Many finger the ratings agencies for a portion of our current problems, and to be sure, they deserve blame.? Many of the recommendations call for eliminating the opinions of the ratings agencies from anything that might determine regulatory capital levels.? Let the regulators do it themselves, instead.
That’s a nice dream, or, for those in the insurance industry, a nightmare.? The insurance industry survived such an institution, the NAIC Securities Valuation Office, and lived to tell of it.
It is said that if you can’t get work as a credit analyst, go work for the rating agencies.? They always need people, because the competent would never stay around due to low pay.? Well, the NAIC SVO was if anything worse, and for those of us that interacted with it, we had no sorrow when they moved to the rating agencies.? In terms of speed, much better.? Even the opinions were more intelligent.
I’m not saying that the rating agencies didn’t make errors; of course they did.? Most often it was over asset sub-classes that were new, and had never been through a bust cycle.? They would always be too optimistic.
Now when the regulators blame the rating agencies, it is all too convenient.? Why not blame the regulators?? They can ban any asset class that they hate; in the past, regulators typically banned assets until they were seasoned enough for institutions with trust obligations? to buy them.
The rating agencies typically did well rating asset sub-classes that had experienced significant failure at some point in the past.? Ranking corporate bonds and corporate loans against each other — no one should argue that they did a bad job rating them in aggregate.? Structured products are another matter, and the rating agencies, through their conflicts of interest, got sucked into the boom-bust cycle.
With that, I put it back to the regulators.? You don’t want to depend on the rating agencies?? Fine, create your own rating agency, and staff it with top talent.?? Wait, you can’t afford that?? Okay, staff it with people that could work for the rating agenices.? You can’t afford that either?? Ugh.? Well, at least, limit your goals, and tell those you regulate that they can’t invest in complex products that you can’t understand and rate.? Wait, you’re getting pushback from politicians telling you that you’re killing those that you regulate? Tell them to jump of a cliff.? Wait, they are suggesting the same to you?
Now, many argue that a rating agency run by the regulators would be insulated from influence from Wall Street.? It’s not that easy.? If the ratings have a dominant effect on whether securitizations get done or not, you can bet that Wall Street will call to solicit their opinions in advance of issuance.? Once the ground rules are set, Wall Street will lobby the analysts, showing much the same approach that they did with the private rating agencies, in order to get them to change/loosen their opinions.? (I experienced this with the NAIC SVO; they would usually fall in line with the private rating agencies, because it made their life easy.)
I am not a defender of the private rating agencies as much as a explainer that it is difficult to avoid the problems that they face.? The problems exist in any situation where a third party tries to analyze a wide number of credit relationships.
This is why I am skeptical in the long run of any effort to replace the rating agencies by the regulators.? As a challenge, I say “Go ahead, try it.? Past efforts like this have failed, and you will as well.”? I say this not as a lover of the private rating agencies, because they have done me wrong as well.? The problems of the rating agencies are endemic to any third party evaluation of credit.? Better to be wise to their biases as an institutional investor, and avoid their weaknesses, than to be naively credulous, and complain that you got cheated because a rating was too high.
I’ve said it before, but I came into the investment business through the back door as a risk manager.? Unlike most quantitative analysts, I came with a greater depth of knowledge of economic history, and a distrust of the assumptions behind most quantitative finance models, because things can be much more volatile than most current market participants can imagine. As a result, I often ran my models at higher stress test levels than required by regulation or standards of practice.
Can countries fail?? Sure.? It has happened before.? Can leading countries fail?? Yes, and consider France, Germany and Japan.? Consider earlier history — the failure of a major power has significant effects on the rest of the world.
Understanding economic history can keep one from saying, “That can’t happen.”? Indeed when governments are pressed, they do their best to extract additional revenue out of those that will complain the least.? Qualitative analyses, if done properly, incorporate a wider amount of variation than the quantitative statistics will reveal in hindsight.? Do you incorporate the idea that all novel securities (new industries) go through a big boom bust cycle?? If so, you would have avoided most of the complex debt securities born in the last ten years, and would have been light on risky debt that was the building blocks for those securities.
Though the job should fall to regulators to bar institutions of trust from investing in novel instruments, and they used to do that, the legal codes and regulators, forgetting history, removed those restrictions, and left many financial institutions to their own wisdom in managing their risks.? Some of those institutions were careful and speculated modestly if at all.? Others went whole hog.
The speculators (not called that at the time) pointed to loss statistics that had been generated during the boom phase of the cycle.? They showed how the junk-rated certificates would even be money good under “stressed” conditions.? All of the way through the boom, they pointed to their backward looking statistics, as leverage levels grew, and underwriting quality fell in hidden ways.
We know how it has ended.? In some cases, even AAA securities will not be money good (i.e., principal and interest will not be repaid in full).? Alas for the poor non-US buyers who sucked down much of the junk securities.
This forgetfulness regarding booms and busts affects societies on a regular basis. It happens everywhere, but the freewheeling nature of the US makes it a model country for this exercise (boom period in parentheses):
This list isn’t exhaustive, but it’s what is easy for me to rattle off now.? Cycles are endemic to human behavior.? Governments and central banks may try to eliminate the negative part of a cycle of cycles, but it is at a price to taxpayers, savers, and increased moral hazard.? Why limit risk when the government has your back?
All that said, relying on historical patterns to recur, or simple generalizations that say that “the current crisis will follow the same track as the Great Depression,” are too facile and subject to abuse.? The fine article by Paul Kedrosky that prompted this piece makes that point. Too often the statistics cited are from small data sets, or unstable distributions generated by processes that are influenced by positive and/or negative feedback effects.
Studying economic history gives us an edge by giving us wisdom to avoid manias, and avoid jumping in too soon during the bust phase.? I’m still not tempted by housing or banks stocks yet.
That’s why I write book reviews on older books dealing with economic history (among others).? As Samuel Clemens said, “History doesn’t repeat itself, but it does rhyme.”? It doesn’t give a simple roadmap to the future, but it does aid in developing scenarios.? As Solomon said in Ecclesiastes 1:9, “That which has been is what will be, That which is done is what will be done, And there is nothing new under the sun.”
I’ll close the article here, but I have an application of this for politicians and regulators that I want to develop in part two.
If you have time, there are two long articles that are worth a read.? The first is from the Washington Post, and deals with the demise of AIG, highlighting the role of AIG Financial Products.? It was written in three parts — one, two, and three, corresponding to three phases:
Growth of a clever enterprise, AIGFP.
Expansion into default swaps.
Death of AIG as it gets downgraded and has to post collateral, leading to insolvency.
What fascinated me the most was the willingness of managers at AIGFP to think that writing default protection was “free money.”? There is no free money, but the lure of “free money” brings out the worst in mankind.? This is not just true of businessmen, but of politicians, as I will point out later.
My own take on the topic involved my dealings with some guys at AIGFP while I was at AIG.? Boy, were they arrogant!? It’s one thing to look down on competitors; it’s another thing to look down on another division of your own company that is not competing with you, though doing something similar.
As I sold GICs for Provident Mutual, when I went to conferences, AIGFP people were far more numerous than AIG people selling GICs.? The AIG GIC sellers may have been competitors of mine, but they were honest, and I cooperated with them on industry projects.? Again, the AIGFP people were arrogant — but what was I to say?? They were more successful, seemingly.
The last era, as AIG got downgraded, was while I wrote for RealMoney.? After AIG was added to the Dow, I was consistently negative on the stock.? I had several worries:
Was AIGFP properly hedged?
Were reserves for the long-tail commercial lines conservative?
Why had leverage quadrupled over the last 15 years?? ROA had fallen as ROE stayed the same.? The AIG religion of 15% after-tax ROE had been maintained, but at a cost of increasing leverage.
Was AIG such a bespoke behemoth that even Greenberg could not manage it?
My own experiences inside AIG, upon more mature reflection, made me wonder whether there might not be significant accounting chicanery.? (I was privy to a number of significant reserving errors 1989-1992).
In general, opaqueness, and high debt (even if it’s rated AAA), is usually a recipe for disaster.? AIG fit that mold well.
Now AIG recently sold one of their core P&C subsidiaries for what looks like a bargain price.? This is only an opinion, but I think AIG stock is an eventual zero.? Granted, all insurance valuations are crunched now, but even with that, if selling the relatively transparent operations such as Hartford Steam Boiler brings so little, then unless the whole sector turns, AIG has no chance.? Along the same lines, I don’t expect the “rescue” to be over soon, and I expect the US govenment to take a significant loss on this one.
The second article is from Bethany McLean of Vanity Fair.? I remember reading her writings during the accounting scandals at Fannie Mae.? She was sharp then, and sharp now.? There were a loose group of analysts that went under the moniker “Fannie Fraud Patrol.”:? I still have a t-shirt from that endeavor, from my writings at RealMoney, and my proving that the fair value balance sheets of Fannie were unlikely to be right back in 2002.
Again, there is a growing bubble, as with AIG.? The need to grow income leads Fannie and Freddie to buy in mortgages that they have guaranteed, to earn spread income.? It also leads them to buy the loans made by their competitors.? It leads them to lever up even more.? It leads them to dilute underwriting standards.? Franklin Raines’ goals lead to accounting fraud as his earning targets can’t be reached fairly.
One lack in the article is that the guarantees that Fannie had written would render Fannie insolvent at the time the Treasury took them over.? On a cash flow basis, that might not happen for a long time, but it would happen.? Defaults would be well above what was their worst case scenario, and too much for their thin capital base.
The last article is another three part series from the Washington Post that is about the failure of our financial markets.? (Here are the parts — one, two, three.)? What are the main points of the article?
Bailing out LTCM gave regulators a false sense of confidence.? They relished the micro-level success, but did not consider the macro implications of how speculation would affect the investment banks.
Because of turf and philosophy conflicts, derivatives were left unregulated.? (My view is that anything the goverment guarantees must be regulated.? Other financial institutions can be unregulated, but they can have no ties to the government, or regulated financial entities.
The banking regulators failed to fulfill their proper roles regarding loan underwriting, consumer protection and bank leverage.? The Office of Thrift Supervision was particularly egregious in not doing their duty, and also the the SEC who loosened investment bank capital requirements in 2004.
Proper risk-based capital became impossible to enforce for Investment banks, because regulators could not understand what was going on; perhaps that is one reason why they gave up.
The regulators, relying on the rating agencies, could not account for credit risk in any proper manner, because the products were too new.? Corporate bonds are one thing — ABS is another, and we don’t know the risk properties of any asset class that has not been through a failure cycle.? Regulators should problably not let regulated entities use any financial instrument that has not been through systemic failure to any high degree.
Standards fell everywhere as the party went on, and the bad debts built up.? It was a “Devil take the hindmost” situation.? But as the music played, and party went on, more chairs would be removed, leaving a scramble when the music stopped.? Cash, cash, who’s got cash?!
In the aftermath, regulation will rise.? Some will be smart, some will be irrelevant, some will be dumb.? But it will rise, simply because the American people demand action from their legislators, who will push oin the Executive and regulators.
A few final notes:
Accounting rules and regulatory rules were in my opinion flawed, because they allowed for gain on sale in securitizations, rather than off of release from risk, which means much more capital would need to be held, and profits deferred till deals near their completion.
This could never happened as badly without the misapplication of monetary policy.? Greenspan enver let the recessions do their work and clear away bad debts.
Also, the neomercantilistic nations facilitated the US taking on all this debt as they overbuilt their export industries, and bought our debt in exchange.
The investment banks relied too heavily on risk models that assumed continuous markets.? Oddly, their poorer cousin, the life insurers don’t rely on that to the same degree (Leaving aside various option-like products… and no, the regulators don’t know what is going on there in my opinion.)
The insurance parts of AIG are seemingly fine; what did the company in was their unregulated entities, and an overleveraged holding company, aided by a management that pushed for returns and accounting results that could not be safely achieved.
The GSEs were a part of the crisis, but they weren’t the core of the crisis — conservative ideologues pushing that theory aren’t right.? But the liberals (including Bush Jr) pushing the view that there was no need for reform were wrong too.? We did not need to push housing so hard on people that were ill-equipped to survive a small- much less a moderate-to-large downturn.
With the GSEs, it is difficult to please too many masters: Congress, regulators, stockholders, the executive — all of which had different agendas, and all of which enoyed the ease that a boom in real estate prices provided.? Now that the leverage is coming down, the fights are there, but with new venom — arguing over scarcity is usually less pleasant than arguing over plenty.
As in my blame game series — there is a lot of blame to go around here, and personally, it would be good if there were a little bit more humility and willingness to say “Yes, I have a bit of blame here too.”? And here is part of my blame-taking: I should have warned louder, and made it clearer to people reading me that my stock investing is required because of the business that I was building.? I played at the edge of the crisis in my investing, and anyone investing alongside me got whacked with me.? For that, I apologize.? It is what I hate most about investment writing — people losing because they listened to me.
I am not a gambler, and I never will be.? I take the risks of a businessman as I invest, and not those of a speculator.? I found it interesting to to read this Wall Street Journal article where public defined benefit pension plans are not fleeing hedge funds.? This is an area where I half agree.? Because the yields of high yield bonds are so high, this is not a time to abandon aggressive strategies.? Rather, it is a time to embrace them, slowly and carefully.
I looked through the database of my writings in the CC at RealMoney, and I found these two comments that fit the moment well.
This isn’t a burning hot issue at present, but I have been impressed with the increasing amount of money getting thrown at esoteric asset classes by pension plans and endowments, in an attempt to diversify and gain higher total returns. In the intermediate term, it is not sustainable. For now, party on, we are in overshoot mode.
By esoteric asset classes, I mean: commodities, timber, credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of asset- and mortgage-backed securities, hedge funds and private equity.
Many novel asset classes provide both higher returns and diversification when they are first used. As more and more players get comfortable with it, they buy in, lowering the required total return needed to attract investors, but pushing up returns to pre-existing holders as the price rises.
This can be self-reinforcing for quite a while, with a lot of money blindly flowing in, until some player games the system, selling securities that fail miserably. A panic ensues, and the asset class goes through a maturation process that learns to distinguish quality within the asset class.
With the rise in yields, high quality bonds have been giving holders a hard time in total return terms. But you don’t buy bonds for total returns; you buy them for income, and diversification; they tend to do well when risky assets break down.
I guess my short summary is this: with risky asset classes so highly correlated at present, if you want to diversify, go to high quality bonds, or cash. The theoretical diversification of risky assets based on correlation measures calculated over long time periods is no longer valid.
Alternatives to the Terror of Actuarial Funding Targets
9/27/2007 2:57 PM EDT
Jordan, my deep suspicion with respect to the pension plan sponsors is that they are looking at the gap between the yield they can get from investment grade bonds and the yield they need to fund the pension promises, and they realize that they are going to have to make a larger allocation to risky assets. After that, they look at the past track record on public equities, and conclude that they have been hurt by the lack of returns over the past seven years. Then they look at the returns in alternative investments, and say, “What great returns! Why have I been ignoring these? If David Swensen can do it, so can I!”
Well, David Swensen is a bright guy who went to the party early. Alternative investments were truly alternative when he arrived. Today they are mainstream, and some of them have gotten overfished. The plan sponsors can allocate all they like to alternatives, but they aren’t magic… they can do just as bad as public equity, and with far less liquidity.
If I were a plan sponsor today, I would begin trimming alternative areas that look crowded, like private equity, commercial real estate, and certain types of hedge funds while the door is still open. For some areas, like CDOs [Collateralized Debt Obligations] the door is already closed.
I would also lower my return expectations, and plan on contributing more. Heresy, I know. But alternatives are over-used, and no longer alternative. They won’t deliver the same high returns in the future that they did in the past.
Position: none
I am not unsympathetic here as public pension plans essentially say, “Well we have to earn enough to meet our actuarial funding targets, and at this point, bonds of the highest quality don’t help us.? Hedge funds promise high returns regardless of market movements, so we need to allocate money there.”
At this point in the cycle, I might have some sympathy, because enough arbitrage relationships are broken, offereing some opportunity.? At the same time, and ordinary investment in a basket of lower investment grade and high yield bonds offers a nice return for those willing to live with some default risk, which is over-discounted here, even with things as bad as they are.
In a bear market, once you have taken a severe amount of damage, the question is “what offers the best return from here?”? The answer might be unpopular, but it should be pursued.? Even as defined benefit managers pursued seeming diversification with bad payoffs as noted above, and should have sought long term guarantees, at a time like now, where guarantees are tremendously expensive, and yields are high? because of possible default, it is a time to take risk, and fund the best entities that may not make it.
These are ugly times, but we have to think like Ben Graham during the Great Depression.? What will survive?? Where can a little bit of additional capital spell the difference between death and survival?
This is a time to take risk.? Things could get worse from here, so don’t overcommit, but don’t fail to commit either.? Make some reasoned judgements about what is likely to do well ten years out, and invest for it.
This is a rough time.? I offer solace to those that are battling the markets; you are having a rough time of it.? The challenge here is whether the risk premium in fixed income assets offers enough compensation versus Treasury quality assets.? My answer is yes, realizing that this is a bumpy trade, and will require patience to receive the returns promised.
I’ve subscribed to The Economist for 22 years.? IN my opinion, it is the best English language newsweekly in the world.? Every now and then they toss a game into the magazine.? This time, the Internet aids the game, in that you can download cards, money, pieces, and rules.
This evening, three of my eight children said they wanted to play the game with me.? How it happened: I had printed out the money, cards, pieces and rules, and I had The Economist open to its centerfold, and the one who recently scored well on the National FInancial Literacy challenge saw it and asked what it was.? I told him it was a game from The Economist, and that if he made the effort to cut the pieces of paper and get the pieces together, we would play the game.? Two other children joined in, and we started the game.
Now, ay my house, you learn about the markets atmospherically.? As one of my kids said, who is not markets-oriented, “Yeah, in school neither the teacher nor the students understood what was going on in the economy, but I was able to explain it.”? (That floored me.)? As for the children that played with me this evening, it was filled with “Dad, what does it mean by…?” and laughter over the concept of naked short selling, especially given the graphic on the board.? There were a lot of “teachable moments” from a home schooler’s point of view.
The board and cards are filled with the clever humor of KAL, The Economist’s main cartoonist.? The kids picked up the copious easy humor, while I smiled at the nuances that they missed.? We have not finished the game yet, and two of my other children have said they want to play the next game.? One more aspect of the game: it starts in an intensifying boom cycle, and moves to an intensifying bust cycle.? The business cycle concept is definitely taught.
The length of the game seems to be an hour at minimum, and I’m not sure what the maximum could be.? Already the children are learning aspects of negotiation.? After one child went bankrupt for the second time, she received a buyout offer, a contingent debt offer in exchange for a “Get out of Chapter 11 free” card, and a free offer of money with the condition that if she went bankrupt again, she would sell out for a price fixed now.? She chose the contingent debt offer, and we all said she made the right move.
It may not be Monopoly, but it’s a fun game, and it is free.? Give The Economist and KAL credit for a clever game that sheds some light on the current crisis in a fun way.
This is a wonky book, and not for everyone.? It details the actions of monetary policy in the United Kingdom for much of the 19th Century.? In Great Britain, that was a century of incredible growth, and yet stability of the overall price level.? The Gold Standard worked, and the UK Government di not try to cheat on it, as it did in the early 20th century before the Great Depression.
One of Bagehot’s main ideas was that during a crisis, central banks should lend at a penalty rate without limit, and that would re-liquefy the marginal banks in the system that just needed a little to get by.? Bad banks would fail; good banks would not need to borrow.? We can contrast that with present policy of the Fed to lend against marginal collateral at favorable rates.? Ain’t no chance of us getting out of the problem that way.? All we do is create a new class of arbitageurs to extract money from the taxpayers, or Treasury note buyers.
The mangement of a good central bank is very conservative, and keeps a reserve large enough to avoid all disasters.? This again is the diametric opposite of the Federal Reserve, which was not in a conservative posture, and believes it can solve all of the credit problems through the wanton expansion of its balance sheet.
PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? I?m not out to sell things to you, so much as provide a service.? Not all books are good, and not every book is right for everyone, and I try to make that clear, rather than only giving positive book reviews on new books.? I review old books that have dropped of the radar as well, like this one, because they are often more valuable than what you can find on the shelves at your local bookstore.
1) There are firsts for everything.? Americans paid down debt for the first time, according to a Federal Reserve Study that started in 1952.? America has always been a pro-debt and pro-debtor nation.? It goes all the way back to the Pilgrims, who paid back the merchant adventurers who funded them at a rate of nearly 40%/yr over a 15-20 year period.? But, the Pilgrims did extinguish the debt.? Us, well, I’m amazed at the decrease, but we need more of that to restore normalcy to financial institutions.
2) Dropping to 45%, though, is the amount of aggregate home value funded by equity.? With the decline in housing values, the fall in the ratio was inevitable.? The low ratio puts downward pressure on home prices, because it means that more homes are underwater.? Perverse, huh?
3) It’s a long interview, but Eric Hovde (my former boss) has a lot of important things to say regarding the financial sector.? Few hedge funds focused on financials remained bearish on the sector, but Hovde’s funds survived to 2007-2008 where his bets paid off.
4) Is there a Treasury bubble?? Yes, but it may persist for a while because of panic, central bank buying, buying from pension funds and endowments, mortgage hedging, and more.
5) Now these same low yields whack Treasury money funds. How many will close?? How many will cut fees?? How many will break the buck, and credit negative interest?? An unintended consequence of monetary policy.? Another unintended consequence reduces liquidity in the repo markets.? Yet another unintended consequence is the reduction in investment from Japan and other nations that don’t want to hold dollars at low rates.
6) Brave Ben Bernanke is fighting the Depression.? If his theories are right (and mine wrong), if he succeeds, he will face a difficult challenge in collapsing the Fed’s balance sheet as inflation re-emerges, without taking the wind out of the economy.? But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed and the US Government to handle.
7) Inflation is the lesser evil at this point.? It would raise the value of collateral over the value of the loans, dealing purchasing power losses to those that made the bad loans, but not nominal losses.
8 ) I have said before that the Fed and Treasury are making it up as they go, and Elizabeth Warren now confirms it for the Treasury.? My Dad (turned 79 yesterday) used to say, “The hurrier I go, the behinder I get.”? So it is for the TARP bailout.? Policy made hastily rarely works.? Spend more time, get it right.? The market won’t die as you work it out.
9) But will AIG die, or the automakers?
Sales are slow for assets at AIG.? (no surprise valuations are crushed, and all likely buyers face lower P/Es and higher debt costs.)
And who knows where the writeoffs end?? As I said long before the failure of AIG, don’t trust the financial statements.? The palce was too complex, and the culture of fear inhibited objective financial reporting.
From Credit Slips, the important idea is that without a good business plan the automakers are toast anyway.? I predict they will be back hat in hand in half a year even with a bailout.
10) Even VCs are looking at the survivability of their portfolio holdings.? Who can survive and become cash-flow positive in a tough environment.? Who needs little additional funds?
11) Leveraged loans are attractive, but it is a situation of too many loans with too few native buyers.? Watch the loan covenants, so that you can get good recoveries in a default.? If you are an institutional investor, this is a place to play now that will deliver reliable returns net of defaults.? For retail investors, the closed end funds typically employ too much leverage — it is possible that one could collapse before this crisis is over.
12) Residential mortgages continue to weaken along with property prices.? Two examples: Alt-A loans and second mortgages.
17) The export boom is dead, for now.? Fortunately, imports are falling faster, so the current account deficit is falling.
18) I blinked when I saw this Wall Street Journal Op-Ed.? Sorry, but the secret to changing the residential real estate market is not lowering interest rates, but writing-off? portions of loan balances.? Most delinquents can’t make even reduced payments, half re-default, and can’t refinance because the property is underwater.? Yes, I know that the government is pressing to have Fannie and Freddie suck down more losses by letting underwater loans refinance, but if you’re going to do that, why not be more explicit and let the losses be realized today by resetting the loan’s principal balance to 80% of the property value, and giving the GSE a property appreciation right on any growth in the home value on sale, of say 150% of the amount written down?
19) On commercial property, when do you extend on a loan vs foreclosing?? In CMBS, if the special servicer has no bias, or if a healthy insurer/bank holds the loan on balance sheet, you extend when you are optimistic that this is just a short-term difficulty with the property, and you think that the property owner just needs a little more time in order to refinance the loan.? More cynically, extensions can occur in CMBS because the juniormost surviving class directs the special servicer to extend because it maximizes the value that they will get out of their investment, because a foreclosure will wipe out a portion of their interests, since they are in the first loss position.? With a less than healthy bank or insurer, the same procedure can happen if they feel they can’t take the loss now.? (I know that in a extension/modification there should be some sort of writedown, but some financial entities find ways to avoid that.)
20) Time to go bungee jumping with the US Dollar?? As Bespoke pointed out, the Dollar Index has just come off its biggest 6-day loss ever.? Should we expect more as the US heads into a ZIRP [zero interest rate policy], with aggressive expansion of the Fed’s balance sheet, much of which might be eventually monetized?? The best thing that can be said for the US Dollar is that it is already in ZIRP-land, and much of the rest of the rest of the world is being dragged there kicking and screaming.? As the interest rate differentials narrow in real terms, the US Dollar should improve.
But, there are complicating factors.? Future growth or shrinkage of the demand for capital will have an impact, as will future inflation rates.? Even if the whole world is in a global ZIRP, there will still be differences in the degree of easing, and how much easing the central bank allows to leak into the money supply.
This is a mess, and over the next few years, expect to see a whole new set of metrics develop in order to evaluate monetary policies and currencies.? For now, put your macroeconomics books on the shelf, because they won’t be useful for some time.
Many people have asked me what to do in this market environment, and I have sat and thought about it.? My own personal portfolio is around 60% equities, 15% my home, and 25% cash.
I think probabilistically.? I don’t focus on just one scenario.? I try to balance across a wide number of scenarios, and ask what will do the best.? In a foggy situation like today, that answer is not easy.
I will give you an example.? 8.5 years ago, the leaders of my church came to me and said “Would you invest the money for our congregation’s building fund?”? My initial answer was “no.”? I don’t like investing money for friends, generally.? They came back again, and said, “Please?”? I felt ashamed, and said, “Okay, fill out this risk questionnaire.”? They gave me a series of answers that essentially said, “We don’t know when we need the money, but get a good return for us.”
Ugh.? In May of 2000 went back to Ben Graham’s 50/50 (stocks/bonds), and then adjusted it, taking 10% from the area of the market that I liked worst, and added it to the area I liked best.? I took growth stocks and sold them and bought long term corporate bonds.
Since then I have made further adjustments.? The current portfolio is:
Much as I like Vanguard, I am not endorsing any of their funds here; they are example for asset allocation.? I am very light on US stocks here, and intentionally so.? This portfolio has an anti-inflation bias, and will do better against a weaker dollar.? The corporate bonds, both investment grade and high yield, replace equity exposure.? Corporates are cheap relative to common stocks, and they have better protective characteristics as well.? Though I don’t have any closed-end corporate floating rate funds here, they could be interesting if their leverage was low enough, which isn’t common.? As for the international developed market stocks, a basket of different countries will likely do better than a simple US exposure, even if the dollar continues to fall.
TIPS have been a fatal attraction for me, and I hope to have a post? out in the near term explaining their value in this environment where inflation is negative for now.? My view is that the Fed will eventually monetize the debts they are incurring.? Also, as the dollar gets weaker, inflation will get imported back into the US.
What could go wrong here?? We could have a trade war, or the US government could take actions to protect the value of debt held by foreigners (not likely).? If the equity markets rally, investment grade corporates and high yield will not be far behind, but this portfolio would lag.
No portfolio is perfect.? This one certainly isn’t, but it is my attempt to position for what I view as a lousy economic environment that will eventually yield inflation.
Full disclosure: long VIPSX, and my church long what is listed above
When I think about the present market difficulties, I think about both the situation as a whole, and the personalities involved.? We might look at Bernie Madoff as a poster child for the current distress, but back during the Great Depression. we might have considered Richard Whitney.
Though the conditions are different, when conditions move from boom to bust, cheaters get revealed — those who were relying on good times in order to make good on promises gone wrong.? Both Madoff and Whitney had sterling reputations as well, and they both played a significant role in the trading of the market.
Perhaps big frauds require seemingly upright men who command trust from their peers.? Practices that can be gooten away with during a bull phase of the market will fall flat during the bear phase.
Aside from the Whitney story, Once in Golconda tells the story of boom and bust for the financial economy as a whole.? Taking chances ramped up, supported by a too-easy monetary policy.? After the peak, opportunities were few, and few had the spare capital to invest in ventures that were seemingly rich, as measured against boom conditions.? Such is the nature of scarce liquidity after a boom.
This is a fun book.? You can see the gathering storm as liquidity grows, and markets boom.? You can see the increasing furor nearing the peak.? At the peak, you can’t hear much.? During the fall you can hear investors go through the five stages of grieving as they watch their investments die.
This is a good book, well-written, and appropriate for our era.? I recommend it.
PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? Such a deal if you wanted to get it anyway?
One of the great conceits in investments is trying to earn above average returns with low variability of returns.? Yet, when you consider the Madoff scandal, it is what can attract a lot of money from credulous investors.
One of the glories of a capitalistic economy is that markets are unstable, they adjust to point out what is no longer needed.? Often the adustments occur violently, because businessmen/consumers chase trends, which can lead to bubbles and bubblettes, until the cash flows of the assets cannot bear the interest flows on the debts that have been created to buy the assets.? Attempts to tame this, such as Alan Greenspan’s aggressive provisions of liquidity just build up more debt for an economywide bubble, followed by a depression.? We got the Great Moderation because of trust in the Greenspan Put.? The Fed would only take away the punchbowl for modest amounts of time, so speculation on debt instruments, real estate, financial institutions, etc., could go on to a much greater degree.? Boom phases would be long; bust phases short and low-impact.
There have been problems with lax regulation of bank underwriting, and investment bank leverage, but the key flaw was mismanagement of the money/credit supply.? Had the Fed held credit tighter during the ’90s and 2000s, we would not be here now.? The Fed could have kept the fed funds rate high, rewarding savings, perhaps leading to a lower cuurent account deficit as well.? Debt growth would have slowed, and securitization, which hates having an inverted or flat yield curve, would have slowed as well.? GDP growth would have been slower, but we would not be facing the crisis we have now.
Or consider housing, and how it became overbuilt because of lax loan underwriting, accommodative monetary policy, and a follow-the-leader mania.? Here’s an old CC post from the era:
1) For those with stable businesses that throw off a lot of earnings and cash flow, and want to dodge the tax man, here’s a possible way to do it, courtesy of the Wall Street Journal: start a defined benefit plan. Disadvantages: complex, relatively illiquid and expensive. Advantages: you can sock away a lot, and defer taxes until you begin taking your benefit, possibly (maybe likely) at lower tax rates.
(This message brought to you courtesy of one actuary who won’t benefit from the message itself… but hey, it helps the profession.)
2) Sea changes in the markets rarely take place in a single day or week. Tops, and changes in leadership tend to take place over months, and feel uncertain. Though Jim is pretty certain that it is time to shift out of energy, I am willing to hang on, and get my opportunities to average down if they come at all. My rebalance points are roughly 20% below current prices anyway, so I’d need a real pullback in order to add.
Though there may be temporary inventory gluts, the basic supply/demand story hasn’t changed, and energy stocks still discount oil prices in the 40s, not the 60s.
3) Contrary to what Jim Cramer wrote in his housing piece today, you can lose it all in housing. Granted, it would be unusual to see homeowners in multiple areas in the country lose their shirts all at the same time; that hasn’t happened since the Great Depression, and we all know that the Great Depression can’t recur, right?
Thing is, local hot real estate markets often revert; if the reversion is bad enough, it leads to foreclosures. Think of Houston in the mid-80s, and Southern California in the early 90s. For that matter, think of CBD real estate in the early 90s… not only did that threaten real estate owners, it did in a number of formerly venerable banks and insurance companies.
Real estate is not a one way street, any more than stocks are. We have never financed as much real estate with as little equity as today before. We have not used financing instruments that are as back-end loaded before. Finally, this speculation is being done on a basis where renting is far cheaper than owning, leaving little support for property prices if the incomes of leveraged homeowners can’t be maintained in a recession. (Oh, that’s right. No more recessions; the Fed has cured that.)
Look, I’m not pointing at any immediate demise of housing in the hot markets. I still think that any trouble is a 2006-7 issue. But this is not a stable situation; if you have a large mortgage relative to your income, make sure your employment situation is really stable. If you can make the payment, prices on the secondary market don’t matter. If you can’t… those prices matter a lot.
One more note: an average investor can sell all of his stocks in the next 20 minutes, with little effect on the market. This is true even in a bad market. In a bad real estate market, you can’t sell; buyers are gunshy — it is akin to what I went through as a corporate bond manager in 2002. There are months where there is no liquidity for some bonds at any reasonable price. So it is for houses in some neighborhoods when half a dozen “for sale” signs go up. No one can sell except at fire sale prices.
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Well, that’s the macroeconomic problem with stability.? When it gets relied on, after a self-reinforcing boom, it goes away.? Trust in stability is dangerous in other contexts, though.? From another CC post:
Oil and Economic Strength (and a Rant on the Sharpe Ratio)
8/31/2005 3:13 PM EDT
I haven’t really talked about the issue of whether high oil prices portend economic strength or weakness for a good reason. No one knows. There are too many moving parts, and separating out the different effects is impossible; opinions here come down to more of one’s personality (optimist/pessimist) or investment positions (stocks/bonds/energy).
Even if someone did tests using Granger-causality, I’d still be suspicious of the result, whichever way it would point, because of the high probability of finding spurious correlations.
And, speaking of spurious correlations, since Charles Norton brought up the Sharpe ratio, I may as well say that it is a bankrupt concept as commonly used by investment consultants. First, variability is not risk. Losing money over your own personal time horizon is risk (which implies that risk varies for each investor). Second, there is not one type of risk, but many risks. Systematic risk may be measurable in hindsight, but never prospectively.
Third, any measure going off historical values is useless for forecasting purposes, because the values aren’t stable over time. When managers get measured in order for clients to make decisions, they are using the figures for forecasting purposes. It is no surprise that they don’t get good results from the exercise.
Why do figures like a Sharpe ratio gets used, then? Because consultants like simple answers that they can give to their clients, even if the answers yield no insight into the future. (It makes the math really simple, and allows a large number of strategies to be rapidly compared. It eliminates real work and thought.) Investment is a far more messy process than a few simple ratios can illustrate, and those that use these ratios get the results that they deserve.
Finally, an aside. Why am I so annoyed by this? Because of money lost by friends and clients who have been led along this path by investment consultants. There is a real cost to bad ideas.
Time Series Regression and Correlation (for wonks only)
7/12/2007 3:11 PM EDT
We’ve had a few discussions here recently involving correlation, so I thought I might post something on the topic. First, it is easy to abuse statistics of all sorts. Few on Wall Street really understand the limitations of the techniques; I have seen them abused many times, often to the tune of large losses.
When comparing multiple time series of any sort, the results can vary considerably if you run the calculation daily, weekly, monthly, quarterly, annually, etc. As you use fewer and fewer observations, the parameters calculated will change. The best estimate will be the one using all available observations, that is, assuming that the underlying processes that generated the time series will be the same in the future as in the past.
It gets worse when comparing the changes in time series. Here moving from daily to weekly to monthly (etc.) can make severe differences in the calculations, because two data series can be almost uncorrelated in the short-run, and very correlated in the long run. My “solution” is that you size your time interval to the time interval over which you make decisions. If daily, then daily, annually, then annually. Again, subject to the limitation that that the underlying processes that generated the changes in time series will be the same in the future as in the past.
But often, the results aren’t stable, because there is no real relationship between the time series being compared. High noise, low signal is a constant problem. Humility in financial statistics is required.
As an example, calculations of beta coefficients often vary significantly when the periodicity of the data changes. People think of beta as a constant, but I sure don’t.
For those who want more on this, there are my two articles, “Avoid the Dangers of Data-Mining,” Part 1 and Part 2.
Enough of this. Back to the roaring markets! Haven’t hit the trading collars yet!
Position: none, but intellectually short Modern Portfolio Theory [MPT]
My point is this: investors look for stable relationships that they can rely on.? Those relationships are precious few.? Sharpe ratios aren’t stable; correlation coefficients aren’t stable; return patterns aren’t stable.? They shouldn’t be stable.? They rely on a noisy economy? which is prone to booms and busts, and industries that are prone to booms and busts.? Seeking stable returns is a fool’s errand.? Warren Buffett has said something to the effect of, “I’d rather have a lumpy 15% return, than a smooth 12% return.”? Though we might mark down those percentages today, the idea is correct, so long as the investor’s time horizon is long enough to average out the lumpiness.
So, if we are going to be capitalists, let’s embrace the idea that conditions will be volatile, more volatile on a regular basis, but given the lower debt levels across the economy because of regular shakeouts, no depressions.? But this would imply:
Higher savings rates.
Greater scrutiny of balance sheets.
Aversion to debt, both personally, and in companies for investment.
Less overall financial complexity, and a smaller financial sector.
Lower P/Es at banks.
Even lower P/Es in non-regulated financials.? It’s a violent world.
.? Or, you can 
