Real Estate and Mortgages – Page 18

Book Review: Inflated

Posted on 15 January 201120 June 2017 by David Merkel

This book was not what I expected.? I expected a book on the current crisis, and got a book on monetary/credit policy over the whole of the existence of the US.? What is more, unlike most books that cover a long sweep of history, this book is even, and does not overemphasize the recent past, which is a humble thing for an author to do, because we don’t know the full ramifications of recent actions yet.

Now, I respect the writings of Chris Whalen at Institutional Risk Analytics and elsewhere — a bright guy.? But this outperformed my high expectations.? Some books I glide through because I know the topic well.? This was a book where I thought I knew the topic well, but found that I did not know as much as I thought, and so I read more slowly than I usually do.

But this book changed my view on financial crises.? Whether one is under a gold standard or a fiat currency standard, the main order for assuring stability is the regulation of banks and credit.

In the same way that people need help in verifying whether a drug is effective or food is pure, they need to know that promises to pay will be honored.? It does not matter what backs the currency if banks are allowed to overlever, or mismatch assets long — there will be a financial panic, and it is not due to gold, silver, or fiat money necessarily, but that that banks made promises that could not be kept under all scenarios.

Yes, I think it is better to be under a gold standard, because it restricts the power of the government.? But that is not the main issue with financial crises; we need to restrict that ability of banks to borrow short and lend long; we also need to restrict their overall leverage.? Do that, and crises disappear — also, banks are far less profitable, and that is a good thing.? We will get fewer banks, and bright people will go to more useful places in the economy.

Other things that stood out to me were the First and Second National Banks of the US, and how their creation led to booms, and dissolution led to busts.? Lincoln is unique in every way, even in monetary policy terms, as he created unbacked paper money to fight the civil war, which funded a lot of it.? After the war, the return to the gold standard, much as it should have been done, was depressive, but it was an effect of paying off the war.

I came away from this book with a more balanced view of US politics — many of those I like came off worse, and those I did not like were shown to have been better than I thought — with the exception of Lincoln, who in hindsight seems to be a radical in most senses.? I am very glad that slavery is gone, but not the way that it got done.

Quibbles

Ignore Roubini’s introduction.? Better Whalen should have gotten a real intellect like James Grant or Caroline Baum.

Also, in the middle of the book, in WWII, the US spends far more than its GDP on the war.? I get it, but I think it would be more reasonable to classify defense spending inside GDP so that we can see what proportion of national output is going to the war effort.

Who would benefit from this book:

Anyone with a moderate intellect or better could learn from this balanced account of America’s monetary and credit policies.? It is very well written; those with little knowledge will learn much, but those with greater knowledge will still learn something.

If you want to, you can buy it here: Inflated: How Money and Debt Built the American Dream.

Full disclosure: This book was sent to me, because I asked for it.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Creating a Stable Financial System, Part I

Posted on 11 January 2011 by David Merkel

I’ve been thinking a lot about bank reform lately.? Here’s the core of the problem: deposits are sticky in ordinary times, particularly once you have a guarantor of deposits like the FDIC.? But for some banks, they look to other short term funding, whether it is short CDs or repo funding.

Now to me a lot of the issue is asset-liability mismatch.? Banks borrow short and lend long.? That leads to banking panics.? Financing illiquid assets with liquid liabilities is unstable, and begs for bankruptcy at the first significant loss of confidence.

But there is a greater mismatch present, which I want to explore.? Every asset is financed with some liability or equity.? And, every liability is someone else’s asset, but not vice-versa, because assets owned free and clear are equity-financed.

Assets financed by debt are frequently mismatched short.? Long mismatches are rare because of the cost of financing being too high.? Now, if short mismatches are small, that’s not a problem.? There is enough flexibility in financial balance sheets to accept small mismatches.? Real disasters happen when long assets are financed in such a way that there is a risk that the financing will fail prior to the assets being paid off.

The fundamental mismatch in debts that finance assets is that the ultimate assets being financed are longer-dated than the financing.? We fund land, houses, buildings, plant & equipment, and do it off of deposits, savings accounts and CDs.? Some financial companies finance off of short-dated repo funding.? The reason that this mismatch is hard to avoid is that average individuals who save want short-dated assets that can be used for transactions.? That doesn’t fit well against the need to fund long-term assets.

The same problem exists in the municipal bond market.? Much more money wants to invest short, while municipalities want to borrow long.? This leads to a steep muni yield curve.? Commercial insurers writing long tail business, and wealthy people that can tolerate interest rate volatility end up buying the long end, and lower taxes in the process.

If banks were required to approximately match cash flows for assets not financed by equity, yield curves would steepen for other areas of the fixed income markets.? Areas of the financial market where there are long/strong balance sheets, such as Life Insurers, Commerical Insurers, Defined Benefit Pensions and Endowments would get higher yields for longer commitments.? Banks would become a lower ROE business, and that would be good, as there would be many fewer failures, and there would be fewer banks; we are over-banked.? Time to re-educate bankers for more productive activities.

Long dated floating-rate loans could be a solution for banks funding loans? off of short-dated lending, or, using interest rate swaps to achieve the same result.? The risk is that a bank locks in what proves to be a low spread on the asset, while funding costs are volatile.

A few final notes: 1) the standard of broadly matching asset and liability cash flows should be applied to all regulated financial institutions, including investment banks.? Only surplus assets not needed to match liabilities can be used for investments with equity-like risk. 2) There must be an unpacking of complex vehicles with embedded leverage to do the Asset-Liability management.? As examples:

Securitizations
Repo Funding
Private Equity
Hedge Funds
Margin loans
SIVs and the like

would need to be reflected as looking through to the items ultimately financed.? As an example, the AAA portion of a senior-sub securitization is long the loans, and short the certificates sold to the rest of the deal.

Repo funding has its own issues.? In a crisis, haircuts rise as asset values fall.? Institutions relying on that funding often fail at those times, and leaves losses to the repo lender.? There would need to be something reflected for the risk of repo market failure, though the grand majority of the losses go to the borrower, and not the lender.

3) Even short lending to those getting loans that do not fully amortize should be reflected as loans that are longer-dated, because of the risk of rates being higher, and refinancing is not possible.

I have more to say, but I’m going to hit the publish now.? Comments are welcome.

Redacted Version of the December 2010 FOMC Statement

Posted on 15 December 2010 by David Merkel

Comments

They highlight that they have a ?statutory? mandate, and a ?dual? mandate.? They are trying to say that they are required by Congress to do these things, and that it is a tough job.? The flip side is that they admit the Congress has the right to tell them what to do, which Ron Paul may make clear as the Chair of the House?s subcommittee on Monetary Policy.
The question is this: will the mechanisms of credit transmit inflation to goods and services?? So far, it has not.? Lowering the policy rate does little to incent borrowing when enough people and financial institutions are worried about their solvency.
Beyond that, if they succeed, how will it be received on Main Street, especially if price inflation is not accompanied by increases in employment, or is accompanied by higher interest rates or lower stock prices?? Stagflation is not popular.
That said the economy is not that strong.? In my opinion, policy should be tightened, but only because I think quantitative easing actually depresses an economy.? It does the opposite of stimulate; it helps make the banks lazy, and just lend to the government.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
They have no idea why their policy is not working, and they don?t know what to do about it.? Monetary policy works with long and variable lags, so they won?t say that their policy isn?t working.? It?s just slow in taking effect.

Book Review: All the Devils are Here

Posted on 9 December 2010 by David Merkel

Have you ever seen a complex array of dominoes standing, waiting for the first domino to be knocked over, starting a chain reaction where amazing tricks will happen?? I remember seeing things like that several times on “The Tonight Show with Johnny Carson” back when I was a kid.

When the first domino is knocked over, the entire event doesn’t take long to complete — maybe a few minutes at most.? But what does it take to set up the dominoes?? It takes hours of time, maybe even a whole day or more.? Often those setting up the dominoes leave out a few here and there, so that an accident will spoil only a limited portion of what is being set up.

Those standing dominoes are an unstable equilibrium.? That is particularly true at the end, when the dominoes are added to remove the safety from having an accident.

Most books on the economic crisis focus on the dominoes falling — it is amazing and despairing to watch the disaster unfold, as the leverage in the system is finally revealed to be unsustainable.

This book is different, in that it focuses on how the dominoes were set up.? How did the leverage build up?? How was safety ignored by so many?

The beauty of this book is that it takes you behind the scenes, and describes how the conditions were created that led to a huge creation of bad debts.? I was a small and clumsy kid.? My friends would say to me during sports, “There are mistakes, but your error was so great that it required skill.”

The same was true of the present crisis.? There were a lot of skillful people pursuing their own private advantage, using new financial instruments which were harmless enough on their own, but deadly as a group.? So what were the great financial innovations that enabled the crisis?

Creation of Fannie and Freddie, which led to an over-issuance of mortgages.
Securitization, particularly of mortgages.? This led to a separation between originators and certificateholders. (And servicers, though the book does not go into servicers much.)
Having parties that guarantee debt, whether GSEs, Guaranty Insurers, the Government, or credit default swaps [CDS]
Loosening regulations on commercial banks, investment banks and S&Ls.
Regulatory arbitrage for depository institutions.
Loose monetary policy from the Federal Reserve, together with a disdain for regulating credit.? They saw Mexico and LTCM as successes, and thought that there was no crisis that could not be solved by additional liquidity.
Bad rating agency models, and competition among rating agencies to get business.
Regulators that required the use of rating agencies for capital modeling.
The broad, misinformed assumption that real estate prices only go up.
The creation of Value-at-risk, a risk management concept that has limited usefulness to true crisis management.
The creation of CDOs that did not care for much more than yield.
The development of synthetic CDOs, which allowed securitization to apply to corporate bonds, MBS, and ABS not owned by the trusts.
The creation of subprime loan structures, where are that was cared for was yield.
The creation of piggyback loans, so that people could put no money down for a home.

There are no heroes in this book, aside from tragic heroes who warned and were kicked aside in the hubris of the era.? Goldman Sachs comes out better than most, because they saw the crisis coming, and protected themselves more than mot investment banks.

I learned a lot reading this book, and I have read a dozen or so crisis books.? I didn’t learn much from the other books.? In this book, the authors interviewed hundreds of people who were integral to the crisis, and read a wide variety of sources that wrote about the crisis previously.

I found the book to be a riveting read, and I read it cover to cover.? I could not change into scan mode; it was that well-written.

This is the best book on the crisis in my opinion, because it takes you behind the scenes.? You will learn more from this book than any other on the crisis.

Quibbles

They don’t get the difficulties of being a rating agency.? There is the pressure to get things right over the cycle, and get it right on a timely basis.? These two goals are contrary to each other, and highlighting that conflict would have enhanced the book.

Who would benefit from this book:

Anyone willing to read a longish book could benefit from this book.? It is the best book on the crisis so far.

If you want to, you can buy it here: All the Devils Are Here: The Hidden History of the Financial Crisis.

Full disclosure: This book was sent to me, because I asked for it.

Redacted Version of the November 2010 FOMC Statement

Posted on 3 November 2010 by David Merkel

September 2010	November 2010	Comments
Information received since the Federal Open Market Committee met in August indicates that the pace of recovery in output and employment has slowed in recent months.	Information received since the Federal Open Market Committee met in September confirms that the pace of recovery in output and employment continues to be slow.	No real change.
Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.	Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.	No change.
Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls.	Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls.	No change.
Housing starts are at a depressed level.	Housing starts continue to be depressed.	No change.
Bank lending has continued to contract, but at a reduced rate in recent months.		Removes sentence.
The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term.	Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters.	Deletes one sentence, inserts another.? From the language below, they have lost confidence in ?higher levels of resource utilization? anytime soon.? Attempts to say that inflation expectations are under control, but that deflation is governing the present.
Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability.	Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate.	They highlight that they have a ?statutory? mandate, and a ?dual? mandate. Aside from that, they comment that unemployment is ?elevated.?
With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.	Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.	Translation: we have no idea why our policy is not working, and we don?t know what to do about it.? Monetary policy works with long and variable lags, so we won?t say that our policy isn?t working.? It?s just slow in taking effect.
	To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities.	New sentence.? Launching the QE II.
	The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month.	New sentence.? They will stealth-fund the US Government to the tune of $600 Billion.
	The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.	New and meaningless sentence.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.	The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.	No change.
The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings.		Sentence dropped.
The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.	The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.	Changes from prepared to act, to will act.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.	Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Sarah Bloom Raskin; Eric S. Rosengren; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.	Adds in Raskin and Yellen.
Voting against the policy was Thomas M. Hoenig, who judged that the economy continues to recover at a moderate pace. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and will lead to future imbalances that undermine stable long-run growth. In addition, given economic and financial conditions, Mr. Hoenig did not believe that continuing to reinvest principal payments from its securities holdings was required to support the Committee?s policy objectives.	Voting against the policy was Thomas M. Hoenig. Mr. Hoenig believed the risks of additional securities purchases outweighed the benefits. Mr. Hoenig also was concerned that this continued high level of monetary accommodation increased the risks of future financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy.	No real change here; if anything, Hoenig is more firm in his opinions.

Comments

The Fed launches the QE II.? As I have commented, elsewhere, but can?t find now, the market was looking for about $1 Trillion in QE, so the long end of the Treasury curve sells off.
They highlight that they have a ?statutory? mandate, and a ?dual? mandate.? They are trying to say that they are required by Congress to do these things, and that it is a tough job.? The flip side is that they admit the Congress has the right to tell them what to do, which Ron Paul may make clear as the Chair of the House?s subcommittee on Monetary Policy.
The question is this: will the mechanisms of credit transmit inflation to goods and services?? So far, it has not.? Lowering the policy rate does little to incent borrowing when enough people and financial institutions are worried about their solvency.
Beyond that, if they succeed, how will it be received on Main Street, especially if price inflation is not accompanied by increases in employment, or is accompanied by higher interest rates or lower stock prices?
Hoenig still dissents; hasn?t gotten bored with it yet.
That said the economy is not that strong.? In my opinion, policy should be tightened, but only because I think quantitative easing actually depresses an economy.? It does the opposite of stimulate; it helps make the banks lazy, and just lend to the government.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
My guess is they have no idea why their policy is not working, and they don?t know what to do about it.? Monetary policy works with long and variable lags, so they won?t say that their policy isn?t working.? It?s just slow in taking effect.

The Path of Least Resistance

Posted on 30 October 201031 October 2010 by David Merkel

As with anything in economic forecasting, what I am about to say is at best an educated guess.? Given the present environment, where is the global economy likely to go?

Any analysis like this has to contend with political factors that drive the major imbalances of the global economy.? Here are the imbalances as I see them:

China insists on keeping its currency cheap in order to promote employment at home.
The US does not care about deficits or currency debasement, as it seeks Keynesian remedies to its economic crises.? (Little realizing that they are making things worse…)
The Eurozone protects profligate euro-fringe nations, at the possible cost of destroying the Eurozone as a whole.

If China will not allow its currency to strengthen, well then, the path of least resistance is for the US to debase its currency, leading the world in a cycle of competitive debasement/inflation.? Since many nations want to be net exporters, US Dollar weakness is responded to through debasement, or purchase of US Dollar assets.

Putting it simply, the path of least resistance is inflation.? Reduce the value of nominal debts in real terms.? Eliminate underwater debts by raising the nominal prices of the collateral.

Now, surplus nations like China and Germany will resist this, but I suspect they will be dragged to this, kicking and screaming.

We are in the process of trying the alternative approach to solving the Great Depression via inflation, which will have a different set of problems than the foolishness of FDR.? The problem is too much debt, which needs to be changed into equity, but government tinkering discourages compromises.

Rather than the deflation that characterized the Great Depression, inflation may be what drives the future.? The question could be “how much?”

But all that said, there are other possibilities.? We could raise taxes and pay off the debt.? We could default on the debt.? Neither of these are favored by current politics, but they could happen.

So as you invest, consider an inflationary bias.? I think it is the likely wave of the future.

The Rules, Part XX

Posted on 26 October 2010 by David Merkel

In the end, economic systems work, and judicial systems modify to accommodate that.? The only exception to that is when a culture is dying.

I have been scratching my head over all the problems in the residential mortgage market.? How can foreclosure take place, when there is no note, properly endorsed, to display?? How can certificate holders of securitizations be comfortable when the transfer of ownership interests in mortgages was never completed.

But, I’m not all that worried.? In one sense, the bigger the problem, the easier it is to solve.? Why?? Because the political systems that surround the economic systems tend to focus better on big problems than little problems.

As in Cordwainer Smith’s “The Instrumentality of Man,” the first priority of any government is to survive.? This is one reason why it is easier for them to survive large crises than small problems.? That’s why I give Rudy Giuliani relatively little credit for what he did on 9/11, but give him more credit for what he dealt with on budget issues.

In large crises, the range of options becomes limited.? Also, it becomes easier to see which option is the best one.

So, given the systematic and severe errors that occurred in residential mortgage securitization, shouldn’t there be an obvious answer to what must be done now?? Yes, but a solution here will take time.? Banks will have to make the effort to secure the notes that allow them to foreclose.? And then, they will foreclose.? Will that mean a lot of upset for the residential property market in the short run?? Yes.? Will the residential property market survive this?? Yes.

Foreclosures will take place.? But the legal niceties that protect our property rights in other areas must be observed by the banks.? Courts should not give in to pressure that they must do something to preserve the proper functioning of the market.? Yo, courts.? The markets will survive even if you delay.? Take your time and do it right. Yo, lenders; delay is the price for not having done it right in the first place.

As for the securitization certificateholders, let me remind you of the investment banks and AIG.? AIG absorbed subprime mortgage risk from all of the investment banks.? The investment banks thought they were pretty clever, until they realized that they all had taken advantage of AIG, and thus, AIG might not be able to make good on all the risks that they had absorbed.

In the same way, if all residential mortgage-backed securitizations are unwound at the same time, the sponsors of the mortgage-backed securitizations will not be able to make good on their obligations.

As I see it, residential mortgage-backed certificate holders have an incentive to work with the sponsors to see how this crisis can be worked through.? And as I see it, perhaps the solution is to pay a consent fee to the certificate holders in exchange for waiving their rights to sue over the malfeasance of not transferring the notes from the originator all the way to the trust.

=-=-=-=-=-=-==-=-=-=-=-=-

As with other crises, the probability of total failure is remote.? Total failure only occurs when those at the top of the power structure are so self consumed that they do not see the threat to their lives.

That’s why I see a slow but reasonable solution coming through the court system to solve the malfeasance engendered through the sloppy execution of securitizations.? Yes, things are bad.? Yes, our current politicians are clueless.? But there is enough interest in coming to a solution for society as a whole that an equitable solution will be arrived at in the courts ? not through Congress, not through the President.

That doesn’t mean that things won’t be choppy and messy.? Indeed, there will be many ugly times en route to a solution.? But things are not so bad in our judicial systems, as a whole, that we will not come to the correct solution, after exhausting all imaginable alternatives.

Dave, What Should I Do?

Posted on 8 September 201011 September 2010 by David Merkel

I get requests from local friends fairly regularly for aid in understanding their finances.? While coming home from church recently, I mentioned to my wife that many were seeking my opinion in our congregation.? Her response was, “So what else is new?”? Then I began to list it, family by family, and the congregations that were seeking my opinion for their building/endowment funds, and/or borrowing needs.? As I went down the list, my wife’s responses were “Not them!”, and “Them too?!” and “No!”

What can I say? My wife is the best wife I have ever heard of, but even married to me, economics is a distant topic.? Her father was well-off, but humble, and I am well-off, and I try to be humble.? You can be the judge there.

I say to my friends asking advice, “Remember, I am your friend.? I will take no money, but I won’t hold your hand and guide you either.? I will give you very basic advice, and it is up to you to learn and implement it.”? I don’t want to be a financial planner, but I don’t want to leave friends in a lurch.

With that, the scenarios:

1) 90-year old widow, who lives with her daughter and son-in-law.? Another son-in-law, given to incaution, is advising putting everything into gold and silver.? What to do?

She has adequate assets to support her through the rest of her life.? Her husband was responsible.? I asked her if she needed more income, and she said no.? I told her, then relax, ignore the other son-in-law (I know him to a degree), but if you want to, invest 3-5% in precious metals.? She didn’t see the need, and I told her that was fine.? She asked me what I would do in her shoes, and I said that it was a very difficult environment to be investing in, and that we could not tell what the government might do in a crisis, so the best thing to do was to stay diversified, and invested in companies which would have continued demand.? But if you don’t need the money, don’t take the risk now.

2) 80-year old widow, assets in even better shape.? Her husband was a great guy; an inspiration to me in many ways.? He was a mutual fund collector, and left her a basket of 30+ funds, as well as two homes free and clear.? What to do?? I suggested that she harvest funds that had been doing particularly well and reinvest in funds that had lagged.? I suggested purging certain funds that were likely mismanaged.? I also suggested liquidating one property if she could get an acceptable bid.

3) 50-year old bachelor, never married.? Funds are from TIAA-CREF.? We decided on a 50-50 stock-bond mix three years ago.? Recently we rebalanced to add more equities.? He was disappointed that his portfolio had moved backward.? I said “Welcome to the club.”

I will continue with more in part two, but 2008 blew apart many people’s expectations over what their assets could deliver.? My stylized view of it stems from comments that I got at church.? In 1999, my friends were people into equities, as I was holding back.?? In 2002, many said they were exiting equities, and moving to what they understood, residential real estate.? I was adding fresh cash to my positions, and paying off my mortgage. By 2006-2007, they began getting interested in stocks again.? By 2009, both stocks and residential real estate was tarnished, leaving bonds remaining.

Closing then, with three final notes:

a) The low interest rate policy is definitely hurting seniors, and I believe all investors.? We all become worse capital allocators when there is no safe place to put excess funds.? It tempts people to stupid decisions.? If Bernanke wants to do us a favor, let him resign, and put John Taylor or Raghuram Rajan in his place.? Tempting people to dumb investment decisions hurts the economy in the long run, it does not help us.

It may help the banks have a risk-free arb on short government bonds, but that’s not what we should want either.? If they are sound, they should be lending. Raise short rates, and let the banks have a harder time, and give investors a place to put money while they look for better opportunities.

b) Average people, and sadly, many professionals, are hopeless trend-followers.? They have no sense of looking through the windshield, rather they ask what has worked, and do that.? Mimicry can be a help in much of life, e.g., finding where to buy good furniture cheaply, but is harmful with investing where figuratively the devil takes the hindmost.

c) People get caught on eras, and have a hard time letting go of them.? The 70s biased many against inflation, and toward residential real estate. The residential real estate lesson got reinforced in the ’00s.? The equity markets seemed magical from 1975 to 2007, and asset allocators increased their allocations to equities in response.? Now you hear of “bonds only” asset allocations, just as the amount of juice available in most of the bond market is limited.

People got used to refinancing their mortgage every few years, and enjoying the extra cash flow.? The modern era reveals the hidden assumptions on that: that property values would never fall.

The point: markets aren’t magic.? They can only deliver what the real economy does.? Stocks only do well over the long run if profits do well. Valuations come and go.? Bonds make money off the stated interest (coupon) rate less default losses.? Valuations come and go.? Real estate is worth the stream of services that the land and improvements can deliver.? Valuations come and go.

Now, you can play the “come and go” if you are smart, but with the “come and go,” for every winner there is a loser.? But asset allocators need to be more humble in their assumptions for financial planning and not assume that they can earn more than 2% over the 10-year Treasury, or over expected growth in nominal GDP.? The share of income that goes to profits and interest also tends to mean-revert over time, so humility is needed when:

Illustrating an investment plan for a family
Setting the discount rate for a defined benefit pension plan
Setting the spending rate on an endowment
or even, setting assumptions for the Social Security trust funds.

Queasing over Quantitative Easing, Part V

Posted on 2 September 2010 by David Merkel

Does it matter who controls the businesses of the country?? Does it matter who regulates the businesses of the economy?? Should these people be smart or dumb?

One cost of the meddling that the Fed and Treasury have done through the bailouts is that dumb people are left in place.? People who mismanaged their firms still manage them, and regulators that misregulated are still in their jobs.? Both are rescued by taxpayer largess, but it reveals another hidden cost of bailouts — they make us less competitive/effective as a nation, because we do not let? firms fail, and we don’t fire regulators that were negligent, including the Fed.

The optimal outcome would be for bright managers to buy failed firms out of bankruptcy, and for failed regulators to be replaced with new ones that have a chance of doing things differently.? Aside from that, if you never fire regulators for failure, you will never motivate them to do what is right.

And this is true of most meddling by the Fed or the Treasury, picking favorites, not letting bad firms or regulators fail.? This extends to QE.? If you need lower rates in order to survive, you probably don’t deserve to.? All a lower rate structure does, if the government or Fed is forcing it, is encourage investment in lower yielding investments, because they can be financed cheaply for now.? This is an aspect of the liquidity trap, and the Fed is deepening it with their policies.

Remember, there is no evidence that QE works.? It has not helped Japan; it may have harmed Japan.

What I have found interesting over the last week are the number of discordant voices that are not in favor of QE or fiscal stimulus.? Here are some examples:

Consider what John Taylor and Richard Berner have to say in this article.
Listen to what Trichet has to say about government debt.? He says that the failure to cut debt has led to Japan’s malaise.
David Goldman questions QE here, suggesting that the US will fare worse with that strategy than Japan.
Or consider Raghuram Rajan, who in this article argues that low rates encourage speculation in risky assets, which may not result in growth in the long run, which is similar to the arguments of Fed dissenter Thomas Hoenig, who is also cited in the article, and me .? The difference that I have with Hoenig is that the economy is not strong here, and he thinks things are pretty good.? Hoenig thinks that low rates are hindering growth because banks sit back and make risk-free profits lending to the Treasury, and I agree with that.? It would be more stimulative of private sector lending to raise Fed funds to 1.5%, because then banks could not make money in Treasuries without taking a lot of interest rate risk.? They would have to go out and make real loans, or shrink their balance sheets.? Either would be good.
For an odd pro-QE view, Thomas Palley argues something complex, suggesting that Fed funds should be raised to promote saving and restrain speculation, while QE should be used to depress mortgage rates and state general obligation bonds.? I disagree, because we have too many houses, and state governments are too large now, having grown fat on the rising revenues generated by the credit bubble.? But do you see how when the QE genie is let out of the bottle, every special interest lines up to plead for the investment?? Bad enough that we have fiscal policy playing favorites for indebted homeowners at the expense of renters and those who own free and clear, but to make it a permanent part of monetary policy is foolish; it just creates a glut of homes, with marginal borrowers.

But consider Japan, which has not given up on QE, not because it works, but because they can’t think of an alternative.? It’s not as if there is a lot of demand for loans in Japan, but the Bank of Japan boosts a loan program anyway in the political season.

It makes me think that both Japan and the US have a comeuppance coming.? One cannot borrow forever without a bad result occurring, whether that be default, inflation, or high taxes.? But, in the short run, that game can go on with the politically connected disproportionately benefiting.? Though not on QE, this article from the Washington Post highlights the huge increase in Federal spending, and mentions in passing the huge benefits to DC, Virginia, and Maryland.? Yes, the benefits flow unequally, and it wasn’t as if the mid-Atlantic region was in bad shape.? Those near the capital benefit overmuch, and the hinterlands pay.

Summary

I stand by my thesis, which I hope to flesh out for stimulus spending in coming days.? QE does not benefit the US economy in the long run because it:

Creates dependency on the Federal Reserve to continue the financing.
Subsidizes governments and industries that need to shrink, and focus on core demand, not further expansion of mission.
Drives up the costs of funding long-term liabilities
Drives down the marginal efficiency of capital as the government and central bank does more of the investing, and invests in low ROE, or even negative ROE ventures.
Only looks at the present, and at politics, leading to decisions that benefit those connected
Tempts investors to take non-economic risks, where they will lose more than if they had stayed in cash.
Makes average people less certain about the future, which makes them more conservative in spending.
Undermines confidence in the fairness of government, and the value of a central bank.
It helps leave foolish men in charge of governments and bureaucracies that should have failed.

Queasing over Quantitative Easing, Part III

Posted on 28 August 2010 by David Merkel

I have a post on the futility of fiscal policy coming, but the hubbub over Jackson Hole has made me alter my publishing schedule.? I want to give one more shot on the idea that the Fed is out of ammunition, and that unorthodox moves are more likely to scare the public than result in increased real GDP.

I am better off than all of my friends, I think.? A common occurrence for me is a friend coming to me and saying, “How can the government borrow so much?? It doesn’t make sense.? Why do they spend money on this and not on me?”? I understand the paradox of thrift, but I don’t agree with it.? One reason is that because it is a paradox, ordinary people will react badly to actions of the government that they can’t do themselves.? Second, when the government or central bank does it, it seems like a form of theft, because no one should get something for nothing, and it degrades the ordinary person’s view of the honesty of the Government or Central Bank.? Third, what the money gets used for is viewed as a waste by some.

This consideration of the basic sense of fairness among average people should not be discounted by policymakers, nor the fear engendered when policymakers take such actions.? It is how average people think.? If you remember my review of the book Priceless, you might realize that people often act out of a sense of fairness, not out of economic interest.? When you think about the Paradox of Thrift through that prism, it is plain why government action doesn’t work — many people do nothing different when the government/central bank is making bold moves, because they are less certain about the future because the powers that be are dishonest in their view.

That said, the main reason I don’t agree with the solution to the paradox of thrift is that the government generally misspends money on cronies or projects of cronies.? It does not build the productive capacity of the economy, but only current consumption.? It does not aid growth.

Monetary Policy Now

Looking over a variety of articles on the options the Federal Reserve has, I would say that they are out of ammo that can do good.? They have plenty of ammo to destroy the economy, but little to build it.? What options does the Fed have left?

Lower the Fed funds rate into lower positive territory.
Offer language that says that the Fed Funds rate will be low for a long time.
Buy more long-dated Treasury bonds.

And the unorthodox options:

Lend directly to classes of private borrowers.
Create negative interest rates for Fed funds.
Debase the currency by expiration dates, lotteries, etc.

I will pick up on this tomorrow, and explain why the options that the Fed has are limited.