power to encourage the private sector to borrow money until it chokes, we need something that enables timely reduction of debt in TBTF (too big to fail) institutions, delevering them? with minimal impact to taxpayer and the rest of the economy.

This morning we have the following articles:

In my proposal, the Treasury Secretary would initiate the process, but then would get handed off to a special bankruptcy court for adjudication of claims.? The Treasury becomes the DIP lender, but otherwise is a minor player in the process.

Why not let the Treasury do it all?? Wouldn’t it be faster?? Yes, it would be faster, but at a price.? The current Bush/Obama administration policies have relied heavily on intelligent discretion from regulators.? We haven’t gotten that yet.? Even really intelligent regulators are men with limited time.? Even big organizations staffed with Ph.D. economists and other bright people like the Federal Reserve are less than the sum of the parts, as the bureaucracy enforces groupthink (and the Treasury is even worse).

When the Treasury Secretary or the Fed Chairman acts with discretion, there is always the charge of unfairness that can be laid at their doors.? Why is the credit of the US going to support special interests?? You say that it is for the good of the nation, but then why aren’t equity and preferred shareholders wiped out, management thrown out, and bondholders forced to compromise, and accept back equity in the new firm in exchange for their debt claims?

Our bankruptcy processes are transparent, fair, and even speedy (for what is being done) in the US; we just need to augment them for firms that pose risk to a large portion of the financial and economic systems.? But regulatory discretion in bailing out firms in this crisis has been a disaster.? Speed kills; a handoff to the bankruptcy court with the US Treasury backstopping the firm in the short run would be the best minimalist solution, stopping contagion, and allowing for an orderly resolution of competing claims under conditions transparent to the US taxpayer.