Insurance is complex by nature.? Anytime one brings in a third party to be a protector/guarantor against adverse events, it creates some weird dynamics.? Now, a few of the states, including the best of them, New York, have been regulating insurance for a long time.? But the Feds have not dealt with insurance in any significant way, because that role has been ceded to the states.
With the failure of AIG, and it getting acquired by the Feds, the questions of regulation have taken on new significance.? I have written before about the Federalization of insurance regulaton, indicating some indifference about who regulates it, but pointing out the difficulties — what an effective insurance regulator needs to learn.
The following is personal to me in four ways:
I used to work for AIG (’89-’92)
My main local paper is the Baltimore Sun (though I don’t subscribe, because of lack of value)
Elijah Cummings is my Congressman, at least since the last gerrymander. (Hey, give him credit, he voted against the bailout.)
I have interacted with many insurance regulators of varying abilities over the last 20+ years.
Elijah Cummings and some other congressmen have gotten offended over seemingly extravagant expenses over conferences, particularly for agents/representatives of the company.? Now, as a young actuary, I would sometimes say, “Why do the agents get to go to all of the fun conferences?”? Not true — only the top agents went to those conferences, and it was a reward that would stimulate extra performance (and the real reward was bragging rights — the companies often made money off of conference-type rewards).? Actuaries are nice, and all that, but the ability to sell product, particularly in life insurance and annuities, is rare.
When the government gets involved in industry, the incentives become messy:
A1) We need to do a lot of mortgage workouts for the good of mortgage payors and those in residential real estate.
A2) We need to minimize the cost of the mortgage bailout to the taxpayer.? Or, we can’t borrow that much.
B1) We must reduce tobacco smoking in our state; it is harming our dumbest citizens.
B2) But we issued tobacco bonds against the recent settlement with the tobacco companies.? We can’t afford to lose revenue.
C1) We’ve got to crack down on shady life insurance sales practices.? Too many people are getting cheated.
C2) That insurance company employs a lot of people in our state, and they are located in the district of the head of the commerce committee.
D1) Gambling has introduced new forms of addiction to our state, and perhaps organized crime as well.
D2) We can’t afford to give up the tax proceeds from gambling — the schools depend on it.
Have I made it clear?? Politicians want political results, and they want tax revenues, which are often opposed to each other.? They aren’t typically businessmen, so they don’t understand the tradeoff.? Rather, they swing from one to the other, as political convenience dictates.
And so in this situation, I would say that the amounts in question are rather nominal.? Why fuss over the conferences?? Rewarding top performers is important, and if you don’t do that, you will lose business, and the government will lose on its “investment” (what a word 😉 ) in AIG.? Most companies have conferences like AIG, and I can tell you, they wil think twice about coming under the government’s umbrella for that reason, as well as many other reasons that have political significance, but harm corporate performance.
State legislatures took time to build up expertise in insurance regulation.? Some more so like New York (we should move the NY regulators to DC if we federalize), and some less so.? Congress doesn’t have the vaguest idea on what to do with insurance and AIG.? The ignorant statements of Rep. Cummings are a great example.? Ed Liddy has only been on the job for less than two months.? Why call for his head?? Insurance companies are complex organizations where most significant things are planned a year in advance or so.
Now, so I like the AIG bailout?? No, perhaps we should have let the holding company fail, and the underlying insurance subsidiaries would have been fine.? Some CDO holders would have been hurt, but what are you doing dabbling in CDOs, anyway?? And why didn’t you question why so much of your CDO exposure was AIG guaranteed?? When only one company guarantees much of the business, that is a bad sign (underpricing).
But seeing the ruckus here, this is why it is bad for the government to own an insurance company.? All of the incentives are confused, which will lead to a greater failure, and more expense to the taxpayers.
Before I try to explain what a Depression is, let me explain what a bubble is.? A bubble is a self-reinforcing boom in the price of an asset class, typically caused by cheap financing,? with the term of liabilities usually shorter than the lifespan of the asset class.
But, before I go any further, consider what I wrote in this vintage CC post:
In light of Jim Altucher’s and Cody Willard’s pieces on bubbles, I would like to offer up my own definition of a bubble, for what it is worth.A bubble is a large increase in investment in a new industry that eventually produces a negative internal rate of return for the sector as a whole by the time the new industry hits maturity. By investment I mean the creation of new companies, and new capital-raising by established companies in a new industry.This is a hard calculation to run, with the following problems:
1) Lack of data on private transactions.
2) Lack of divisional data in corporations with multiple divisions.
3) Lack of data on the soft investment done by stakeholders who accept equity in lieu of wages, supplies, rents, etc.
4) Lack of data on corporations as they get dissolved or merged into other operations.
5) Survivorship bias.
6) Benefits to complementary industries can get blurred in a conglomerate. I.e., melding “media content” with “media delivery systems.” Assuming there is any synergy, how does it get divided?
This makes it difficult to come to an answer on “bubbles,” unless the boundaries are well-defined. With the South Sea Bubble, The Great Crash, and the Nikkei in the 90s, we can get a reasonably sharp answer — bubbles. But with industries like railroads, canals, electronics, the Internet it’s harder to come to an answer because it isn’t easy to get the data together. It is also difficult to separate out the benefits between related industries. Even if there has been a bubble, there is still likely to be profitable industries left over after the bubble has popped, but they will be smaller than what the aggregate investment in the industry would have justified.
To give a small example of this, Priceline is a profitable business. But it is worth considerably less today than all the capital that was pumped into it from the public equity markets, not even counting the private capital they employed. This would fit my bubble description well.
Personally, I lean toward the ideas embedded in Manias, Panics, and Crashes by Charles Kindleberger, and Devil take the Hindmost by Edward Chancellor. From that, I would argue that if you see a lot of capital chasing an industry at a price that makes it compelling to start businesses, there is a good probability of it being a bubble. Also, the behavior of people during speculative periods can be another clue.
It leaves me for now on the side that though the Internet boom created some valuable businesses, but in aggregate, the Internet era was a bubble. Most of the benefits seem to have gone to users of the internet, rather than the creators of the internet, which is similar to what happened with the railroads and canals. Users benefited, but builders/operators did not always benefit.
none
Bubbles are primarily financing phenomena.? The financing is cheap, and often reprices or requires refinancing before the lifespan of the asset.? What’s the life span of an asset?? Usually quite long:
Stocks: forever
Preferred stocks: maturity date, if there is one.
Bonds: maturity date, unless there is an extension provision.
Private equity: forever — one must look to the underlying business, rather than when the sponsor thinks he can make an exit.
Real Estate: practically forever, with maintenance.
Commodities: storage life — look to the underlying, because you can’t tell what financing will be like at the expiry of futures.
Financing terms are typically not locked in for a long amount of time, and if they are, they are more expensive than financing short via short maturity or floating rate debt.? The temptation is to choose short-dated financing, in order to make more profits due to the cheap rates, and momentum in asset prices.
But was this always so?? Let’s go back through history:
2003-2006: Housing bubble, Investment Bank bubble, Hedge fund bubble.? There was a tendency for more homeowners to finance short.? Investment banks rely on short dated “repo” finance.? Hedge funds typically finance short through their brokers.
1998-2000: Tech/Internet bubble.? Where’s the financing?? Vendor terms were typically short.? Those who took equity in place of rent, wages, goods or services typically did so without long dated financing to make up for the loss of cash flow.? Also, equity capital was very easy to obtain for speculative ventures.
1998: Emerging Asia/Russia/LTCM.? LTCM financed through brokers, which is short-dated.? Emerging markets usually can’t float a lot of long term debt, particularly not in their own currencies.? Debts in US Dollars, or other hard currencies are as bad as floating rate debt,? because in a crisis, it is costly to source hard currencies.
1994: Residential mortgages/Mexico: Mexico financed using Cetes (t-bills paying interest in dollars).? Mortgages?? As the Fed funds rates screamed higher, leveraged players were forced to bolt.? Self-reinforcing negative cycle ensues.
I could add in the early 80s, 1984, 1987, and 1989, where rising short rates cratered LDC debt, Continental Illinois, the bond and stock markets, and banks and commerical real estate, respectively. That’s how the Fed bursts bubbles by raising short rates.? Consider this piece from the CC:
One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:
2000 — Nasdaq
1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed
1994 — Mortgages/Mexico
1989 — Banks/Commercial Real Estate
1987 — Stock Market
1984 — Continental Illinois
Early ’80s — LDC debt crisis
So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.
But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it.
Position: None
Bubbles end when the costs of financing are too high to continue to prop up the inflated value of the assets.? Then a negative self-reinforcing cycle ensues, in which many things are tried in order to reflate the assets, but none succeed, because financing terms change.? Yield spreads widen dramatically, and often financing cannot be obtained at all.? If a bubble is a type of “boom phase,” then its demise is a type of bust phase.
Often a bubble becomes a dominant part of economic activity for an economy, so the “bust phase” may involve the Central bank loosening rates to aid the economy as a whole.? As I have explained before, the Fed loosening monetary policy only stimulates parts of the economy that can absorb more debt.? Those parts with high yield spreads because of the bust do not get any benefit.
But what if there are few or no areas of the economy that can absorb more debt, including the financial sector?? That is a depression.? At such a point, conventional monetary policy of lowering the central rate (in the US, the Fed funds rate) will do nothing.? It is like providing electrical shocks to a dead person, or trying to wake someone who is in a coma. In short: A depression is the negative self-reinforcing cycle that follows a economy-wide bubble.
Because of the importance of residential and commercial real estate to the economy as a whole, and our financial system in particular, the busts there are so big, that the second-order effects on the financial system eliminate financing for almost everyone.
We face a challenge as great, or greater than that at the Great Depression, because the level of debt is higher, and our government has a much higher debt load as a fraction of GDP than back in 1929.? It is harder today for the Federal government to absorb private sector debts, because we are closer to the 150% of GDP ratio of government debts relative to GDP, which is where foreigners typically stop financing governments. (We are at 80-90% of GDP now.)
We also have hidden liabilities through entitlement programs that are not reflected in the overall debt levels.? If I reflected those, the Debt to GDP ratio would be somewhere in the 6-7x GDP area. (With Government Debt to GDP in the 4x region.)
We are in uncharted waters, held together only because the US Dollar is the global reserve currency, and there is nothing that can replace it for now.? In the short run, as carry trades collapse, there is additional demand for Yen and US Dollar obligations, particularly T-bills.
But eventually this will pass, and foreign creditors will find something that is a better store of value than US Dollars.? The proper investment actions here depend on what Government policy will be.? Will they inflate away? the problem?? Raise taxes dramatically?? Default internally?? Externally?? Both?
I don’t see a good way out, and that may mean that a good asset allocation contains both inflation sensitive and deflation sensitive assets.? One asset that has a little of both would be long-dated TIPS — with deflation, you get your money back, and inflation drives additional accretion of the bond’s principal.? But maybe gold and long nominal T-bonds is better.? Hard for me to say.? We are in uncharted waters, and most strategies do badly there.
Last note: if you invest in stocks, emphasize the ability to self-finance.? Don’t buy companies that will need to raise capital for the next three years.
1) General Growth Properties — another case of too much leverage, illiquid assets, and liquid liabilities.? I live near Columbia and Baltimore, so I know of a lot of property owned by General Growth that was bought when they acquired the Rouse Corp.? I can hear the Rouses in the distance congratulating themselves on a good sale.
For those that haven’t read me much, the deadly trio of too much leverage, illiquid assets, and liquid liabilities is what causes most corporate defaults of financial companies, not lesser issues like mark-to-market accounting.
2) The government thinks it is doing something good, and then it realizes that it is in over its head.? Consider AIG and Fannie Mae.? Where does the bailout end?? The government does not have a team of financial analysts competent to dig into murky balance sheets, and they have the mistaken notion that they must act fast.? Having worked on several takeovers of large financial firms, I can tell you that work done quickly destroys value.? Either there is an underestimate that leads to losing the bid, or an overestimate that leads to overpaying, and an eventual writeoff of part of the investment.
With Fannie Mae and AIG, (and probably Freddie also) the government clearly did not know what it was doing.? What were the main drivers of the loss, and how much worse could they get?? Is this scenario self-reinforcing?? The cursory work led to a bad result that is getting worse.
3) Amazing that we are almost to the end of the first $350 billion of bailout capital.? The government is behaving like a person that just won the lottery, and is profligate with spending, because they’ve never had that much money to throw around with complete discretion until now. As it says in Proverbs 13:11, “Wealth gained by dishonesty will be diminished, but he who gathers by labor will increase. [NKJV]”? Easy come, easy go.? I am not surprised in the slightest that the US Government has mis-estimated the loss exposures.? They don’t have anyone with a concentrated interest (a profit motive) in the result.
4) Here’s another angle in the Fed refusing to disclose what assets they are financing.? If we knew who they were buying from, and what they were buying, the markets would ask the question, “How much more firepower are they willing to expend?”? If the judgment is “little”, market players would sell what the Treasury/Fed was buying, and if the judgment is “a lot”, market players would buy what the Treasury/Fed was buying.
That leads me to believe that the Treasury/Fed doesn’t want to commit a lot more resources to this fight.? If they felt they had a lot more firepower, they would happily disclose their actions, because the private markets would aid their actions.
5) I’ve been talking about it for over a decade, so pardon me if I point at the great pensions disaster.? We have had a lost decade where DB pension money needed to earn 8-9%/yr, and earned around 1%/year.? That gap of 7-8%/yr over 10 years is enough to destroy most well-funded plans at the beginning of the period.? The problem exists for DC plans as well, because as people age, they lose time to compound their money.? Hey, think of this — the dumb guys that put all their money in the stable value fund did much better than those that put their money at risk.? So much for the equity premium in hindsight, but now it’s time to begin committing funds to riskier assets.? (Don’t do it all at once.)
6) At least Mr. Obama can make one market go up — muni bonds.? Wait, that’s not good?!? At least healthy municipalitiestheir borrowing rates improve as higher taxes lead the wealthy to shelter income from taxation.
7) Maybe Obama’s tax poicy could have more bite.? Close down tax havens.? This is something I can get behind.? I like low tax rates, but I don’t like the ability for some to lower their tax rates, and not others.? Let there be a level playing field in the tax code, such that there is no advantage to moving profits offshore.
8 ) I understand why the Treasury did it.? They wanted an opaque way of encouraging the purchase of weak banks by stronger banks.? So, they let them absorb tax losses of the acquired bank.? Too bad it is not legal, but legality doesn’t affect our government much these days.
9) Give Spain a hand — they managed to increase capital requirements on their banks during the good times.? Things aren’t perfect now, but Spanish? banks are in decent shape given all of the credit stress.
10) Why is the Fed funds rate so low?? The 75 basis fee point forces the effective Fed funds rate from 1.00% to 0.25%.? Though some see the Fed hemmed in here, I think that as they reduce the Fed funds rate, they will also reduce the 75 bp fee.
Capital structure is relevant.? Promises are significant.? Contracts are definitive.
This will be short (it better be, I’m tired and want to sleep), but I have no end of friends asking me how bad it is out there.? First I tell them my opinion is a minority opinion.? Second, I tell them that debt-laden economies are inherently inflexible.? Third, I tell them that when the banks are compromised, ordinary monetary policy is useless, because there is no way to make a bank that is worried about its solvency lend more.? Fourth, even extraordinary monetary policy may not work, as the Fed tries to target lending markets, and finds that they can absorb bad assets, but can’t readily recycle them.
The aggregate capital structure of the economy is not a matter of indifference.? If there are many debt claims, and firms with debt finance other firms via debt, who finance other firms via debt, etc., then we set up a bunch of financial dominoes, where a disturbance can knock one down and carry others with it.
This is why the total debt to GDP ratio matters so much.? Economies stop functioning when they have high levels of embedded debt and a slowdown hits.? That is where we are now, at levels of Debt to GDP that exceed those of the Great Depression.? Until we get that ratio down from 350% down to 150%, normalcy will not return.? Air is leaking out of the debt bubble, and the ability to reflate is not there, because the market value of the assets have sagged to such a level that even a zero Fed funds rate will not raise the market value to the levels where the assets are booked.
People are not reliable; they sin; they default.? Economic systems that are primarily equity financed are better able to deal with the nature of man, because they have more flexibility.? Economic systems that are more heavily debt financed face more problems when someone cannot live up to his promises, because it means that others relying on the performance may not be able to live up to their promises also.
Things are different now.? In past economic cycles, there were sectors of the economy that could be stimulated by the Fed lowering the Fed funds rate.? But now, because of too many fixed committments, there is no sector of the American economy that can absorb more debt, and stimulate everyone else.
Thus the task of levering up falls to the Federal government.? But will they be able to honor all the promises that they have made?? Given that they control the printing press, the answer is yes in nominal terms, but no if in inflation-adjusted terms.
Bloomberg sues the Fed for refusing to disclose what sort of collateral they are lending against.? I come at this from having worked in insurance for two decades.? Insurers have to disclose every asset that they own in their Statutory filings.? When I looked at a bank’s call report recently, I was surprised to see only summary data available.? The insurance industry has high disclosure, and it hasn’t hurt them.? Why should the Fed cower, and refuse to reveal what they are lending against?? Five possibilities, and none of them good:
The Fed is breaking its own rules, and lending on collateral that it publicly said that it wouldn’t lend against.
They are playing favorites with institutions, and don’t want that to be revealed.
The assets in question are technically in compliance with the rules of the Fed, but are worth far less than the amount loaned against them.
Certain banks would be embarrassed by revealing what they own.
It’s just a power game, and the Fed thinks it is above the law, particularly during a crisis (that it helped to cause).
For another example, I would be happy to see who they are lending to in their CPFF program.? Are they lending a lot to AIG through CP?? Anyone else notice that AIG is A-/A3 from S&P and Moody’s which would make them A-2/P-2, and ineligible for the Fed to lend to, but S&P and Moody’s still have them at A-1/P-1.? Weird.
In my opinion, there is no good reason why the Fed can’t disclose the collateral, and the institutions involved.? They assure us that they are being upright and prudent; let them prove it.
There is a common error with contrarian investing.? It is not a question of identifying things that people believe that are wrong, but finding things that people rely on that are wrong.? Reliance is the critical component.? I don’t care about what people think if they don’t have any skin in the game.? When someone relies on a certain result happening (or not happening), then there will be series of behaviors that happen as what he believes in fails, from intensifying the bet in the early phases, to throwing in the towel in disgust at the end.
I’m going to take this idea and twist it a different way tonight.? One thing that the Democrats and Republicans (except Ron Paul) agree and rely on is that they know how to avoid a repeat of the Great Depression.? The textbook answer is:
Easy Money
Fiscal Stimulus
Don’t Raise Trade Barriers
Ben Bernanke learned this as a young college student, and built it up in his Ph. D. dissertation.? He has the same moral certainty about this that George Bush, Jr. does about fighting terrorism.? And, I’m going suggest that Bernanke, and most of the political establishment (which hasn’t really changed in the last few days) are wrong.
What is a bubble?? My definition: a bubble is a self-reinforcing cycle where monies invested obtain a negative return in aggregate over the long haul.? It is characterized by significant borrowing at low rates to invest in already appreciated assets in order to profit from a momentum-driven market.? When cash flow is insufficient to pay the interest to finance the bubble, the bubble pops, and a self-reinforcing bear market ensues.? When that bear market encompasses most of the financial system, we call it a depression.
What is a depression?? A severe recession where the banks are impaired.? In an ordinary recession, lowering the Fed funds rate can stimulate the banks to lend.? Not so now; the banks are licking their wounds, and letting profits grow by financing at lower rates, and sucking in bailout cash to shore up their balance sheets against future real estate lending losses.
The Great Depression ended when the Debt to GDP ratio dropped below 150%.? When enough debts were extinguished by payoff or default, the system could once again be normal.? Virtually none of the efforts of FDR focused on eliminating debts; in my opinion, he lengthened and intensified the Depression by not encouraging the liquidation of bad debts.? And now we do the same thing.? We perpetuate the misallocation of resources by trying to keep house prices high, by bailing out institutions that should go through the bankruptcy process.? This fails to convert bad debts into equity in newly solvent businesses.
All the US government is doing is creating a bigger bubble.? What will happen when the Treasury auctions fail, or, stretch the yield curve so wide that there is panic.? We don’t want our financial institutions to fail, so we are willing to wager the creditworthiness of the nation in order to save them.? I don’t like that bet.? Many empires have died choking on debt.? Is the US to be next?
When I wrote articles opposing the bailout, I did so because I did not think it would work, and that one-off conservations/liquidations would be preferable, but not optimal.? Optimal to me would be using the bankruptcy code on a expedited basis, wiping out junior capital, and making senior capital take haircuts.
But in the present, we contemplate borrowing to bail out all manner of problems — bail out homeowners, automakers, banks, insurers, guarantors, etc.? The end to this phase will come when the creditors of the US write off their prior lending, and decide not to throw good money after bad.? I have no idea when that time will come, but the dreamy schemes of politicians aiming to solve every financial hurt will help to force such a time to happen.
I regularly read “A Dash of Insight,” and greatly appreciate the commentary of Dr. Jeff Miller.? What I write here is an effort to encourage what he wrote in this piece advising President-Elect Obama.? (I would have my own advice for the President, but there are so many vying for his ear now, that I sigh and say “Let the poor man get on with it.? He will be imprisoned for the next four years, and likely find less capability of doing what he wants than he imagined.”)
How would one implement what Dr. Jeff suggests?? As a bond manager, I was pretty good at price discovery.? I would convene a committee of large holders of the illiquid instruments and ask them what are the largest classes of homogeneous structured securities that no longer have markets now.? Once they agree on the classes (probably the AAA portions of the senior-sub structured ABS, RMBS and CMBS deals), the agent for the Treasury picks a subset of the largest deals, and announces how much of each security (say 10% of each tranche) they will offer to buy.
Market participants are then invited to submit binding offers to sell any amount of the securities up to the maximum.? The Treasury’s agent could require a minimum amount of bids in order for an auction to be valid (say 2-3x the purchase amount).
One tweak I would put in would be to award the bonds to the winning bidders at the price offered by the bidder with the highest bid not receiving bonds.? I used this successfully for years in bond auctions, and though it makes the trader shake his head initially, when I would say, “I’m offering protection against regret in advance, besides, I want aggressive bids.” they would say, “Okay, I get it.”
After the auctions, there would be benchmark prices, yields, and spreads for a wide number of securities, and then the modelers would apply those prices to the mezzanine and maybe the subordinate tranches, which are too small to hold auctions for.
Similar securities might find trading levels as well, but if not, the Treasury could run another set of auctions, and repeat as necessary.? Given the most of the securities auctioned are AAA, at worst, the Fed might have an interest in the short-to-intermediate AAA paper.
If the Treasury followed a procedure like this, it could unjam the securitized fixed income markets, and do so at prices where the taxpayer bears modest losses at best.? I am not as optimistic as Bill Gross or Warren Buffett on this matter.? The point of the auction is to get the sellers to compete against each other, not compete with the government’s agent.
Now, price discovery is a two-edged sword.? FInding the market clearing price will make the markets start moving again, but it also might prove that some financial institutions are inverted (negative net worth), if not insolvent (can’t get enough cash to pay all immediate claims).? If we are willing to stomach the possible insolvencies that this will reveal, then I am game for Dr. Jeff’s proposal.
And, maybe this will show the need for RTC II, successor to the old Resolution Trust Company.? Bad financial institutions need to be conserved/liquidated, so that leverage can be reduced in the financial system of the US.
So, let something like this be tried, but be ready for adverse consequences if the pricing turns out to be worse than anticipated.
1) It is a wonderful thing to be the world’s reserve currency; we can milk the rest of the world until things change.? There is some push from emerging markets to have a change, but the effectiveness of that push is questionable.? Someone has to give the US an ultimatum, and no one is there yet.
2) With the decline in fixed income volatility, mortgage yields are falling.? Good for mortgages, but the real question is what happens when the Treasury starts borrowing like a maniac.
3) Many hedge funds have raised the gates.? Capital cannot easily exit.? GIven the weak balance sheets that hedge funds have, this is normal for a bear market.? The only surprise is that investors did not anticipate the troubles.
4) Perhaps the money to banks from the government is going only to relatively sound institutions.? That is consistent with the idea of making some institutions sound, and letting them buy up marginal banks.? Upshot: don’t expect an early increase in lending.
5) Analyze those that are on the other side of the table.? If they have a reputation for being smart, be extra careful.? Many municipalities and other entities lost money dealing with investment banks.? No surprise.
6) Many do not understand mark-to-market accounting.? First, GAAP is the least of the problems — collateral agreements require MTM.? Regulators can ignore MTM as they please. Second, MTM is misapplied by auditors; it does not mean “last trade,” but an estimate of where a liquid market would trade.
It’s election day, and I may as well try to fuse economics and politics for a moment.? Personally on an economic basis, I don’t think this election means that much.? Consider this post at RealMoney from earlier this year:
Cultures are Bigger than Economies, Which are Bigger than Governments
1/7/2008 1:19 PM EST
To start this off, I don’t fit neatly on the political spectrum. I am an economic libertarian, socially a conservative, but utterly against the recent wars that we have pursued. I also think that we need to find a way to dismantle the two party system, but that will never happen. So now you have enough to disregard me if you like.
I don’t think the primaries make any difference at all. The three leading Democrats are all very alike. It doesn’t matter which one wins the primary. The Democrats would have their best chance with Obama, because general elections tend to be won on (sadly) which candidate is more likeable.
As for the Republicans, there are differences, but not to any great degree on likely economic policy. I say “likely economic policy” because none of their differential policies are likely to survive if one of them wins the general election. Any Republican win is unlikely to have that much of a mandate.
There are differences between the Republicans and Democrats on economic policy, but this is where my headline comes into play: “Cultures are Bigger than Economies, Which are Bigger than Governments.” Given the mismanagement of our government, particularly with respect to entitlement programs, though also costly wars, future governments will have less wiggle room. Raise spending, cut taxes? Go ahead and try. No surprise that the US Dollar continues to fall. Outsiders will eventually tire of funding US deficits in US currency.
The Republicans will leave the micro-economy more free than the Democrats, but aside from that, I don’t think the election matters much, at least as far as economics goes. There may be other reasons to vote for one side or the other, but pocketbook issues rank low for me, and in this election, the payoff from the differences will not be big.
Now, cultural change, in the unlikely event that it would occur, is another matter. But American history has been replete with big shifts before, and the economy and politics get dragged along. Perhaps the question to ask is what will be the next big shift in American culture? I don’t have any read on that now, but then, when it happens, it is often fast.
Position: none
Our biggest bubble, which is still inflating, are the debts of the US Government, both explicit and those not accrued for.? We are going to have a difficult time borrowing in the present for all of these new bailout/stimulus/pork programs.? Our debts are getting deeper, not shallower.
We may have a slight breather from the increase in total debt recently (2006-7), but it is going up in the near term.? My view is that we need delevering, and that will be a big theme in coming years once the government tires of the new policy of shifting private debts onto the public balance sheet.
Now, I’m still dubious that the bailout policy will work.? Reasons:
We’re still unclear on what bailout money is for.? Consider the banks.? Is it so they can lend, buy marginal banks, or so they don’t go insolvent?? (No, Barney, there is no direct way to force them to lend…)
Where the government is intervening in the markets, it seems to be replacing the markets, and not encouraging risk-taking on the part of private investors.
Areas where the government isn’t intervening are still under stress.? When Verizon has to offer nearly 5% over Treasuries to get $3.25 billion of financing, that is stress.
When a foreign holder of Treasuries is willing to give up 40 basis points of yield on a 10-year T-note yielding 3.80%, so that they can get paid off in Euros if there is a repudiation of US Treasury obligations, there is significant uncertainty over the creditworthiness of the US Government.? (That’s just an example, there are other reasons to enter into such a CDS.)
Now, the debt-to-GDP graph above doesn’t take into account pension and entitlement underfunding/non-funding.? From another comment at RealMoney:
Digging a Hole to China (So We Can Borrow Some More)
10/28/03 08:26 AM?ET
With a gracious assist from one of our readers at Economy.com, here is the link I promised yesterday. The report does not break out one final number — one has to look at the “balance sheet” on page 58, and the “Statements of Social Insurance” on page 65, which they count as an off balance sheet liability, and add them up. It looks like this (in USD):
Net Liability: $6.8 trillion
Soc Sec, Pen & Dis: $4.6 trillion
Medicare, part A: $5.1 trillion
Medicare, part B: $8.1 trillion
Total: $24.6 trillion
This doesn’t take into account the value of land and certain less tangible assets that the U.S. Government has. It also does not take into account the considerable operating and capital lease liabilities, deferred maintenance, or liabilities for the GSEs, and other lending guarantee programs of the federal government.
np
That $24.6 trillion figure was from September 2002. As of September 2007, it would now be around $50 trillion. ( Here’s the link to the 2007 figures.? New figures out in two months.)? By the way, thanks Mr. Bush, for being such a reformer of Social Security and Medicare. You added on another $10 trillion of unfunded liabilities that future generations will have to fight over bear in your prescription drug program.? You have been the most damaging president on economics since Nixon.? (Sorry, I lost my cool. 🙁 )
That $50 trillion does not count in state and corporate underfunding of pensions and benefits.? Oh, and with the fall in the markets, they want a bailout also.
Who doesn’t want a bailout?? The US Government can just borrow some more to aid us on our way to prosperity.? Those debts and unfunded promises will have to be paid someday, either through taxes, inflation, or repudiation (total or external).? The economic mess at that point will be far worse than it is today for all those who rely on the US Dollar.
Our problems in the US are larger than our politics.? It goes down to our very culture, borrowing from the future to take care of the present.? It is true for our Government, and many corporations and individuals.? The pain will come, the only question now is what form it will take.
Until I read the last sentence of this Wall Street Journal article on AIG’s risk models, I felt somewhat sympathetic for the guy who developed the models.? Having developed many models in my life, I have seen them misused by executives wanting a more optimistic result, and putting pressure on the quantitative analyst to bend the assumptions.? Here’s the last paragaph:
On a rainy morning last week, Mr. Gorton briefly discussed with his Yale students how perplexing the struggles of the financial world have become. About 30 graduate students listened as Mr. Gorton lamented how problems in one sector caused investors to question value all across the board. Said Mr. Gorton: “There doesn’t seem to be a fundamental reason why.”
When I read that, I concluded that the poor guy was in over his head for years, and did not have the necessary expertise for what he was doing at AIG.? All good credit models contain something for boom and bust.? Creditworthiness of borrowing entities is highly correlated, especially during the bust phase of the credit cycle.? That said, to get deals done on CDO-like structures, the modeler can’t assume that correlations are as high as they are in real life, or the deals can’t get done.
But to my puzzled professor, there are fundamental reasons why.
Overlevered systems are inherently unstable.? Small changes in creditworthiness can have big impacts.
Rating agencies undersized subordination levels in order to win business.
Regulators allow regulated financials to own this stuff with low capital requirements, partially thanks to Basel II.
Much of the debt was related to Financials, Housing, and Real Estate, and all of those sectors are under pressure.
When financials ain’t healthy, ain’t no one healthy.
Now, for another look at the problem from a different angle, consider this New York Times article on Wisconsin public schools buying CDOs for teach pension plans.? As a kid, I played against a number of the schools mentioned in sports, etc., so many of these names bring back old memories for me.
Again, what is clear is that the guy advising the school one of the school districts barely understood the ABCs of what he was doing, and the district trusted him.? I’ll say it again, if you don’t understand it, or you don’t have a trusted friend on your side of the table who does understand it, don’t buy it. Also, relatively high yields on seemingly safe investments typically don’t exist.? Beware the salesman that offers high yields with safety; there is usually one of four things involved:
Financial leverage
Options sold short
Low credit quality of the underlying debt instruments
Foreign currency risks
These deals fall far short of the “prudent man rule” in my opinion.? Not only is the salesman culpable in this case, so are the board members that did not do proper due diligence.? For something this complex, not reading the prospectus is amazing, even though it might not have helped, given the complexity of the beast.? At least, though, a board member should read the “risks and disclosures” section of the prospectus.? There is usually honesty there, because that is what the investment bank is relying on to protect themselves legally if things go bad.
The districts should have accepted a lower rate of return on their investments, and asked the taxpayers for contributions to the pension plans, etc., to make up any deficits.
We will probably see many more stories like this over the next year.? Politicians and bureaucrats are often short-sighted, and look for “that one little thing” that will magically close a gap in the budget.? It’s that little bit of fear of the taxpayers and other stakeholders that caused “that one little thing” to become so tempting.? But now they have to live with the bad results; heads will roll.
