Monday, October 25, 2010 at 04:04PM Here it is: Office of the Inspector General for the Troubled Asset Relief Program of Oct. 26, 2010.
We particularly like the snappy 1984ish, Brave New World style of jargon:
Thursday, October 14, 2010 at 11:44PM Amity Shlaes wrote a fascinating article in the WSJ on FDR and the notion of confidence, part of which is excerpted below:
Over the summer of 1933 ... Roosevelt launched a novel gold purchase program. The plan was to drive up the general price level by buying gold. Each morning, FDR set the gold price target, personally ... theoretically, Roosevelt's idea of reflating can be defended...
But the exposure to investors that Morgenthau was getting through the gold purchase project of 1933 was already teaching him something. Investors didn't like the arbitrariness. It took away their confidence. One day Morgenthau asked FDR why the president had chosen to drive up the price of gold by 21 cents. The president cavalierly said he'd done that because 21 was seven times three, and three was a lucky number.
Sound familiar? Arbitrary decisions make for uncertainty which now permeates the entire process of our nation's allocation of capital and paralyzes the wealth creation process. Consider arbitrary nature of
Our problems arose from the cumulation of distortions and mis-allocations of capital mostly induced by the corruption of law, regulation, and leadership. We concede some base level of manifest error, but in our view it is corruption operating in absence of appropriate checks and balances. When countries mis-allocate capital badly over time, the standard of living declines. Productivity counts. The primary problem is that our tax code and budget process have become instruments by which Congress monetizes its ability to dispense economic favor. You don't need 67,505 pages and the K Street lobbying industry to treat people equally. And everybody knows it.
Consider the sheer magnitude of the unproductive burden of tax compliance on citizens and business alike. We now have whole industries and legions of tax lawyers and accountants dedicated to intermediating an unfathomable, incomprehensible extraction of wealth by the government where by compliance is impossible by virtue of complexity, so enforcement becomes discretionary. And out of this process comes not one wit of real production, not one loaf of bread, not one bucket of bolts, not a single chip or Ipad. Nothing but sludge and friction and now sobering, if not heartbreaking, macro costs. Keep it simple, so everyone can understand the deal without engaging a Wall Street law firm. Eliminate Congress' ability and inclination to corrupt itself and the process so essential to the well being of our country.
Until then three is still a lucky number.
Tuesday, October 12, 2010 at 11:42AM The fraud of Social Security becomes the fraud of General Motors becomes the fraud of California and moves soon to a theatre near you. Owners of municpal paper take note.
The FT today reports US cities face big public pension deficits excerpted below.
Big US cities could be squeezed by unfunded public pensions as they and counties face a $574bn funding gap, a study to be released on Tuesday shows.
The gap at the municipal level would be in addition to $3,000 bn in unfunded liabilities already estimated for state-run pensions, according to research from the Kellogg School of Management at Northwestern University and the University of Rochester.
Now how could that have happened?
Thematically, its the same old stuff. Shall we take a little flashback to General Motors? Kudos to Tony Jackson of the Financial Times for his article GM is just a hedge fund in disguise (Aug 22, 2010 also excerpted below).
As public offering for GM rev’s up, one might well ask, “How is this going to work?” Well, it’s not going to. The US government, or rather the current & future US taxpayers, have provided us with another opportunity to short a pig. Let’s set aside the sobering competitive reality that we as consumers already know well. No one buys their cars. That’s why they went bust. Let’s further set aside the sobering global competitive threats of Ford, Honda, Toyota, and Hyundai.
GM has pension liabilities of some $100 billion, funding of which is well, running a bit short. Quelle surprise! The stated deficit of some $27 billion bananas is, of course, based on the assumption that the existing pension assets earn 8.5% for the rest of time in eternity AND that GM operates with sufficient profitability and cash flow to fund its pension expenses and everything else.
Well, good luck with that 8.5%. What…? You need a bigger number, no problem? Just pop the asset mix and up risk a bit. Why not?
The reality of all this is that GM…is in economic terms a hedge fund, with its operations a mere sideline. And as a hedge fund, it is fairly racy.
Mr Ralfe calculates that only 35 per cent of its assets are in investment-grade bonds, either Treasury or corporate. The rest is spread across real estate, equities, hedge funds, private equity and so forth.
This poses an interesting question. Why would investors put their money into GM, rather than into regular hedge funds that are not distracted by the vexing business of selling cars in competition with the giants of Asia?
Oh, good. But wait, there’s more. The first half operating earnings of GM were about $2.9 billion (the highest since 2004) so let’s double it to ballpark 2010’s annual operating earnings, well, call it a little less than $6 billion. Let’s set aside the hockey stick earnings forecast by management and soberly assume that the 8.5% sustainable investment return on the pension assets is overly aggressive, at least at the front end of the period. GM then has to dedicate at least all of its operating earnings for the next 6-8+ years minimum to merely funding the pension liability. Forget about growing warranty expense or debt service or funding unsold inventory. Kaboom! We’re all shareholders on this bus.
Now, let's now move our gaze to California which is now in a funding crisis, acutely short of cash with limited financing options... all dressed up, sitting by the phone at 7 pm on prom night. CALPERS, being helpful sympathetic types, lob in a call. They know a good deal when they see it, the opportunity to buy every politician in the state with make a prudent bridge loan to a large politically & economically important state whose pensions they run. CALPERS is, of course, the California Public Employee’s Retirement System. They’re proposing to lend to the state. The cash, of course, comes from the pensions of the state's employees. Oh, did we mention that many of the CALPERS' pension plans have funding deficits also? Something about understated liabilites and under performance of investment assets…
Flash back to GM: GM’s annual payments to its US pensioners are running at $9.3bn. On US fund assets of $85bn, that ostensibly requires a return of 10.9 per cent.
Flash back to the Social Security trust fund: there is no social security trust fund.
Systemic risk, anyone?
hb
The WSJ reports that the “U.S. government could continue to be a shareholder in General Motors Co. for several years as it gradually reduces its majority stake, Chief Executive Dan Akerson said Thursday.” Yes, several more years, indeed.
hb
ed - oops, some of the initial editing didn't take. Fixed now, we hope.
hb
The data below, estimated by Joshua Ruah an associate professor of finance at the Kellogg School of Management at Northwestern University, needs to be supplemented by the list of the 11 best states so we may observe an object lesson in the mobility of capital that will accompany the progress of time and increases in tax burden of these states (the following excerpted from linked article).
And Now, 11 State Pension Funds That May Run Out of Money
#1 Illinois
Year pension fund runs out: 2018
Bill in the following year: $13.6 billion
Share of state revenue: 32%
#2 Connecticut
Year pension fund runs out: 2019
Bill in the following year: $4.9 billion
Share of state revenue: 27%
#3 Indiana
Year pension fund runs out: 2019
Bill in the following year: $3.6 billion
Share of state revenue: 17%
#4 New Jersey
Year pension fund runs out: 2019
Bill in the following year: $14.4 billion
Share of state revenue: 34%
#5 Hawaii
Year pension fund runs out: 2020
Bill in the following year: $1.7 billion
Share of state revenue: 24%
#6 Louisiana
Year pension fund runs out: 2020
Bill in the following year: $4.3 billion
Share of state revenue: 27%
#7 Oklahoma
Year pension fund runs out: 2020
Bill in the following year: $3.7 billion
Share of state revenue: 30%
#8 Colorado
Year pension fund runs out: 2022
Bill in the following year: $7.8 billion
Share of state revenue: 54%
#9 Kansas
Year pension fund runs out: 2022
Bill in the following year: $2.5 billion
Share of state revenue: 23%
#10 Kentucky
Year pension fund runs out: 2022
Bill in the following year: $5.3 billion
Share of state revenue: 35%
#11 New Hampshire
Year pension fund runs out: 2022
Bill in the following year: $1.0 billion
Share of state revenue: 30%
uncertainty, unfunded liabilities Wednesday, September 8, 2010 at 12:29PM Morningstar just came out with a nifty analysis of mutual funds: cheaper is better. We believe by proxy the same analysis & concepts extend to ETF's, although liquidity and transaction costs need to be considered.
"Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two quintiles, and you’ll be on the path to success." - How Expense Ratios and Star Ratings Predict Success, Russell Kinnel, Director of Fund Research & Editor, in Aug. 2010 Fund Investor
hb
What are the odds of picking a winner? Over 15 years some 71% of mutual funds either underperformed or simply went away. "of the 3,842 funds that were available on January 1, 1995, 1,646 (43%) underperformed the Dow Jones U.S. Total Stock Market Index through 2009, and another 1,071 (28%) were merged or liquidated along the way." source: Vanguard, Commentary, Aug 2010, fund data from Morningstar's 9 box system
costs, portfolio strategy Wednesday, September 1, 2010 at 11:22AM We recommend the analysis of Ask Not Whether Governments Will Default But How? (Mares of Morgan Stanley: Aug 25, 2010) as an important work for those who wish to understand the nature of the problem with global sovereign finance. It proposes the notion of “financial oppression” of citizens (or more broadly holders of capital) as a viable strategic alternative available to central banks and governments in lieu of default. This is bold language for Morgan Stanley, a mainstream global house, to use publicly in our brave new regulatory world. We commend them. The analysis is spot on.
For those with a tolerance of flippancy (if not rude language) but who also appreciate clarity of logic, we also suggest A Termite Riddled House. It complements Mares’ line of thought for those who might need to grok differently and also happens to have a link to one of the most instructive graphs, a time series, of the Fed’s balance sheet.
The graph demonstrates the back end of the cycle. In the front end, as prelude,
That’s where we are. The toxic assets are still there, still hanging around. Look at the balance sheet of the Fed. Look at the increase of federal debt.
The strategy of the Fed is very clear. The nature and magnitude of the macro economic problems are so large and complex that resolution of the problems is not feasible from their perspective as a practical or political matter[1]. Scale, complexity, and time make for diverging rather than converging sets of solutions. The cone of possible outcomes they see gets wider and more chaotic.
So, the strategy of the Fed is not to solve large scale, complex problems but rather to avoid several specific bad outcomes
in favor of inducing controlled, chronic inflation to buy time and stability. Default is off the table. The Fed has no more ideas, options or ammo. That’s it.
What does this all mean? It means we anticipate the Fed will induce structural inflation, which they hope will be moderate, as a best case outcome. We wouldn't go long duration just right now or anytime soon. Those who follow us know we've been inclined to shorter duration and investment grade credits in fixed income for some time. We concede the spread party is over but are content with investment grade spreads for now. We like TIPs as a segment of fixed income strategy. We have been following the muni market with some concern, noting that capacity to repay declines dramatically when you no longer have either cash or a viable tax base. We'll re-consider when we see the risk premia reset (note Harrisburg defaulted on a payment of a general obligation bond today). If we could buy renminbi bonds, we'd think about it.
As things currently stand we do not anticipate deflation. However, here we come to the uncertainty part, the 'as currently stands' part. It's unclear on the margin how much more imprudent policy and uncertainty we can tolerate without setting off a chaotic response. The lack of experience in the executive and leglislative branches now adds risk. They don't understand that if you push it hard enough, it will fall over.
The bi-polar mind sees two ways to hit the reset button: a hard reset to equilibrium by crisis of either inflation or deflation. The temperate and optimistic see that with sensible & timely reform we can fix this. When was the last time you saw sensible & timely out of Congress? November might well be the last chance saloon.
Funny how the equity market goes up when the dividend yield exceeds the 10 yr Treasury rate, isn't it?
[1] We will leave for another day the consideration of the hypothesis that in the main the citizenry lacks the capacity to understand what got us here, and therefore we lack the political capacity to resolve it (c.f. dependency ratio > 50% and failures of the educational system). [2] Also thanks JS for correcting the error of 'grock' to 'grok'.
Friday, August 6, 2010 at 10:42AM From today's Financial Times Even Bondholders Have Deflation Doubts (excerpted below):
But something weird happened this week in Treasury inflation-protected securities, or Tips, US inflation-linked government bonds. For only the second time in history, the five-year Tips offered a negative real yield; that is, buyers get back less than inflation.
Why would anyone want to buy an inflation-protected bond that is guaranteed not to protect fully against inflation? Perhaps if inflation were expected to be very high, prompting a rush for even partial protection. But that is hardly the case today. Rather, it is because Tips investors expect inflation to be higher than nominal bond yields: only by one hundredth of a percentage point, but enough to make it worth buying Tips with a definite real loss rather than straightforward bonds.
The substance of this phenomena is worth thinking about. Seems to us this analysis is just about right, although risk preference may come in to the calculation as well. Deflation, of course, brings a whole new meaning: "I would gladly pay you less on Tuesday for a hamburger today."
What to do? We think not much and certainly nothing rash. The key is the longer term strategy. Those, including ourselves, who have genetic disposition to chronic fear of inflation, would do well to consider the substance of the market view that any pick up in aggregate demand may not eventuate in the near to intermediate term...or even later. The bond vigilantes counter argue that the only actionable solution is to monetize the debt by inflation (check the CBO report below). Certainly, in the context of fixed income portfolios, the quest for real value will chafe against the avoidance of risk (do no harm), and the uncertainty in the markets once again suggests that the basics of diversification and risk management are essential.
inflation risk Thursday, July 29, 2010 at 01:14PM
Updated on Wednesday, September 1, 2010 at 07:56AM by
hb
Updated on Friday, November 26, 2010 at 12:00PM by
hb
Updated on Tuesday, January 18, 2011 at 05:06PM by
hb
We thank a reader for bringing to our attention a newsy story on MarketWatch covering the municipal bond markets, Municipalities on the brink, but muni bonds hang in there. The article is worth a read if only for a bold market call.
We are given to understand that
All state governments "will pay principal and interest in a timely fashion, even the states that are most in the news." said Gary Pollack, head of fixed-income trading and research at Deutsche Bank Private Wealth Management...States in particular are generally safe because they can't really file for bankruptcy and most are required to pass a balanced budget every year..." (exerpted)
We beg to disagree with just about every dimension of this perspective.
Wednesday, July 28, 2010 at 11:34AM The Congressional Budget Office just released an important study, Federal Debt and the Risk of a Fiscal Crisis, July 27, 2010. The good news is that we have the analysis. The bad news is akin to the cart before the horse. The country needs this analysis before of the decisions get made, so citizens may make informed, reasoned decisions. Congress and the Administration turn a willful blind eye to such nicities, by operating in such a way that prohibits the free, open, and timely dissemination of such information to the citizens.
Read the fine print and learn that Alternative Fiscal Scenario is where we're heading. Its ugly.
The CBO points out the consequences of growing debt might include
What options does CBO present as available to cure the problem? Three out of four are problematic... at least for economic viability.
No, we're not making this up. Read the article, learn of government debt/gdp of Argentina (50%), Greece (110%), and Ireland (70%).
Now square the picture above with the current US Treasury rates.
Monday, July 26, 2010 at 08:42PM The AP today reports:
"WASHINGTON (AP) -- Some major health insurance companies will no longer issue certain types of policies for children, an unintended consequence of President Barack Obama's health care overhaul law, state officials said Friday.
Florida Insurance Commissioner Kevin McCarty said several big insurers in his state will stop issuing new policies that cover children individually. Oklahoma Insurance Commissioner Kim Holland said a couple of local insurers in her state are doing likewise.
In Florida, Blue Cross and Blue Shield, Aetna, and Golden Rule -- a subsidiary of UnitedHealthcare -- notified the insurance commissioner that they will stop issuing individual policies for children, said Jack McDermott, a spokesman for McCarty.
The major types of coverage for children -- employer plans and government programs -- are not be affected by the disruption. But a subset of policies -- those that cover children as individuals -- may run into problems. Even so, insurers are not canceling children's coverage already issued, but refusing to write new policies..."
Many are of the view that this phenomena is not an unintended consequence, that it is by design of policy. It is a logical and predictable response to cost structures and burdens imposed by the new 'health care reform'. We predict more insurers will follow and that health care providers across different sectors in increasing numbers will start to limit treatment or otherwise refuse to accept reimbursement schedules that cause them to incur losses.
healthcare Monday, July 26, 2010 at 02:46PM The March 2010 issue of Research Insights from S&P Indices puts forth some interesting results of an analysis of 5 years of data ending 12/31/2009:
"The S&P Indices Versus Active Funds (SPIVA) Scorecard reports performance comparisons corrected for survivorship bias, shows equal- and asset-weighted peer averages, and provides measures of style consistency for actively managed U.S. equity, international equity, and fixed income mutual funds... The CRSP Survivor-Bias-Free U.S. Mutual Fund Database provides the underlying data…
Over the last five years,
costs, portfolio strategy Wednesday, July 21, 2010 at 02:11PM
Updated on Friday, July 23, 2010 at 11:46AM by
hb
Updated on Wednesday, July 28, 2010 at 02:36PM by
hb
At some point Congressional imbecility becomes malfeasance. The Wall Street Journal today reports: Standard & Poor's, Moody's Investors Service and Fitch Ratings are all refusing to allow their ratings to be used in documentation for new bond sales, each said in statements in recent days. Each says it fears being exposed to new legal liability created by the landmark Dodd-Frank financial reform law.... That is important because some bonds, notably those that are made up of consumer loans, are required by law to include ratings in their official documentation. That means new bond sales in the $1.4 trillion market for mortgages, autos, student loans and credit cards could effectively shut down.
regulation, uncertainty Thursday, July 1, 2010 at 12:00PM Below are the 5 year credit default swap rates for selected countries. We note the US enjoys a mere .07% pa advantage over Germany and has only .59% basis points separating us from France.
|
5 yr CDS / .00% pa |
Counter party |
|
39 |
USA |
|
46 |
Germany |
|
78 |
United Kingdom |
|
91 |
Japan |
|
98 |
France |
|
201 |
Italy |
|
431 |
Romania |
Well, a little math: if the yield on the 5 year US Treasury is 1.75% pa, and we strip out the credit risk (a novel concept for those who used to think the US Treasury represented the ‘risk free’ rate) you get something like 1.36% which on a good day should include the embedded real interest rate, inflation expectations, and counterparty risk on the swap. Think about that for a minute while we wander elsewhere.
We have John Taylor in today’s WSJ (perhaps taking the cue from WWB?) blasting Congress for fundamental potentially fatal flaws in the putative “financial reform” legislation. We have President Obama now threatening critics with “calling their bluff” next year by “presenting some very difficult choices.”
Meanwhile we have in Daniel Henninger commenting on the decay in the rule of law, quoting Justice George Sutherland: “a statue which either forbids or requires the doing of an act in terms so vague that men of common intelligence must necessarily guess at its meaning… violates the first essential of due process of law.”
Unfortunately Judge Sutherland has come to describe much of the legal and regulatory status of modern economic and private life today. By operation of complexity or lack of clarity good faith compliance with law or regulation has become nearly impossible, a stochastic venture in the Heisenberg principle[1]. This has the consequence that enforcement has become chaotic at best or discretionary at worst. Mel Brooks is correct: “it’s good to be the king.”
Outcomes matter. Is Mel Brooks or George Washington working the levers? Allocators of capital don’t have the luxury of waiting for visions of clarity. The cash is here, what’s the trade? Take zero to negative real returns on short term, low risk assets or ponder the range of risks and uncertain returns imposed by chaotic political, fiscal, monetary, regulatory, and legal frameworks? For the bricks & mortar crowd, build the factory here or abroad, or scrap it altogether?
Uncertainty paralyzes capital which impairs productivity. Consider the response of a risk officer when asked if the risk of the deal was acceptable:
“Risk in & of itself is rarely unacceptable. The question is at what price?”
Well, the Dow seems to be pushing 9,500 and the US is only 7 basis points away from parity with Germany. We, meaning the United States and its citizens, now have fewer valuable goods & services, less wealth, and our risk profile has increased. You can price it by the minute.
And let’s go back to that mysterious 1.36% we came to at the beginning of this posting ... seems like the market isn’t scared of inflation. Deflation seems to be the major concern. Keynesian economics basically claims that value is created by borrowing from Poppa to pay Peter to dig a ditch and then to pay Paul to fill it back up (you do recall Cash for Clunkers?). We are now borrowing from the unborn children of Peter and Paul to pay for the digging and filling up of holes.
The market is pricing in quality & effectiveness of governance and uncertainty of rule of law, also known as country risk, for the US. It also seems that deflationary expectations now dominate those of inflation, a sobering thought. Equities are getting significantly cheaper and that, for proper context, in face of greater risks. Treasuries are either cheap or dangerously expensive, depending on your view of the inflation vs. deflation argument.
Our bias shows, so we may as well say it directly. You better have some cash on hand. Rebalance to get some equities cheap (buy on ugly and be prepared for uglier). Stay short & high quality on the fixed income side. We discourage trying to juice yield via duration, credit risk, or artifice. There is no free lunch, and the market will mete out a rough frontier justice to those who think so.
Farmers know the fallacy of Keynes, that crops must be grown before they can be eaten. Or taxed.
[1] We cite Tim Geithner’s plea as to Turbo Tax but leave the reader to determine the issue of good faith.
Friday, June 25, 2010 at 11:28AM "It's a great moment. I'm proud to have been here," said a teary-eyed Sen. Christopher J. Dodd (D-Conn.), who as chairman of the Senate Banking Committee led the effort in the Senate. "No one will know until this is actually in place how it works. But we believe we've done something that has been needed for a long time. It took a crisis to bring us to the point where we could actually get this job done." Washington Post, June 25, 2010
This pronouncement is stunning in many respects. First, it is true. ‘No one will know…how it works’, and Senator Dodd was not even under oath. It is also true that it took a crisis, and one of Congress’ own doing, to bring Congress to a point where it felt it had to act. With the US on its way to losing its Aaa/AAA ratings, the economy on the rocks, record deficits and the like, Congress needed to revise the mechanic by which it monetizes its ability to regulate.
Set aside for a moment the abject imbecility that ‘no one will know…how it works’. Consider that vague law and regulation encourage rent seeking behavior from deep pocketed market participants: take a member of Congress to lunch today and it better be good. Political favor, not efficiency or customer satisfaction become the rule (GE comes to mind). Rent seeking behavior prejudices the success of smaller, more innovative market players. Worse, vague law and regulation are the means by which government diminishes our freedoms.
We again affirm that absent reform of the national, residential real estate mortgage markets any presentation or claim of financial reform is simply manifest political fraud of the highest order.
regulation Tuesday, June 22, 2010 at 12:44PM The Impact of Public Guarantees on Bank Risk Taking: Evidence from a Natural Experiment, a paper by Reint Gropp, Christian Grundl and Andre Guttler dated April 10, 2010, is clear and unsurprising. The abstract is below:
Abstract: In 2001, government guarantees for savings banks in Germany were removed following a law suit. We use this natural experiment to examine the effect of government guarantees on bank risk taking, using a large data set of matched bank/borrower information. The results suggest that banks whose government guarantee was removed reduced credit risk by cutting off the riskiest borrowers from credit. At the same time, the banks also increased interest rates on their remaining borrowers. The effects are economically large: the Z-Score of average borrowers increased by 7% and the average loan size declined by 13%. Remaining borrowers paid 57 basis points higher interest rates, despite their higher quality. Using a difference-in-differences approach we show that the effect is larger for banks that ex ante benefited more from the guarantee. We show that both the credit quality of new customers improved (screening) and that the loans of existing riskier borrowers were less likely to be renewed (monitoring), after the removal of public guarantees. Public guarantees seem to be associated with substantial moral hazard effects.
We need to apply this common sense to reform of Fannie and Freddie. Any reform that does not include them is simply a fraud on the American public.
Monday, June 7, 2010 at 11:12AM Arthur Laffer in the June 6th WSJ article, Tax Hikes and the 2011 Economic Collapse, is a sobering read and expresses a view that is increasingly difficult to dismiss. He points to the plasticity of investor behavior in respect of tax incentives. Take a look at the graph below, excerpted from the article, and consider that the Reagan tax reductions were enacted in 1981 but did not go fully effective until 1983.
Mr. Laffer makes a compelling case that this works in reverse as well, and it's an ugly picture:
Plasticity of investor behavior is geek-speak meaning that investors tend to modify their behavior and their portfolios to accommodate changes in conditions & rules... kind of like when people move out of the way of large buses before they get hit. Well, what fast moving buses might we have?
Rising taxes - see The war on capital: yours
Nationalization of private sectors - pick a sector.
Declining macro returns on capital - Our scarce national capital has ceased to be allocated to highest & best economic uses. As national policy we see huge distortions of capital flows for losing propositions such as Cash for Clunkers; General Motors; Merrill Lynch (you do remember Merrill Lynch?); TARP; TARP II; pretty much everything on the Fed's balance sheet including AIG; the counterparty payments to foreign banks & Goldman; federal funding for Acorn; or the IMF, all of which channel capital to political rather than economic purpose. The outcome will be a lower national standard of living. Real productivity counts.
Uncertainty of rule of law & property rights - Look at the uncertainty of the rule of law and the vitiation of property rights such as in Kelo; the unprecedented & coercive settlements of claims of senior secured Chrysler & GM debt holders; the pending 'regulation' of the financial sector; or the outright unfathomable whimsy of US personal, corporate or estate tax code. 'Badges?....We don't need no badges!"
Loss of confidence- It is the loss of confidence in leadership, the current political structure, and the erosion of rule of law & property rights in the US that is currently being priced here. Risk assets in the US are now being discounted like those of a banana republic. We all know the Euro is no longer viable as a reserve currency. The price of gold indicates the US $dollar is also under pressure. Even Moody's has warned about the risk to the US's Aaa rating. This is how we create a scenario of declining macro productivity and increasing investor uncertainly. This is the impact of an endless loop of entitle, tax, issue debt, seek rent, and inflate. This is the process that will, in fact, turn Laffer's picture upside down.
That is where we are now. All these trends increase investor uncertainty, raise risk premia, lower multiples, and slow or distort the capital allocation process by which scarce resources are allocated to the highest & best uses.
Try allocating investment capital in this environment. And in fact, right in the middle of this writing, we see Bank of Montreal come out with a rather plain but extraordinary dictum: they quit.
We advocate switching out of equity positions and going to cash. The European sovereign debt crisis appears to be nowhere near over. The global credit environment is worsening. Cost of capital is going up and availability is going down. There are large gaps between where the credit market prices risk and where the equity market is priced. Equity is lagging the deterioration in credit conditions. Moves in currency, equity and commodity markets are mirroring the moves in the credit market. Global growth, in a credit-constrained environment, will slow. Profits will be squeezed by the higher cost of capital. (Focal Points, June 8, 2010, Go To Cash- In Plain English by Mark Steele
This is a non-trivial pronouncement from a generally sober Canadian institution of global stature ... these guys aren't radicals ... and it seems they'll watch from the sidelines for now. A client in the large scale excavating business asked recently in respect of portfolio management, "Every machine & piece of equipment I own has a big red button on it, an emergency shut down. Where's our red button?"
Seems like BMO just hit theirs. They got spooked and fear that the European soverign crisis will migrate to the fragile European inter bank markets, seeing tells in CDS spreads and the US$/Euro currency swap spreads (already in process). In their scenario the contagion starts in Europe, spreads to the Asian banks, which then in turn kills any global recovery. The central banks then run out of food, water, ammo, money, and ideas, and select European sovereigns & financials start to run short on US $ funding. The Fed will try to hide the symptoms, so watch the the currency swap spreads. The outstandings of foreign banks in the US commercial paper markets is the simple form of the canary in the coal mine.
Fortunately, we have our big red button, too (not yet, Bill!). Before anyone jumps, I suggest you (always) read Jim Paulsen's latest where he raises the notion of 'irrational pessimism'. He's the CIO, of Wells Capital Management, and one of the best in the business. Bob Doll, chief equity strategist for BlackRock makes good, though less convincing to my eye, relative argument in support of The Bullish Case for US Equities.
I think it's premature for the red button, but note caution and diversification are never bad things. We constantly talk about getting the risk budget right, how it translates to the appropriate asset allocation.
Many individuals and institutions simply can't afford to get it wrong. Most models assume normal distributions of returns and serial, stable correlations across asset classes over time. And in times of market stress, of course, those don't hold so well, and the only thing that rises is correlation. Keurtosis just makes a mess of everything, and all the bets come off. What makes the asset allocation process so problematic these days is that the primary determinants are now politically driven. Unintended consequences ... you know, the thrashing about of idiotic, pompous politicians can induce powerful non-linear responses of chaotic systems to create Black Swan like events. Think of Congress, the Administration, and Alfred E. Newman chiming in, "What's this button for, Captain?"
And talk about distortions, keep your eye on these:
Tax driven selling pressure: There may very well be significant selling pressure for the balance of this year brought to bear by tax regulations. Investors with embedded long term capital gains in their portfolio will see this as the last year to monitize long term gains at the 15% rate, and they will. Additionally, this year offers the last chance to roll over traditional IRA's to Roth IRA's. Investors who will probably elect the conversion will likely be executing in aggregate for size. So you have a large pool of time constrained sellers of the net tax liability due on conversion. All should should plan their tax and liquidity book well in advance. A fellow doesn't want to be the last one through the door in December, particularly if the banks, foreign or otherwise, are having a tough time with year end liquidity.
Fixed income dilemma: Short rates offer little to negative returns, but our thought (or more accurately, bias) is that now is not the time to buy duration or risk in search of yield. Be patient, stay short to intermediate term with a bias to high & investment grade credits. Any retake of aggregate demand will stoke inflation fears, and people will find out what duration means. The counter trend is that the Euro is no longer viable as a reserve currency, which presumably will stoke the bid for US Treasuries (buy a drunk a drink?) and any further geopolitical conflict will drive the 10 year Treasury to less than 3%. Just to make things worse, just as you see the concern shift from deflation to inflation, you will likely see the correlations of bond and stock markets reverse.
So, two days after BMO tells the world to go to cash, the market is up ~200 points ... ummm, make that 270 now. Perhaps a bad day for them, but if they're in cash they can go home early. Go figure.
(WWB does not offer legal or tax advice and nothing herein shall be so contrued.)
Friday, May 28, 2010 at 03:49PM Mark Spitznagel in today's WSJ piece, excerpted below, has got it exactly right. We encourage all to read it in full and also in conjunction with our posting, No Better than Monkeys Throwing Darts, in which Larry Swedroe recounts William Sheridan's research on 'expert' economic forecasting.
Whenever markets are manipulated by regulatory fiat there are unanticipated consequences, systemic or otherwise. The wealth transfer, perhaps one of the largest of all time, from investors to borrowers effected by the artificial manipulation of low to negative real rates is having untoward consequences on market function and risk allocations. One suspects there are many more unanticipated consequences yet to come.
"The profitability of an investment is simply its return on capital beyond the cost of that capital. It is against this spread that investors must assess risk. So when the Fed distorted the cost of capital following the 2008 collapse by lowering it for many by roughly 2% (to about 0% for banks), it had the same effect as the 2% higher aggregate dividend yield for stocks or higher credit spreads for investment grade bonds. Suddenly what was toxic looked cheap.
The Fed lured everyone to buy everything and anything that was risky—and did so itself with outright purchases of risky assets like mortgage-backed bonds. Anyone eager for easy profits fell right in line, bidding up dangerous assets like clockwork. Sensing safety in numbers, the herd quickly followed, and in no time the market had consumed the Fed's gifted 2% profit spread and then some.
The Fed has managed to align every little market fault right with each other such that they all succumb to the very same stresses at the very same time. Meanwhile—no surprise—the world remains a very seismically active place. What's extraordinary is that the Fed continues this intentional deception about the real cost of credit, even as we've repeatedly witnessed the consequences of this policy.
Left alone, the market works naturally, with waves of buy-order ruptures and waves of sell-order ruptures. Sometimes mini-ruptures coincide to form much larger ones, such as on May 6. But searching for a discrete trigger for such events is futile. To find the real source of the system's excessive fragility, the regulators will need to look much closer to home."
Do we want thin markets or thick markets? It's not a tough call.
fed, regulation Tuesday, May 18, 2010 at 11:12AM The Houston Chronicle reports
Texas doctors are opting out of Medicare at alarming rates, frustrated by reimbursement cuts they say make participation in government-funded care of seniors unaffordable.
Two years after a survey found nearly half of Texas doctors weren't taking some new Medicare patients, new data shows 100 to 200 a year are now ending all involvement with the program. Before 2007, the number of doctors opting out averaged less than a handful a year.
“This new data shows the Medicare system is beginning to implode,” said Dr. Susan Bailey, president of the Texas Medical Association. “If Congress doesn't fix Medicare soon, there'll be more and more doctors dropping out and Congress' promise to provide medical care to seniors will be broken.”
More than 300 doctors have dropped the program in the last two years, including 50 in the first three months of 2010, according to data compiled by the Houston Chronicle. Texas Medical Association officials, who conducted the 2008 survey, said the numbers far exceeded their assumptions.
This is currently an under reported phenomena nationally, and one which will accelerate with the advent of our new national health care. Look for doctors, patients, and companies in the US to migrate away from the new nationalized system (think of the Post Office with operating rooms) into a few variations which will include a luxury service for the ultra rich; off-shore medical care competing on unregulated price, quality, and value; and some other variations we haven't thought of yet. Those who can not afford the off-plan services will be forced to use the national plan as there will be no affordable options.
The proper word is monopoly, and we need look only to the quality of education delivered via the educational monopoly to the children of the major urban school districts. It is the proper model through which one can envision the glide path of our national health care.
Meanwhile we are left to ponder the fate of a whole new set of villians, at least as presented by our government. You may cast your vote for these Texan docs, Goldman, or the greedy oil companies.
Thursday, April 29, 2010 at 09:44AM As our clients are concerned with the creation and preservation of wealth, we thought it might be helpful to present some very basic concepts as to the impact of taxation has on valuation. The linkage is not well understood, so read this, and you'll know more than most Senators.
Let's start with a corporation which, through some stroke of effort and luck, manages to be profitable:
| Corporation | ||
| Net Income before tax | $ 100.00 | |
| Corporate tax @ 35% | $ (35.00) | |
| Net Income after tax | $ 65.00 | |
| less dividend (30% payout) | $ (19.50) | |
| Add to retained earnings | $ 45.50 |
Out of their $100 in pre tax profits, we assume they pay the corporate tax rate of 35%. We ignore state & foreign taxes for simplicity, which is just as well because you can't figure them without retaining a Wall Street law firm. We further assume that an individual shareholder receives the dividend and must pay taxes (which we illustrate below at the prospective rates as indicated in today's Wall Street Journal).
| Current | New | ||
| Dividend Income | $ 19.50 | $ 19.50 | |
| Personal tax | |||
| Current | 15.0% | $ (2.93) | |
| New | 43.4% | $ _______ | $ (8.46) |
| Dividend after tax | $ 16.58 | $ 11.04 | |
| % increase in tax | 289% | ||
| after tax dividend income as % of current | 67% | ||
Let's focus: the after tax value of dividends to that individual is now 67% of what it was before. You used to have a $1.00 of spendable income, you will have 67 cents.
This will adversely impact every man, woman & child in the United States who plans on retiring; educating their children or themselves; providing for elder care, theirs or others; or simply accumulating enough wealth to buy a small boat or a fiancée a wedding ring ... you may recall the quaint notion in our distant past, the pursuit of happiness? We see here simply a transfer of wealth, a 'taking' by fiat.
Back to the markets
Most valuation models of equity markets can ultimately be tied to the company's ability to deliver cash to its owners. Gordon's Dividend model defines equity value as a function of the present value of all the dividends the stock pays.
Gordon's model can be stated as
. where P = the price or value; D = the dividend; k = cost of equity; and g = expected growth rate of D.
We're going to keep it simple. If you are the only shareholder of the whole market (kind of like Warren?) and your dividends are now only 67% of what they used to be, what do you think happens to the value of what you own? Yup, it goes down and by a bunch. The value of the components of the S&P 500 as of Weds March 28 was $10,763,310 (source: www.indexarb.com). The dividend yield was approximately 1.93% or $207,969. Well, individuals have to pay taxes, so let's pay the taxes, hold the macro assumptions the same (without commenting on their validity) and see what happens to the implied value:
| After taxes | |||
| Current | New | ||
| S&P $ Dividend yield | $ 207,969 | $ 176,774 | $ 117,710 |
| Cost of Equity | 6.7% | 6.7% | |
| Growth rate of dividend | 5.1% | 5.1% | |
| Value per model | $ 10,763,310 | $ 7,167,098 | |
| $ Value of S&P 3/28/10 | $ 10,763,310 | $ - | |
| % of S&P value 3/38 | 100% | 67% | |
That 67% should look familiar to you by now. Your cash flows, if you think about it, are exactly what happens if someone takes 33% of your stock: you only have 67% of it left. This is what is known as a tax on capital. This is what it does.
We should not get lost in the technical weeds: the purpose of this exercise is indicative. Analysts (aka 'propeller heads') can and should raise a host of problems/issues in this analysis, including but not limited to
We know enough, however, to conclude broadly that this tax is not good for equity values and potentially very bad. It is certainly detrimental to individuals who were planning on dividend or interest income from savings to retire, educate their children, provide elder care, or otherwise pursue happiness. As a matter of course these changes will increase the ability of politicians to monetize their ability to dispense economic privilege through manipulation of the tax & regulatory code and will increase the price of that service... yes, you may read that as a rational increase the in the cost of corruption and the value of rent seeking behavior. And certainly, the value of barter & black market activity will greatly increase.
As to markets, investors will modify their behavior and seek:
One important tactical issue for planning: the coming increase of tax rates on long term capital gains goes effective next year and may induce a wave of selling. If you're relying on the sale of assets with embedded long term gains to fund college, retirement, or anything else, you might want to consider the timing of your sales. In addition to the selling induced by the higher capital gains tax, there may very well be a wave of selling induced by the conversion of regular IRA's to Roth IRAs. It could get very crowded in the fourth quarter, and you don't want to be the last in line waiting to get out before year end. This could be non-trivial.
Tuesday, April 27, 2010 at 09:19AM Based on the facts as I have come to understand them, I don't think the SEC has a case against Goldman. That’s not to say the SEC can’t make a boatload of trouble, or that they don’t have a specific agenda. They clearly do. It's also not to say that adverse facts might not show up.
As far as I can tell, the identity of the securities in the portfolio was known to any investor who cared to look at the offering memo. The loan selection agent attested that it picked the reference loans (there was no cash product, this was synthetic). No one attested, as far as I know, that the loan selection agent did not select the loans. Everyone will attest that everyone had more opinions than fingers on each and every loan and tranche. Evidently, AIG liked some of them sufficiently well to write some CDS protection on them.
To do synthetics you need counterparties on both sides of the trade (and everyone, particularly institutional investors, knew this). Remember the old Venn diagram? The transaction takes place in the intersection of price, risk & liquidity views. This occurs in the private cash markets all the time, and is in fact necessary for complex and illiquid deals. When the rubber ultimately hit the road, everyone seems to have had access to the same information on the portfolio.
Long is OK, short is NOT OK?
A sale is an expression of a view on price and risk with some liquidity preference baked in it. So is a purchase. The notion that a broker-dealer should not facilitate the expression of differing views of price or risk or liquidity preference leads to some very strange places. How is it that a broker-dealer whose mission is to service the needs of the putatively 'most sophisticated' investors in the world should be prohibited from:
There may be more relevant facts as to the relationship between the loan selection agent than are currently visible, but as it stands now, I see defective business judgment in allowing Paulson effectively 'observation rights' at the front end of the underwriting process. This isn’t the Goldman of old, but again we note, the identity of the securities in the portfolio was known to any investor who cared to look.
There appears to be something else at work, and it starts with a revisionist view of how the mortgage market worked out. Congress, of course, engineered & regulated the whole deal. You may remember the Community Reinvestment Act, Franklin Raines& Fannie, Freddie, Sallie, the Office of Federal Housing Enterprise Oversight (“OFHEO”), Barney Frank, Chris Dodd, and, oh, so many more! Hmmm… we need a donkey on which to pin the tail and not just any donkey.
Call me old fashioned, but I thought the SEC used to try cases in court, not on TV or the front pages of the NY Times or the Wall Street Journal. If they've got a fraud case, put the hammer down and bust 'em. Otherwise this smells like regulatory & legislative manipulation. Where’s my donkey?
It’s noteworthy that the SEC went after a Vice President…. a lowly, stinking Vice President? Seems they don’t have a case or won't or can’t bust senior people who can donate their way out of it.... that they just want to send a message to everyone that no matter what or who, and without regard for the processes and vetted market practice (and dare we say regulated?) at the time, we can retell the story to suit our needs.
Don't get me wrong, this market stank. And I am no friend of Goldman, but nowhere are we hearing that Congress set it up this way. Congress designed and mandated the regulatory framework & gave the rating agencies their monopoly power. The SEC, the FDIC, and the Fed presided over the failure of the control environment. The regulators knew it, and senior management ran the printing presses. This was all bought & paid for...and not by Vice Presidents at Goldman or junior auditing people. You need to ask: where did the originators of all this defective product get the juice? From whence the override on credit quality? The answer is Congress.
So, driven by the infinite wisdom of Congress, we created large concentrations of aggregated risk created by politically allocated capital; declare them unsafe after they’ve blown up; have the taxpayers underwrite the whole deal while allowing sovereign entities and foreign banks (the larger counterparties to AIG) to walk with no haircut whatsoever; and now propose to aggregate risks into larger, more concentrated pools of risk, and kick in $50 billion of contingent capital for grins.
Banks will become large zombies. Capital & risk will be allocated by political process and rent seeking behavior (green finance perhaps?). Think of large scale financial organizations who are protected from failure and whose creditors impose no discipline as they look to sovereign or semi-sovereign implied guarantees (GSA's anyone?). This, of course, creates organizations with the quality standards & acumen of General Motors. Innovative capital will try to move offshore, and taxpayers once again will pay the tab for any unpleasant long tailed risk that eventuates.
Oh, by the way, don’t even think about criticizing the financial reform bill.
This is how Alfred E. Newman manufactures six sigma events. Have you taken a look at municipal CDS spreads lately or perhaps state pensions?
hb
Comments on the Senate "hearing" yesterday:
Few, if any, Senators understand even the most fundemental distinctions and legal responsibilities that attached by law or regulation to an underwriter, broker-dealer, placement agent or a fiduciary. They have no clue and less interest in learning. And they wrote the laws.
Few understand, even on a primative basis, why or how derivatives work or how derivatives are used in the context of managing risks embedded in portfolios or operating companies. No clue.
They simply lack the fundamental understanding necessary to fix the mess, and it is highly likely the fix will result in an unintended compounding of systemic risk. "Systemic" means the US tax payer wears the risk.
