Value Investing – Page 65

Stressing Bank Tests

Posted on 11 May 200911 May 2009 by David Merkel

Perhaps we have it easy in the life insurance industry. Solvency is defined on two criteria: risk-based capital, and a variety of cash flow testing schemes, both contingent and noncontingent. Truth is, it’s not that easy, but the life insurance industry has been more proactive on risk management than the banks.

I have not talked much, if at all about the “bank stress tests” for one major reason: in life insurance, there are detailed rules for performing cash flow analyses. With the bank stress tests, the adverse scenario posited higher unemployment, lower residential housing prices, and lower real GDP than “baseline” estimates.

Okay, that’s nice, but as is often said, the devil is in the details. Did the banks get relief from the scenarios? It seems so. Why? When I first saw the adverse scenario, I said to myself, “Not adverse enough. Aside from that, how do you translate the adverseness into actual credit losses?”

The latter question is a critical assumption, particularly for complex financial institutions. There is no immediate good answer, so how did the US government simplify matters? We do not know, but we do know that the financial institutions pushed back.

What concerns me the most is that the stress scenarios did not explicitly consider weakness in commercial mortgage pricing. This is a process that is in its early phases. Much as REIT stock prices have fallen, and CMBS prices have fallen, the impact has yet to be realized on commercial whole loans on bank balance sheets.

It is very difficult to transform the macroeconomic assumptios of the stress test into usable credit loss data. Reasons:

Differences in bank lending practices makes uniformity tough.
Attempts at getting accurate on a company-specific basis introduces the ability of the company to tilt the analysis their way. Also, company specific loss estimates lack credibility.
Loss estimates on new lending classes also lack credibility.
Estimates of how sensitive loss estimates are to unemployment, GDP and residential housing prices lack credibility for most lending classes. We don’t have enough data.

Now I have done stress tests at life insurance companies. You estimate how much you can take in credit losses without having to dip into surplus assets over a 1, 3, 5, 10, etc-year periods. You compare those statistics to worst few credit losses over 1, 3, 5, 10, etc-year horizons to get an idea of the likelihood of such large losses. That has its troubles, but it is better than nothing. The life insurance industry keeps pretty extensive statistics on its asset losses.

I didn’t get too encouraged by the results of the stress tests. They were easy tests to pass for many because:

The stress scenario isn’t that severe. I give it better than 50% odds of occurring. A real stress test has perhaps a 5% chance of occurring.
The stress scenario isn’t very prolonged, like the Great Depression.
Creating the models that connect the economic assumptions to the loss costs is problematic. Errors are unlikely to be on the conservative side — both the banks and the regulators are incented to be aggressive, because they don’t want to cause specific panic over their company, or general panic over the banks. Remember, their is a large number of people who think this panic is merely confidence/liquidity, and not solvency. (Then why are we raising capital or selling assets?)
There are many new lending classes that have not gone through a full asset default cycle, so their default loss properties in an era of debt deflation won’t be calculable. We don’t have the data.

When I look at the modest cost of $75 billion of capital to raise, I think of all the capital raised prior to this — and now a measly $75 billion will assure the future solvency of the system. This is only an opinion, but I think that number is too low, particularly with the troubles in commercial real estate being so early in its cycle. Remember 1989-92? The degree of overbuilding now is greater than then. The losses should at least be proportionate.

My simple bit of investment advice is to underweight the securities (bonds, preferred and common stocks), of the companies that failed an easy test. That means underweighting:

Bank of America
Citi
Fifth Third
GMAC (debt, there is no public common)
Keycorp
Morgan Stanley
PNC
Regions Financial
SunTrust
Wells Fargo

At least, this will be worth watching as a basket from 5/8 on. It may give us clues to the economy as a whole. I expect that it will underperform, but I am more certain that it will covary very highly with the market as a whole. Let’s see what happens.

One Dozen Notes on our Current Situation in the Markets

Posted on 8 May 20098 May 2009 by David Merkel

I’m leaving for two days.? I might be able to post while I’m gone, but connectivity is never guaranteed, particularly in southwestern Pennsylvania.? (Sometimes I call it “the land that time forgot.”) Apologies to those that live there — Pittsburgh is the capital city of Appalachia.

Here are a few thoughts of mine:

1) Many have been critical of Buffett after a poor showing in 2008.? Much as I have criticized Buffett in the past, I do not do so here. The mistake that many make in analyzing Berky is forgetting that it is first an insurance company, second an industrial conglomerate, and last an investment vehicle for Warren Buffett for stocks, bonds, derivatives, etc. With most of his investments, he owns the whole company, so you can’t tell how Buffett’s investing is doing through looking at the prices of the public holdings, but by reading Berky’s financial statements. By that standard, 2008 was not a banner year for Berky — book value went down — but it was hardly a disaster. Buffett remains an intelligent businessman who deserves the praise that he receives.

From The Investor’s Consigliere, he agrees with me.? Berky is more like a special private equity shop than like a mutual fund.

2) I’m past my limit for cash for my broad market portfolio.? I have sold bit-by-bit as the market has risen.? I’m planning on buying more of my losers, or finding a few new names to throw in.? Will the current “bull market” evaporate?? There are some sentiment measures that say so.? Also, when cyclicals lead, I get skeptical.

3) As correlations rise, so does equity market risk.? Are we facing crash-like risks now?? I don’t think so, but I can’t rule it out.? My opinion would change if I knew that major foreign investors were willing to “bite the bullet” and recognize the losses that they will experience from investing in Treasuries.

4) My initial opinion of Ben Bernanke, which I repudiated, may be correct.? My initial opinion was that he would be a disaster.? Now that the transcripts of the 2003 Fed meetings are out, he was among the most aggressive in loosening policy, which was the key blunder leading into our current crisis.? It also explains the novel policies adopted by the Fed over the last 18 months.

5) Investors are geting too excited about a recovery in residential housing.? Such a recovery is not possible while 20%+ of all residential properties are under water.? Foreclosures happen because of properties under water where a random glitch hits (death, disaster, disability, divorce, debt spike (recast or reset), and disemployment).

6) I have long had GM and Ford as “zero shorts.”? Sell them short, and you won’t have to pay anything back.? Though Ford is prospering for now, GM is declining rapidly.? In bankruptcy the common is a zonk.? With dilution, the common will almost be a zonk.

7) I worry over our government’s involvement in the markets.? First, I am concerned over contract law.? The bankruptcy code in the US strikes a very good balance between the needs of creditors and debtors.? I worry when the government tampers with that.? I fear that the Obama administration does not grasp that if they attempt to change certain regulations, it will have a disproportionate effect on the economy.

8) I have almost always liked TIPS.? Do I like them now?? Of course, particularly if they are long-dated.

9) Much as I do not trust it, we have had a significant rally in leveraged loans and junk bonds.

10) Did major banks support subprime lenders?? Of course many did.? No surprise here.

11) The EMH exists in a dynamic tension with its opposite.?? Because many, like me, are willing to hunt out inefficiencies, the inefficiencies often get quite small.? So it is that those that come into investing with no hint that the EMH exists think it is ridiculous.? Coming from a household where the EMH had been stomped on for many years (thanks, Mom) made me ill-disposed to believe it, and not just because we subscribed to Value Line.

12) He who pays the piper calls the tune.? To the degree that the government gets involved in business, it will intrude into lesser details that should only be the province of shareholders.? What this says to management teams is “don’t let the government in in the first place,” which should be pretty obvious.? Major shareholders with secondary interests are often painful.? With the government, that secondary interest is regulation, which makes them a painful shareholder.

With that, I bid all of you adieu for a time.? May the Lord watch over you.

Post 950

Posted on 6 May 20096 May 2009 by David Merkel

When I began this blog, I would do a post every 100 posts that pertained to the blog itself, my readers and me.? I did not do a “Post 900” for a number of reasons.? This post is meant to make up for it.? For those that echo my blog, like Seeking Alpha, I ask that you republish this, because I need it this time.

I love writing, but that is not what I do best.? My best talents are managing equity assets.? I have a pitch book that explains my methods, and how I have beaten the S&P 500 since September of 2000.? My problem is this: if you don’t have an institutional investor, institutional investors won’t invest with you.? So, if you have influence over an institutional investor, ask them whether they would be willing to consider me, and I will send them my pitchbook, updated to the end of April 2009.

Again, thanks to all my readers.? Your time is limited, so appreciate that you consider me.? If I gain an institutional investor, oddly, that will free me to write more.

Here is my e-mail address.

Book Review: Trend Following (5)

Posted on 30 April 200930 April 2009 by David Merkel

There are many places where I agree with Michael Covel.? Here are two:

Trend following, or, price momentum, is a good strategy.
Most investment advisors charge a lot, and on average deliver suboptimal performance.
The weak form of the efficient markets hypothesis doesn’t work.

Most of the Wall Street establishment, and those trained by universities and the CFA program believe that the weak form of the efficient markets hypothesis works.? I.e., You can’t make money from past price and volume information. This is why most of them don’t use price momentum.? They would get laughed at.? The weak form of the EMH is holy stuff.

Beyond that, the fund manager consultants try to cram every manager into a simplistic risk control model, leaving managers little room to hold cash, or invest in promising places that don’t fit the narrow pigeonhole that the fund manager consultants use to simplify their work.? Someone who rotates styles, sectors, domestic versus international, or who simply raises cash when opportunities don’t seem so good are anathema to the fund management consultants, no matter how good their performance is.

But as time has gone on, the behavioral finance folks have shown that valuation, price momentum, normalized operating accruals, and other factors have significant predictive potential on future returns.? Hedge fund managers, who have less of a tendency to listen to the fund management consultants, and a greater tendency to do what works, do use trend following, or price momentum in their investing.

What if Everyone Followed Trends?

Suppose everyone except Warren Buffett decided to follow trends.? The market would become very volatile, as was suggested in Investing by the Numbers.? (By his model, anytime momentum investors are more than 20% of the market, things go nuts.)? Buffett would make money hand over fist as he would sell holdings as they soared over fair value, and buy as they crashed well below fair value.? The valid strategy that is less employed makes more money.

There would be another effect.? There is a limitation on the ability to short on the market as a whole, if the borrow is enforced.? The whole world is 100% net long every night.? Shorts and leveraged longs are side-bets in the game of investing.? The more trend followers there are, the more that shorting capacity would prove to be a constraint, because once things start going down, the available shares to borrow would disappear.? The profitability of trend following in a bear market relies on a small enough number of parties selling short.? Everyone can’t sell short at the ame time.? Everyone can’t go to cash at the same time.? The assets must be owned by someone at the end of each day.

There’s only one strategy that could be followed by everyone — Indexing (and not fundamental indexing).? Returns to any strategy decrease as more pursue it.

On Audited Track Records

Bill Miller had a great audited track record, and it imploded in two years, largely because he did not understand the financial stocks that he owned.? While working at Provident Mutual, I interviewed a growth manager who used price momentum heavily, and had a tremendous track record.? I pointed out 10% of his portfolio that had poor earnings quality, and he gave me a “you don’t know the right things to look for” answer.? In the next week, a number of those companies preannounced earnings shortfalls.? The marketing guys came over to me and said, “You called that one.”

In truth, I didn’t.? Rarely do things happen that fast.? But that manager did disappear within a few years, despite his great past track record.

There’s a reason why we say, “Past performance does not indicate future results.”? Because it doesn’t.

I am not saying that I manage money better than Michael Covel, or anyone else.? He has done better than me, even though I have done better than 90% of all long only equity managers over the last nine years.

I do not have an audited track record, but only because I don’t want to pay for something that I don’t have use for.? I am not broadly advertising my services.? If an institutional investor would want to use me, I would get my returns audited.

I write my blog because I enjoy teaching, nothing more.? It fills a hole in my life, a part of a need to give back.

In closing, I can endorse “Trend Following” because its basic premise is true.? Follow price momentum and you will beat the equity market 80% of the time.? I just did not enjoy the lack of logic from Mr. Covel.? Correlation is not causation.? Making money in the past is not proof.? Picking and choosing trend followers does not constitute proof.? Take a more humble attitude, and you have a good book.

Book Review: Trend Following (4)

Posted on 28 April 2009 by David Merkel

While reading the book Trend Following, I was reminded of something that I read in The Intelligent Investor (I have the Fourth Revised Edition.)? These are two very different books.? What could be the same?

Fortunately, you don’t have to have a copy of The Intelligent Investor to see this.? Appendix 1 of the book is, the edited transcript of Warren Buffett’s talk that he gave at Columbia University in 1984 for the 50th anniversary of publication of Security Analysis can be found here.? The PDF version can be found here — it has the tables, but will take a while to load.

Buffett chooses 9 investors in the mold of Ben Graham, all value investors, and shows how they have soundly trounced the market over their tenures.? He uses that correlation to demonstrate that since they all used the same basic theory of investing, it is unlikely that their wonderful performance is due to mere chance.

In appendix B of his book, Michael Covel chooses 14 (or so) investors who are trend followers, and shows how they have soundly trounced the market over their tenures.? He uses that correlation to demonstrate that since they all used the same basic theory of investing, it is unlikely that their wonderful performance is due to mere chance.

See the similarity?? Now, I think that both approaches work to some degree, though not all of the time.? I have known a number of managers that have married the two approaches, usually with some success.? (As Humble Student Cam Hui points out, marrying the two may be more difficult than it seems.? I’m going to have to dig up that copy of the Financial Analysts Journal.)

I would criticize one aspect of Buffett’s logic, and the same would apply to Covel.? I’ve known my share of bad value investors.? Usually they overemphasize cheapness, and forget “margin of safety” as the key intellectual concept of value investing.? It’s easy to come up with a group of great managers following a certain strategy in hindsight.? Where is the grand study of all investors of that class, be it value investing or trend following?? Almost any strategy could be made to look good if one can cherry-pick the investors with the advantage of hindsight.

So, what would qualify as a valid study?? You’d need a relatively complete census of the group following a given strategy, including those that failed and dropped out.? After that, audited returns would help, as Mr. Covel likes to point out.? An alternative would be to follow a smaller closed cohort of managers following a certain management style.? The problem with that is you yourself might have a really good eye for management talent apart from the investment style.

Another alternative would be an academic-style study where the researcher defines the buy and sell criteria and then sees if the method beats the market, whether adjusted for risk or not.? Now, regarding risk, that is one of many places where I agree with Mr. Covel.? Standard deviation does not measure it; beta doesn’t measure it; tracking error doesn’t measure it.? Maximum drawdown, or maybe some obscure statistic from extreme value theory would probably be the best measure.

Why drawdown?? It best measures the ability of a manager to continue his strategy without panicking.? Most of us would question our sanity after a certain level of loss, and give up.? For different investors, the number is different.? For those managing external money, it is more important, because normal investing processes get destroyed when investors pull their money.? Where is that maximum level where investors will stay on board?? It depends on how they were sold on investing their money with the manager.

What are the problems with doing an academic-style study?

Often does not include costs of commisions, market impact, etc.? Liquidity is implicitly free, while in the real world, it is costly, particularly for undervalued oddball securities.
Data-mining may allow anomalous result that are noise to be reported as signal.
Managers using the style being modeled argue that it does not truly represent what they do.
Some studies get skewed by using calendar-year-end dates, where trading is often unusual.

Does that mean doing? definitive studies of trading strategies is impossible?? No, but it is quite expensive to do, so those interested in questions like this often resort to shortcuts, such as academic studies, limited peer group studies, etc.

Now, fairly comprehensive studies for things like growth and value managers exist (tsst… value wins), and some studies for CTAs exist.? But I’m not aware of any comprehensive studies for trend followers.? The academic studies show that price momentum is an important factor in market returns, and many investors with good returns use momentum.

It begs the question, if price momentum, or trend following is a panacea, why is it not more broadly embraced by the money management community?? That is tomorrow’s essay.

Book Review: Trend Following (3)

Posted on 28 April 2009 by David Merkel

What I find interesting about this subject, whether we call it “trend following” or “price momentum,” there has been a confluence of different parties agreeing that price momentum works.? I have reviewed many books recommending momentum strategies (an example), and have usually recommended them (sometimes with reservations).? I will even recommend Trend Following to those who don’t know that positive price momentum aids investment performance about 80% of the time.

What groups of people have come in to support price momentum?

Most quantitative stock screeners/graders use a mix of momentum and valuation factors.
The academics behind behavioral finance support price momentum and valuation factors, in addition to some others.
Many large (and smaller) hedge funds that trade stocks do so using momentum as a positive factor in stock selection, along with valuation, earnings quality, and a host of other factors.

I know, there are still Efficient Markets Hypothesis zealots in the academic community, but they are being outflanked by the behavioral economists who have hard data to support their theories.? The Adaptive Markets Hypothesis describes the way the markets really work.? Rather than using a physics-based analogy, better to use a biological analogy — I view investment strategies through an ecological frame.? Multiple strategies compete to obtain scarce excess investment returns.? The strategies that are least pursued relative to their validity usually have the greatest punch.

Is everyone a fundamentalist?? Momentum strategies win.? Are there a lot of traders chasing momentum?? Value strategies win.? Is there a dominant view to seek dividends?? Growth strategies win.? Is everyone chasing after growth?? Perhaps we should look for dividends.

I don’t know about everyone, but among quantitative investors the opinion is virtually universal that trend following is the right strategy.? Follow price and earnings momentum.? I even put out a small piece weekly on short-term performance of industry groups, which is largely based off of price momentum.

So, if Mr. Covel thinks that trend following is an underfollowed idea, I can simply say that there are a lot of us following it, to the point where the trade might be crowded.? Trend following is a significant part of the total market ecology, and when it becomes dominant, its short-term returns become curtailed, until enough money leaves the trade.

I’ll discuss this more tomorrow, when I discuss how we test the validity of investment strategies.

“Do Half”

Posted on 21 April 2009 by David Merkel

Before I start my piece for the evening, I want to explain why my AIG piece is slow in coming.? Short answer: It’s big, and I am still writing it.? There is a lot there, and I am trying to get it right, realizing that I am just a generalist dealing with complex issues and not enough data.? I hope to have the piece finished on Wednesday for Finacorp clients, and out be the end of the week here.

“Do Half”

What I am going to talk about here is annoying to some who always feel that investing is about taking bold actions.? I had one boss that would go nuts when I would talk about this strategy.? Other friends, akin to deep value investors, would get perturbed as well.

I used this strategy extensively when trading corporate bonds 2001-2003.? I was a fairly active trader, unlike what I do with equities today.? Yet, even with equities, my rebalancing trades which have aided me in this volatile market, mimic some of the benefits of this strategy.? Here are some examples:

1) Say you bought a stock and it rapidly rallies, yet not to the point where you think it is at fair value.? Perhaps recent events have made you re-estimate fair value upward.? What to do?? Sell half of the position, and wait.? If the price falls, buy back the position.? If it rallies further, sell the rest.

2) Say you want to buy a stock, but it is plunging like a stone.? You’ve done our homework — the balance sheet is strong enough to self-finance the company for three years, estimated earnings for the next indicate the company is cheap, what to do?? Buy half of a full position, and wait.? If the companies rallies sharply, sell the position.? If it continues to fall, wait until it stabilizes, confirm your fundamental research and buy up to a full position.

3) Say you like a stock, but it has rallied past your buy point.? What to do?? Buy half.? If the stock comes back to the buy point, buy a full position.? If it rallies further, sell the position.

4) Same as number 3, but reversed for shorting.

I would almost always scale in and out of positions as an institutional investor, rather than doing it all at once.? I credit Jim Cramer for teaching me this.? The real Jim Cramer is not the “lightning round, ” but the guy who scales in and scales out.? The lightning round is binary — buy/sell.? The real world is more nuanced — how much to buy and when?

But the real benefit of doing half is the psychology of the situation.? Many investors suffer from fear, greed, and regret.? Doing half short-circuits those responses.? When the stock price moves in favor of profits, be glad of those profits.? When the stock price moves against profits, reanalyze and either a) go flat, recognizing your mistake, and being grateful that it was small, or b) increase the bet to a full position, and be grateful that you didn’t put a full position on initially.

Scaling in and scaling out gives freedom to investors, and removing many of the psychological burdens that they bear.? It doesn’t mean there won’t be losses.? There will always be losses but they will be easier to bear, with no panic that leads to selling off at the lows, or buying at the highs.

Corporate Anorexia

Posted on 3 April 2009 by David Merkel

As I looked at replacement candidates for my portfolio, I ran across many companies with negative tangible net worth.? Knowing that intangibles often have value, I looked for the gap that should exist between free cash flow (earnings, less depreciation, amortization, and capital expenditure) and earnings, and more often than not, it was not there.

Ugh, as a buyside insurance analyst, I often encouraged management teams to not buy back stock, but build up capital against contingencies.? It was a contrarian point of view, and not listened to for the most part.

I understand the troubles that come from managements that keep too much of a reserve on hand.? That’s not the problem now.? In the bust phase of the credit cycle, companies with more reserves do better.? The disciplines that minimize net working capital are worthless now in the bust phase.

As I have said before, the boom-bust cycle cannot be repealed.

First Quarter Portfolio Changes

Posted on 2 April 20092 April 2009 by David Merkel

With all of the furor over the past quarter, I did not update my actions on my portfolio.? Today I do so.

New Buys

Archer Daniels Midland
Chevron Texaco
General Dynamics
Mosaic
Noble Energy
Oracle (can you believe it?)
iShares Brazil ETF

New Sells

Charlotte Russe
Cimarex Energy
Kapstone
CRH plc
Devon Energy
Tsakos Energy Navigation
Japan Smaller Capitalization Fund

Rebalancing Buys

AIZ (2)
CHIC
CRH
DVN
IBA (3)
LNT
NTE
NUE
RGA (2)
SAFT
SBS
SCVL (2)
VLO
VSH
XEC

Rebalancing Sells

AIZ
CHIC (3)
CRH
IBA
NUE
RGA (2)
SCVL
VLO
VSH
XEC (2)

Candidates List

My candidates list was smaller than usual, as I strictly limited candidates to be solvent in severe scenarios, such as we are facing now.? Nonetheless, here was my list of replacement candidates:

ABT ADM COL COV CVX FLR FMX GD INFY JNJ MCK MHP MOS MSFT NE ORCL PCP RTN SFG VAR

My favorite of those I did not buy was Stancorp.? If I could add more insurers, I would add them.? Stancorp is a? very well run firm.

I traded Brazil for Japan, and cleaned up my portfolio, trading away names with weaker balance sheets for those with stronger balance sheets, and aimed for industries that were not heading into reverse.

Full disclosure: long ADM CVX GD MOS NE ORCL EWZ AIZ IBA LNT NUE NTE RGA SAFT SBS SCVL VLO VSH

The Great Omission

Posted on 27 March 200927 March 2009 by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

Covering Financial Institutions That May Pose Systemic Risks

i. A Triggering Determination

ii. Choice Between Financial Assistance or Conservatorship/Receivership

Options for Financial Assistance

Options for Conservatorship/Receivership

iii. Taking Advantage of FDIC/FHFA Models:

Requiring Covered Institutions to Fund the Resolution Authority

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

The Great Omission

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

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

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

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

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


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

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

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

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

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

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

Addendum

Praises

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

Problems

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