This piece is one of my experiments where I try to straddle two different investment worlds in an effort to bring more understanding.? The two world are stable value funds and commodity ETFs.
Commodity ETFs have a hard job, in that they are supposed to replicate the returns on spot commodities.? Given the difficulty of storage, only a few commodities — gold and silver, can be physically stored — they don’t deteriorate.? Unlike government promises, they are uniquely suitable for being money.? (Sorry, had to say that.)
Other commodities require futures markets or off-exchange markets where swaps get traded.? The swaps introduce counterparty risk, which is a common risk in many currency and commodity-linked funds.? I’ve written about that before, along with criticisms of exchange-traded notes.
One of the problems that some commodity open-end funds and ETFs run into is that their investment strategy is too simple.? “Buy the front month futures contract, and roll to the second month contract before the front month expires.”? Nice, it should replicate holding the commodity itself, until a large amount of money starts to do it, and other investors recognize what a slave the funds are to their strategy.
So, what do the other investors do?? They take the opposite side of the trade early, in order to make it more expensive to do the roll.? Buy the second month contract, and short the first.? As the first gets close to maturity, cover the first, sell and then short the second, and go long the third month contract.? What a recipe to extract value out of the poor shlubs who buy into a commodity fund in order to get performance equivalent to the spot market.
Compounding Money Slowly
If you want to keep your money safe, and earn a little bit, what should you do?? Invest in a money market fund.? “Wait a minute,” some intrepid investor would say, “I can do better than that.? I don’t need all of my money for immediate liquidity.? I can ladder my funds out over a longer period.? I can invest surplus funds out to the end of my period, and earn a better yield, and over time, my funds will mature bit by bit.? I will have liquidity in a regular basis, and I will get a higher yield because yield curves slope up on average.”
Leaving aside the wrap agreements that a stable value fund buys, stable value funds build a bond ladder with and average maturity of 1.0 to 4.5 years.? Commonly, it averages around 2.0 years.
The funds could invest everything short and give up yield.? That would give them certainty, but lose yield.? That is what the commodity funds are doing.
What could go wrong?? There could be a large demand to withdraw funds when longer-dated contracts are priced below amortized cost, and the fund might not be able to meet all withdrawal requests.? So far that has not happened with stable value funds.
The Fusion Solution
Whether in war or in business, it is not wise to be too predictable; opponents will take advantage of you.? In this particular example, I would urge commodity funds to look at their liquidity needs over the next month, and leave an amount maturing in the next three months equal to 4-6x that amount.? Then spread the remainder of funds according to advantage, looking at the tradeoff of time into the future versus yield of the futures contracts versus spot.? Longer dated futures do not move as tightly with the spot markets, but they often offer more yield.
Ideally, a commodity fund ends up looking like a bond ladder, and as excess funds mature, they don’t get invested in the new front month contract, instead, they get invested in the longer dated contracts, near the end of the ladder, as a stable value fund would do.
This maximizes returns for the bond/stable value funds, and I believe it would work for commodity funds as well.? Please pass this on to those who might benefit from it.
A Closing Aside:
Back in the late 90s, I ran one of my interest rate models to try to determine what the best investment strategy would be.? I found that the humble bond ladder was almost always the second best strategy, regardless of the scenario, because it was always throwing off cash that could be reinvested out to the end of the ladder.
Again, please pass this along, and commodity fund managers that don’t get this, please e-mail me.? I will help you.
Since the first time I read him, I have been a fan of James Grant.? He helped to sharpen my focus on how money and credit work in the long run, and how they affect the economy as a whole.? Reading one of his early books, Minding Mr. Market: Ten Years on Wall Street With Grant’s Interest Rate Observer, I gained perspective on the increasingly complex financial world that we were moving into.
But not all have shared the opinion of Mr. Grant’s wisdom.? When I worked for Provident Mutual, the Chief Portfolio Manager (at that time new to me, but eventually a dear colleague) said to me, “feel free to borrow any of the publications we receive.”? For a guy who likes to read, and learn about investments, I was jazzed. But, when I came back and asked whether we subscribed to Grant’s Interest Rate Observer, I got the look that said, “You poor fool; what next, conspiracy theories?” while she said, “Uh, noooo. We don’t have any interest in that.”
Now the next two firms I worked for did subscribe, and I enjoyed reading it from 1998 to 2007. But now the question: why buy a book that repeats articles written over the last fifteen years?
As an investor, why read books that will not give an immediate idea of where to invest now?? Isn’t that a waste of time? That depends.? Are we looking to become discoverers of investment/economic ideas, or recipients of those ideas?? Books like those of Grant and Baum will help you learn to think, which is more valuable than a hot tip.
Here are topics that the book will help one to understand:
How does monetary policy affect the financial economy?
Why throwing liquidity at every financial crisis eventually creates a bigger crisis.
Why do value (and other) investors need to be extra careful when investing in leveraged firms?
What is risk?? Variation of total return or likelihood of loss and its severity?
Why financial systems eventually fail at compounding returns at rates of growth significantly above the growth rate of GDP.
Why great technologies may make lousy investments.
Why does neoclassical economics fail us when trying to understand the financial economy?
How does one recognize a speculative mania?
And more…
The largest criticism that can be leveled at James Grant was that he saw that he would happen in this crisis far sooner than most others.? Being too early means you eventually get disregarded.? The error that the “earlies” made, and I knew quite a few of them, was not recognizing how much debt could be crammed into the financial economy in order to juice returns on fixed income assets with yields lower than likely default losses.? That’s a mouthful, but the financial economy had not enough good loans to make relative to the amount of loans needed to maintain the earnings growth expectations of the shareholders of financial companies. Thus, the credit bubble, facilitated by the Fed and the banking regulators.? You can read all about it in its many facets in James Grant’s book.
Those that have assumed that neoclassical economics adequately explains the way our economy works.
Those that want to understand how monetary policy really works, or doesn’t.
Those that want to learn about equity or fixed income value investing from a quirky but accurate viewpoint.
Those that want to be entertained by intelligent commentary that proved right in the past.
As with other James Grant books, this does not so much deal with current problems, as much as educate us on how to view the problems that face us, through the prism of how past problems developed.
Full disclosure: If you buy anything through the links to Amazon at my blog, I get a small commission,? but your costs don’t go up.?? Also, thanks to Axios Press for the free review copy.? I read the whole thing, and enjoyed it all.
When I heard the announcement on Tuesday about Social Security and Medicare, I emoted something between a grin and a grimace, and said, “A pity that I have been right on this.”? I’ve always felt that Social Security and Medicare? have had optimistic economic assumptions.? It does not surprise me that the year that Social Security revenues are exceeded by expenses has moved in by one year, from 2017 to 2016.? Medicare, we are already exceeding revenues in 2008 and now.
Many focus on when the trust funds will run out — now 2017 for Medicare, and 2037 for Social Security.? Consider this, the trust funds are invested in nonmarketable US Treasury Notes.? That’s safe, right?? Safe, yes, as safe as the US government.? They will pay with the dollars that they print via their stepchild, the Fed.
This is my advice to all who read me.? Given that these social insurance programs invest only in US government debt, on an accounting basis, it makes sense to unify their balance sheets with that of the US government.? Once we unify the balance sheets, it is easy to realize that the negative consequences will come when expenses exceed revenues, not when the funds go to zero. When expenses exceed revenues, the US government will either need to tax or borrow more in order to make ends meet.? The US Government bonds held are a convenient accounting fiction to show that the taxes paid have been spent for other purposes.? There are no “Trust Funds,” only nonmarketable bit of US debt, that will get repaid through higher taxes, or further borrowings.? China and OPEC, ready to fund US retirements in style? 😉
As for the economic assumptions that Social Security uses, I think they are still optimistic.? One thing I have learned about cash flow modeling is that though the averages matter, the early years matter the most.? There is more time for their results to compound with interest.
We could have two more bad years (flat/down GDP on average), and then face the total system revenue breakeven in 2013.? Even if their assumptions prove correct, total system breakeven will come in 2014-2015.
And the markets will react ahead of that, because it will be so well known.? The need for tax revenues will be significant, and more so as we proceed into the 2020s.? This will lead to the need for solutions — with Medicare, much sooner than Social Security.
Medicare
Possible solutions (and their liabilities):
Nationalize the healthcare system and Medicare goes away.? (Medicare is solved, at the expense of creating a bigger problem.? Other cultures may fit nationalized healthcare, but American will chafe at it.)
Create a second parallel healthcare reimursement system that only serves Medicare clients with limited services to those that are terminally ill.? Ease the pain, but nothing radical and expensive.? (I like this one, so it can’t be a good idea.)
Raise taxes.? (lower the reasons to employ labor)
Raise eligibility ages, and quickly. (Listen to the screams.)
Lower reimbursement rates. (Also won’t work because fewer doctors will do Medicare medicine… and quality drops as well.)
Mandate that doctors must take Medicare clients at Medicare rates.? (Nasty.? But once rights of contract get violated in one place, they get violated in others.)
Eliminate plan D, the drug prescription benefit.? It’s young and too complicated, so just kill it.
Means-test eligibility for reimbursement.? (It would lose political legitimacy.)
Terminate the system, such that children born after 1/1/2010 don’t pay in, and would not receive benefits. (Doesn’t really solve the funding problem, unless mixed with some of the above.)
Social Security
Possible solutions (and their liabilities):
Means-test eligibility for reimbursement.? (It would lose political legitimacy.)
Raise taxes.? (lower the reasons to employ labor)
Raise eligibility ages, and quickly. (Listen to the screams.)
Lower benefit payments. (More screams.)
Remove the cost of living adjustments, and inflate the currency.? (At least this rates the problem back to the Baby Boomers, who would get hurt the worst over this… a generation that failed to save and produce enough kids.)
Terminate the system, such that children born after 1/1/2010 don’t pay in, and would not receive benefits. (Doesn’t really solve the funding problem, unless mixed with someof the above.)
“I’ll Gladly Pay You Tuesday for a Hamburger Today.”
The nature of the US government, the lower Federal governments, many of its corporations, and some of its people has been to promise/borrow today, and pay it off later, because tomorrow will be, much, much, better than today.? With the the debt overhang and the looming pension crises, we are beginning to see that much American prosperity was a debt-fueled illusion.? We are presently in stage 1 of dealing with the grief of this shattered illusion — denial.
If the Federal Social Insurance schemes (Social Security, Medicare, Veterans Pensions, Old Federal Employee Pensions) and most State Pensions and Elderly Medical Care are going to pay off, taxes will have to be raised significantly.? That will be one nasty political fight, which might result in the death of certain sacrosanct laws governing the inviolability of pension promises to state employees, and perhaps Federal employees.? Also note, you can raise tax rates, but if it harms the economy, you will get less taxes.
The Federal Government will try to borrow its way out of the problem, until foreign creditors finally rebel, realizing they are throwing good money after bad.? After that, taxes will have to be raised, or promises abandoned/reduced.
For underfunded private defined benefit and retiree healthcare plans, they will likely be terminated, and lesser benefits paid.? All three of the legs of the modern retirement tripod (social insurance, savings, and pensions) are under threat as the era of debt deflation progresses.
Now, realize that though I talk about the US, most of the rest of the developed world is in worse shape as the demographic crisis affects pensions and elderly healthcare globally — they had even fewer kids than in the US, which is close to replacement rate, and so the ratio of workers to those supported will fall even more than in the US, setting up many nasty political fights — all the more nasty, because the governments are much more heavily involved already.? Don’t even think about China, which will come to regret the one child policy that led to so many abortions, and so many beautiful Chinese girls coming to the US to be adopted.
So What’s a Year Worth?
A year can teach us a lot.? 2008 showed us the limitations of our economy.? Future years will show us the limitations of the power of our governments.? Conditions for prosperity can be created, but prosperity can never created by governments.? That is up to the culture of those governed.
This has gotten a bit long, so I will do a follow-up piece within a few days.? Here are a few good articles to consider:
1) So many managers lose confidence near turning points, like Bruce Bent in this article.? Still others maintain their discipline to their detriment, not realizing that they have a deficiency in their management style.? Alas for Bill Miller.? A bright guy who did not get financials, or commodity cyclicals.
2) We will see rising junk bond defaults in 2009.? Some defaults will be delayed because covenants are weaker than in the past.? But defaults primarily occur because cash flow is insufficient to finance the interest payments on debts.? That can’t be avoided.? After Lehman, what can you expect?
4) I am not a fan of workouts on residential mortgage loans.? Most of them don’t work out.? Loans typically default because of one of the 5 Ds, and modifying terms is adequate to help a small number of the borrowers.
5) I’ve talked about this for a while, but Defined Benefit pensions (what few remain) have been damaged in the recent bear market.? What should we expect?? When companies offer a fixed benefit, and rely on the markets to fund it, they rely on the kindness of strangers, who they expect to buy equities when they need to make cash payments on net.
6) There are two credit markets.? Those that the government stands behind, and those that it does not.? That is the main distinction in this credit market, with Agency securities falling into a grey zone.
7) If we were dealing with your father’s financial instruments, we would use his financial rules.? As it is, more complex financial instruments that are more variable in their intrinsic value must be valued to market, or, the best estimate of market. There are problems here, but remember that market does not equal last trade for illiquid, complex securities.? Also, there should be caution over level 3 modelled results.? From my own work, those results are squishy.
8 ) During a crisis, many relationships boil down to liquidity.? Who has it? Who needs it, and at what tradeoff?? The same is true of venture capital today.? Who will fund their commitments?? Beyond the issue of dilution looms the issue of survival.? VC backed companies lacking cash will have a hard time of it in the same way their brother public companies do.
9) The Fed ain’t what it used to be.? Today it has all manner of targeted lending programs, and a disdain for stimulus through ordinary lending.
11) How can SunTrust be in this much trouble, needing a second does of TARP funds so soon?? I don’t get it, but it is endemic of our banking sector.? The TARP Oversight Panel is supposedly going to ask a bunch of questions to the Administration regarding past use of TARP funds, but the questions are vague and easy to answer in generalities.
12) There were warnings of trouble inside both Fannie and Freddie, as well as a few recalcitrant analysts outside as well (including me).? Now they recognize the trouble they are in, maybe.? (Also: here.)? Congress does what it can now, not to identify what went wrong, but to divert attention and blame away from themselves.? No one supported the expansion of Fannie and Freddie more than Congressional Democrats.? Political critics were marginalized.
13) The euro makes it to its ten-year anniversary, and we are told… see, as sound as a Deutschmark.? Well, maybe.? Having a strong currency might be fine for Germany, but what of Greece, where the credit default swap market is pricing in a 12%+ probability of default over the next five years?? They might like a weaker euro.
14) Is Britain a greater default risk than McDonalds?? Is the US a greater default risk than Campbell Soup?? Sovereign default is a different beast than corporate default.? Corporations don’t control their own currency (hmm… does that make Greece more like a corporation of the Eurozone? or more like California in the US?), and so bad debt decisions compound over longer periods of time, until we end up with inflation, a forced debt exchange, or an outright default.? It is possible for the US to default without Campbell Soup defaulting, but the life of any US corporation would be made so much more difficult by an outright default of the US government, that I would expect an outright default to cause most US companies, states, and other nations to fail as well, because of implicit reliance on the creditworthiness of the Treasury.
Bottom-callers are out in droves, with many sophisticated arguments.? They all hinge on one idea: that we can return to normalcy soon with a compromised financial system, and debt levels that are record percentages of GDP.
The basic idea behind the two pieces is this: sure, we’re at average valuation levels now, but in a real bear market values can get cut in half from here.? My view is this: we’re not at table-pounding valuation levels yet, but someone with a value and quality bent will make money over the next ten years.
An End to Redemption-Related Selling by Hedge and Mutual Funds
Increased Lending
Tax Cuts
I fear this confuses the symptoms with the disease. Yes, it would be nice if many of these happened, but with the deficit hitting record levels, 2 and 5 are problematic.? In an over-indebted economy 1and 4 are tough as well.? As for point 3, you may as well argue with the sunrise, because most investors are trend-followers, whether they know it or not.? Redemptions typically end after the market has turned significantly.? It’s not a leading indicator, nor is it necessarily an “all clear.”
19) From the “read your bond prospectus with care department,” Catastrophe bonds are only as good as the collateral backing the deal or creditworthiness of the obligor.? Though it may have seemed a good idea at the time, allowing for lower quality collateral has caused the creditworthiness of several catastrophe bonds to suffer as Lehman defaulted, and as losses on subprime mortgages rose.? My take is this: analyze all the risks on a bond, even the obscure ones.? A lot of exchange traded note [ETN] investors probably wish they had paid more attention to who they were lending the money to, rather than the index attached to the notes.
20) The “read your bond prospectus with care department” does have a humorous side, as Paul Kedrosky points out on this amendment to some new Illinois GO bonds.? They don’t sound too worried, but maybe the lawyers have to be more pro-active, and put the following new risk factor into the prospectus:
Endemic Political Corruption
Your investment in the state of Illinois is subject to risks involving political corruption, which is a normal fact of life in Illinois. In lending to the State the lender bears the risk that the corruption level gets so great that it affects the trading value of these securities, and that interest and principal repayment could be impaired.
21)? Even if you don’t have 5 of your last 9 Governors removed due to scandal, like illinois, it’s tough to be a state nowdays.? Now you have the credit default swap [CDS] market spooking investors in your bonds.
I’m not sure, but I would be careful here.? What can be used for a single limited pupose today can be put to unimaginable uses tomorrow.? The Fed’s balance sheet is already at much higher levels of leverage than it was three months ago.? Does it really want to take on more?? Granted, seniorage gains/losses go back to the Treasury, which then can borrow less or more in response, but as the Fed’s balance sheet gets more complex, it makes it more difficult to gauge their policy responses, and I think it will lead to a lack of trust in the Fed and the US Dollar.
23) With conditions like these, should we be surpised that volatility is high in the equity markets?? By some measures, it is higher than that in the Great Depression.? I’m not sure I would call it a “bubble” though.? Extreme Value Theory tells us (among other things) that when a probability distribution is ill-defined, don’t assume that the highest value that you have seen is as high as it can get.? Records beg to be broken.
24) It’s not as if I am the only one thinking about issuing longer US Treasury debt.? Now the Treasury is thinking about it as well.? It will fill a void in our debt markets that life insurers, endowments, and DB pension plans will want to invest in (and create a bunch of new leveraged fixed income investments for speculators).
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.
Pensions are complicated.? Necessarily so, because of the wide numbers of parties involved, and the contingencies involved (mortality, morbidity, asset returns, insolvency) over a long period of time.? Anyone who has had a cursory look at the math (or regulations) behind setting pension liabilities, contributions, etc., knows how tough the issues are, and why real experts need to handle them.
I’ve worked at the edge of the pension business for much of my career.? I have designed defined contribution plans, created stable value products, done asset allocation for defined benefit [DB] plans, terminal funding, and other incidentals.? That said, I am a life actuary [FSA], not a pension actuary [EA].
Tonight’s main issue revolves around a good article by the estimable Matthew Goldstein of Business Week.? Steve Waldman, filling in at Naked Capitalism, commented on the article as well.
Here’s my take: it is legal today for companies to shift their pension liabilities to life insurance companies in the Terminal Funding business.? All they have to do is send a description of the liabilities of the plan to the dozen or so companies that are in the business with adequate claims paying ability ratings, and the companies will send back an estimate of what they would require as a single premium payment to take on the liabilities.? Low bidder wins (and loses — he mis-bid).
So, why don’t plan sponsors take the life insurers up on this?? Easy.? The cost of buying the annuities from the insurers is more expensive than the amount of assets in the trust.? For those companies that are overfunded, they don’t care to terminate — it is a great benefit for their employees.
Terminal funding was most common in the late 80s, when companies could terminate DB plans, and any excess assets would revert to the company.? Then the law changed, and most excess assets would be taken by the Federal Government.? Another reason why overfunded plans do not terminate — the excess assets are valuable to the plan sponsor, but are trapped assets.? They are valuable because they give flexibility, and reduce future contributions.
Why is it more expensive to buy annuities from insurance companies than the assets on hand in the trust?
The main reason is that the plan sponsor gets to assume the rates he will earn on plan assets (within reason).? That rate will almost always be higher than the rate that an insurance company can invest at after expenses.? Pension funding rules are significantly more liberal than life insurance reserving and risk-based capital rules.
Insurers must mainly invest in bonds, whereas pension funds can invest in any asset class, subject to the prudent man rule.
Insurers must keep surplus assets to keep the company sound through downturns.? Pension plans have no such requirement.
Insurance companies have profit margins and overhead that pension plans do not.
Often there are funky, hard-to-value benefits in the pension plan.? Subsidized early retirement is the simplest of those.? The insurance companies don’t have a good way of pricing them, so they toss out some guesses.? Often the winner is the one that ignored the cost of the odd ancillary benefits.
Now, for a proposal from the Treasury to be effective, they somehow have to wave their hands at the issues that I just put forth.? Even if they allow other regulated financial companies to take over pension plans, they have the following issues:
Who is responsible for shortfalls?
Does the company taking over the plan have to put in some subordinated capital to give them “skin in the game.”? (Essentially, the life insurers have to do that today.)
How do profit incentives work?? Do they accrue inside the plan as a buffer against shortfalls, or do excess earnings (however defined) get immediately? or over time paid to the buyer of the pension liabilities?? (You can guess what the liability buyers want.)
How do underfunded plans get transferred compared to adequately funded plans?? Hopefully the plan sponsors of the underfunded plans have to pony up to fund them at levels that are adequately funded, then they can transfer them.? It would be a sham to transfer underfunded plans to an entity that says that can fund the plans because they have an ultra-aggressive investment strategy.? The blow-up will leave behind even bigger deficits.
Call me a skeptic here, while I call the head of the PBGC a Pollyanna.? To Bradley Belt: If you think this will solve your underfunding/insolvency problems, think again.? Only through high risk investment strategies succeeding can all of the underfunding be invested away.? Ask this: how would you feel today if the plan sponsors of underfunded plans all adopted highly risky investment strategies?? You would worry.? Well, unless the liability buyers have skin in the game, you will worry just as much after the sale of liabilities.
Sometimes I think politicians/bureaucrats believe in magic.? Some little tweak, a loosening of regulations, and poof!? The problem goes away.? It is rarely that simple, particularly when you are dealing with the math and complexities of long term compound interest, which in my opinion are inexorable.? (Kind of the inverse of compound interest being Einstein’s eighth wonder of the world — it is a wonder when you are compounding assets looking forward, without liabilities to fund, but when your discounted liabilities are greater than your assets, my but that eighth wonder of the world fights you fiercely.)
Now, I’m not going to discuss this at length, because I am getting tired, but the Wall Street Journal had another pension article this week.? A good article, and I must say that I don’t get how the practices described are legal.? The anti-discrimination rules were put into place to deter this issue.? Why they are not enforced here is a mystery to me.? Regulated pension plans should not be able to invest in the debts of non-regulated pension plans.? To allow anything else, is to make a mockery of the regulations.? (Another reason why regulated and non-regulated financials should be separated.)? The Treasury has anti-abuse rules that they can invoke against such practices.? Why don’t they use them?
My guess is that the Bush administration doesn’t care about the issue.? Perhaps the next President will care more.? And, with respect to the sale of pension liabilities, my guess is that that gets left to the next President and Congress, who will not allow the practice as proposed.
PS — One last note: what would be fair, if pension liability buyouts are allowed, is to allow participants the option to roll their net assets into a rollover IRA.? Back in the 80s, many people got burned by less than creditworthy companies who bought their pension liabilities and went belly-up themselves.? It is a normal aspect of contract law that you can’t take a debt and transfer it to another party unilaterally, unless the creditor consents.? So it should be in pension liability transfers.
I?m an actuary, but not a Pension Actuary.I don?t understand the minutiae of pension law; I only know the basics.Where I have more punch than most pension actuaries is that I understand the investing side of pensions, whereas for most of them, they depend on others to give them assumptions for investment earnings.I?ve written on pension issues off and on for 15 years or so.I remember my first article in 1992, where I suggested that the graying of the Baby Boomers would lead to the termination of most DB plans.
I am here to recommend to you the book Pension Dumping.It is a very good summary of how we got into the mess we in today with respect to Defined Benefit [DB] pension plans.Now, much of the rest of this review will quibble with some aspects of the book, but that does not change my view that for those interested in the topic, and aren?t experts now, they will learn a lot from the book.The author, Fran Hawthorne, has crammed a lot of useful information into 210 pages.
The Balancing Act
One of the things that the book gets right is the difficulty in setting pension regulations and laws.In hindsight, it might have been a good idea to give pensioners a higher priority claim in the bankruptcy pecking order.But if that had been done, many companies might have terminated their plans then and there, because of the higher yields demanded from lenders who would have been subordinated.
She also covers the debate on the ?equity premium? versus immunization well.Yes, it is less risky to immunize ? i.e., buy bonds to match the payout stream.Trouble is, it costs a lot more in the short run.With equities, you can assume that you will earn a lot more.
She also notes how many companies were deliberately too generous with pension benefits, because they did not have to pay for them all at once.Instead, they could put up a little today, and try to catch up tomorrow.
Things Missed
?Individuals aren?t good at managing their own money.Even if a participant-directed 401(k) plan is cheaper than a DB plan in terms of plan sponsor outlay, the average person tends to panic at market bottoms and get greedy at market tops.DB plans and trustee-directed DC plans are a much better option for most people.That said, most people prize the illusion of control, and will not choose what is best for them.
?Technological progress was probably a bigger factor in doing in the steel industry, and other unionized industries, than foreign competition.Nucor and its imitators did more damage to the traditional steel industry than did foreign competition.With commodity products, low price wins, and Nucor lowered the costs of creating steel significantly.
?In the analysis of what industries could face pension problems next, she did not consider banks and other financial institutions.Most of those DB plans are very well-funded.Why?They understand the compound interest math, and the variability of the markets.But what if the current market stress led to financial firms cutting back on their plan contributions?
?She gets to municipal pensions at the end, and spends a little time there, but those face bigger funding gaps than most private plans.Also, she could have spent more time on Multiple Employer Trusts, where funding issues are also tough, and plan sponsor failures leave the surviving plan sponsors worse off.
?She also thinks that if you stretch out the period of time that companies can contribute in order to fund deficits, it will make things better.In the short run, that might be true, but in the intermediate term, companies that are given more flexibility tend to get further behind in funding DB pensions.
The book could have spent more time on changes in investing within DB pension plans, which are drifting away from equities slowly but surely, in favor of less liquid investments in private equity and hedge funds. How that bet will end is anyone’s guess, but pension investors at least have a long time horizon, and can afford the illiquidity. My question would be whether they can fairly evaluate the skill of the managers.
Summary
This book describes the motives of all of the parties in DB pension issues very well, and why they tend to lead to DB plan terminations.There are possible solutions recommended at the end, but in my judgment they might save some plans that are marginal, but not those that are sick.If you are interested in the topic of pensions, buy the book, and if you buy it through the links above, I get a small commission.(If you buy anything through Amazon after entering from a link on my site, I get a small commission.That?s my tip jar, and it doesn?t raise your costs at all.)
Personal notes before I get started: I’ve been busy studying for the Series 7 (and also reviewing the compliance manual for my new firm — wow it is big). The two of them fit together, as I get to see how the regulations get applied. I’ve made through the study guide (what do you do when it is wrong — not that I found a lot of errors, maybe half a dozen?), and I am 20% through my first practice test. Went and got fingerprinted for the fourth time in my life yesterday. (The other three times were for adoptions.)
My links are back 🙂 but I had to give up my descriptive permalinks. 🙁 Maybe I’ll get them back when I upgrade the blog to WordPress 2.5.1. Beyond that, I am working on a book review for Gene Marcial’s forthcoming book, “7 Commandments of Stock Investing.”
Catching up on the markets:
Our Unorthodox Federal Reserve, GSEs and Government
1) Repo rates may not be negative now, but they were so recently. Fails (failures to deliver securities) become common, because of the lack of a penalty. Today we should see whether the TSLF has any impact on the scarcity of Treasuries. We should learn more about the direct landing program as well after the close today. It got off to a big start last week. Watch for the H.4.1 report after the close. Given all that is going on, it is becoming the critical weekly Fed document.
2) Now, because of all these actions on the asset side of the Fed’s balance sheet, some are calling the actions of the Fed, including the Bear Stearns bailout, revolutionary. Well, maybe. It’s certainly different than before, but there is a cost to doing business this way. Bit by bit the Fed loses flexibility as more and more of its highest quality assets become encumbered for a time.? The more that they do, also, the harder it will be to unwind, in my opinion.
3)? Greenspan…? If we turn off the spotlight, will he go away?? (Then again, he has enough money to buy his own spotlight.)? It is tough for anyone to defend a legacy, and I don’t blame him for trying, but the Fed became too integrated with the political establishment under his tenure, which made it too activist in avoiding short-term pain.? It made him look like a hero at the time, but now we are paying the price.? Overly loose monetary policy and financial supervision led to gluts of borrowing to finance assets that appreciated dramatically, until the ability to service the debt began to decrease.? I don’t think history will treat him kindly.? He said too much in the past that he is contradicting today.
4) Will the Fed buy agency MBS outright?? I think the answer to that one is yes, if the crisis persists. If housing prices drop enough further, like say 15%, the actions of the Treasury, Fed, FHLB, Fannie, Freddie, FHA, and whatever new lending monstrosity our imaginative Government comes up with will have to be closely coordinated.? At some level, if the Fed can’t trust the implicit guarantee of Fannie and Freddie, why should the rest of us?? That guarantee is as sound as a dollar! 😉
5)? It’s interesting to see the tide shift with respect to GSE involvement in the mortgage market:
Fannie and Freddie being pushed to do more, but facing a shortage of capital, even after the recent required capital reduction from their regulator.? They are likely to buy $200 billion of residential mortgage bonds.? No capital added, just a loosening of a restriction.
6)? On a consolidated basis, our government, with its enterprises, are levering up.? This is a substitution of public debt for private, and more, just a lowering of capital standards for the GSEs.? (I wonder how comfortable the rating agencies are with this?)? This works while Treasury yields are low.? I wonder, though, how much impact this will have on the willingness of foreign buyers of Treasuries to continue their funding of our government?? One thing for sure, this will all get funded by the US taxpayers, together with those who lend to the US (dollar depreciation).
7) Now, it’s not as if the US is the only place in the world with central banking problems.? Consider the Eurozone, where there is still no lender of last resort.? How would they deal with a financial crisis?? I’m not sure; the ECB has quietly helped out some Spanish banks, but it is not really in their jurisdiction.? Under conditions of deflationary stress, it would not be impossible to see a nation whose financial system was in trouble either directly bail out the dud institutions, or even, exit the euro (last resort, but not impossible).
Or consider China, where inflation is getting a nice head of steam.? Their neomercantilism, with their crawling peg against the dollar is forcing them to import loose monetary policy from the US.? As the article cited points out, they need to significantly revalue their currency upward, which would would whack their exports, at least for a time.
8 )? For those that remember the files that I created for my piece, A Social View of the FOMC, it looks like I will have to update the file soon.? We have a successor to Bill Poole nominated, James Bullard.? When he is approved, I will update the file.? (I will miss Poole.? Though he was occasionally out of step with the rest of the FOMC, he always spoke his mind, which was usually more hawkish than the rest of the FOMC.)
9)? Now, Bullard is an Economics Ph. D.? (Surprise!) ? In my earlier piece, Jeff Miller took note of a few of the things that I said, and perhaps attributed to me an anti-Academic bias.? I don’t have a bias against academics, per se.? (Hey, can we put Steve Hanke on the Fed?!? One of my professors…)? I do have concerns about not having enough real debate.? If the neoclassical view of monetary policy is correct, then we don’t have problems, because everyone on the FOMC is either a neoclassical economist, or a monetarist.
Now, I do know the difference between politics and policy formation, and if I hadn’t been trying to keep the number of pages down, I might have had two columns.? (Getting it down to 15 pages was hard.)? But most of the FOMC members had either one or the other, but not both, so I left it as one column.? Next time I change the column heading.? That said, even if one is in a policymaking capacity in the executive branch, there is typically some political affiliation that helps get that person the job.? Those are relevant bits of experience, just as I noted everyone that had foreign experience, or military experience.? But what worries me is a lack of real diversity in views of how economics works.? (Perhaps we could get someone from the Santa Fe Institute?)
10) Finally, there will be a lot of pressure in the future to re-regulate our financial system.? Personally, I don’t think it is possible to create a regulatory scheme that eliminates crises.? The regulator shapes the type of crisis that will come, and when it will come, but it is impossible to wipe out the boom-bust cycle.? (We put off this bust for a long time, and now we are getting it with compound interest for time delay.)? If a regulatory regime is too tight, the financial companies complain because their ROEs are too low.? To the extent that it can, capital begins to exit the industry, or, the stock prices languish, and financials trade at low multiples on book, because they can’t earn much off their net worth.
Financial companies find the weak spots in any risk-based capital formula.? They also lobby the executive branch and Congress effectively.? Unless we slide into Great Depression II, I don’t think things will change remarkably from here.
I? agree that we need to re-regulate, but perhaps after this crisis is done, we can consider systemic reforms, and not the piecemeal stuff we have been dished up in the name of crisis management.? My re-regulation would be to reduce the Federal Government’s role in the credit markets, but then, I am walking out of step, and realize that is not what is going to happen.
One of the troubles with the way that academic research in the social (and biological) sciences is set up, is that there is a bias toward publishing research that is statistically significant. Here are some of the problems:
If honestly done, there is value in publishing research that says there doesn’t seem to be any relationship between variable being studied and the cofactors. If nothing else, it would tell future researchers that that avenue has been checked already. Try another idea.
It encourages quiet specification searches, where the researcher tries out a number of different variables or functional forms, until he gets one with significant t-coefficients. Try enough models, one will eventually hit the 95% significance threshold.
What is statistically significant is sometimes not really significant. The result might be statistically significantly different than the null hypothesis, but be so small that it lacks real significance. I.e., learning that a compound increases cancer risk by one billionth should not be significant enough to merit attention.
Researchers are people just like you and me, and all of the foibles of behavioral finance apply to them. They want tenure, promotions, don’t want to be let go, respect from colleagues and students, etc. They have biases in the selection of research and the framing of hypotheses. For example, we can’t assume that stock price movements have infinite variance, because then Black-Scholes, and many other option formulas don’t work. The Normal distribution and its close cousins become a crutch that allows for papers to get published.
Once an idea becomes a researcher’s “baby”, they tend to nurture it until a lot of contrary evidence comes in. (I’ve seen it.)
Famous researchers tend to get more slack than those that are not well-known. I would trot out as my example here returns-based style analysis, which was proposed by William Sharpe. When I ran into it, one of the first things I noticed was that there were no error bounds on the calculations, and that the cofactors were all highly correlated with each other. The paper didn’t get much traction in the academic world, but was an instant hit in the manager selection consultant community. A FAJ paper in 1998 (I think) came up with approximate error bounds, and proved it useless, but it is still used by some consultants today. (I have many stories on that one; it is that only time that I wrote a pseudo-academic paper in my career to keep some overly slick consultants from bamboozling my bosses.)
Data sets are usually smaller than one would like, and the collection of raw data is expensive. Sample sizes can get so small that relying on the results of subsamples for various cofactors can be unreliable. This is a particular problem in the media when they publish the summary results on drug trials, but don’t catch how small the samples were. People get excited over results that may very well get overturned in the next study.
Often companies fund research, and they have an interest in the results. That can bias things two ways: a) A drug company wants their proposed drug approved by the FDA. A researcher finding borderline results could be incented to look a little harder in order to get the result his patron is looking for. b) A finance professor could stumble across a new profitable anomaly to trade on. That paper ends up not getting published, and he goes to work for a major hedge fund.
The same can be true of government-funded research. Subtle pressure can be brought on researchers to adjust their views. Politically motivated economists can ignore a lot of relevant data while serving their masters, and this is true on the right and the left.
The reason that I write this is not to denigrate academic research; I use it in my investing, but I try to be careful about what I accept.
Now, recently, I took a little heat for making a comment that I thought that the unadjusted CPI or median CPI was a better predictor of the unadjusted CPI than the “core” CPI. So, I went over to the database at FRED (St. Louis Fed), and downloaded the three series. I regressed six month lagged unadjusted, median, and core CPI data on unadjusted CPI data for the next six months. I made sure that the data periods were non-overlapping, and long enough that data corrections would induce little bias. I constrained the weights on my three independent variables to sum to one, since that I am trying to figure out which one gets the most weight. My data set had 80 non-overlapping six-month observations stretching back to 1967. Well, here are the results:
Intercept: -0.0002 (good, it should be close to zero)
Unadjusted CPI: 0.1720 (prob-value 12.3%)
“Core” CPI: -0.1665 (prob-value 11.2%)
Median CPI: 0.9945 (no prob-value because of the constraint imposed)
Prob-value on the F-test: 24.3% (ouch)
Adjusted R-squared: 1.10%. (double ouch)
What does this tell me? Not much. The regression as a whole is not significant at a 95% level. Does the median CPI (from the Cleveland Fed) better predict the unadjusted CPI than the “core” or unadjusted CPI? Maybe, but with these results, who can tell? It is fair to say that core CPI does not possess any special ability to forecast unadjusted CPI over a six-month horizon.
From basic statistics, we already know that the median is a more robust estimator of central tendency than the mean, when the underlying distribution is not known. We also know that tossing out data (“core”) arbitrarily because they are more volatile (and higher) than the other components will not necessarily estimate central tendency better. Instead, it may bias the estimate.
So, be wary of the received opinion of economists that are in the public view. Our ability to use past inflation measures to predict future inflation measures is poor at best, and “core” measures don’t help in the explanation.
, I gained perspective on the increasingly complex financial world that we were moving into.
, by another acquaintance of mine, the equally bright (compared to James Grant) Caroline Baum.? This book followed the same format, reprinting the best of old columns, with modest commentary.? In my review, I cited Grant’s earlier book as a comparison, Minding Mr. Market.
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