I’ll just take the toaster
Lance on Nov 21 2008 | Filed under: Humor
The Four Bad Bears
Lance on Nov 20 2008 | Filed under: Domestic Equities
Doug Short has a bunch of interesting charts on bear markets (click permalink for larger, easier to read version of chart)
You can take a look at what the bottoming process has looked like for all the bear markets since WWII here. Hat tip: Calculated Risk.
Are Stocks Cheap Yet?
Lance on Nov 18 2008 | Filed under: Asset Allocation, Domestic Equities, Valuation, indexes
Yes, but they are supposed to be if you want reasonable returns for the risk, which is one more reason the Fed Model is wrong. Compared to the past however not that cheap. Jim Hamilton takes a look:
We’re currently at a P/E around 14, a bit below the historical long-run average P/E of 16.3, meaning you could expect a slightly above-average return from buying stocks now. Specifically, if companies were to pay their shareholders all the income to which they’re entitled in the form of a dividend, that dividend would give you better than a 7% immediate return, and over the long run, the dividend would grow at least at the rate of inflation. That’s a return that proved more than sufficient compensation to investors for the extra risk they faced from stocks over the last century and a half, which included plenty of times tougher than those we’re going through at the moment. To me, a 7% real yield sounds like an attractive investment, despite the risk, and certainly dominates most other alternatives as a long-run vehicle for saving for retirement.
I agree with that, though I think most people would be surprised that attractive pricing means only a 7% yield plus inflation. In dividends are actually likely to grow 1-2% faster than inflation. Unfortunately we do not get all of that real yield because companies retain far more of their real dividend than necessary and do not distribute it to their shareholders. Much of that retained dividend is wasted. which brings me to a point of disagreement:
But isn’t it possible that the P/E will decline further, to much below the historical average, before the carnage is finished? Sure it is. But here’s another way to look at that. Companies in fact don’t turn over 100% of their profits to the shareholders as dividends, but re-invest some of those profits in the hope that future earnings will increase faster than inflation. The typical stock in the S&P 500 today is giving you a 3% dividend, which you could hope will grow 3% faster than inflation over the long run as a consequence of the reinvested profits. That again to me sounds like a very nice investment. You can buy and hold for the long term with the philosophy that it’s that stream of growing dividends that you really want and are going to get. Let the market price of the stock go up or down from here wherever the psychology of the market may take it– you’ve still received what you paid for, and it’s a reasonable deal.
Loner term those reinvested profits grow only a bit faster than inflation and trail GDP growth. Long term it is only about 1-2% above inflation. So, 3% plus 1-2% plus inflation gives us 4-5% above inflation. Still reasonable, but hardly spectacular. Of course payouts could rise and increase the dividend yield without reducing growth. So 4% dividend yield, plus 2% (let’s be optimistic) and 3% inflation. That is 9%. With some appreciation in the P/E ratio returns could be higher, perhaps substantially so.
The rest of the post is pretty good for someone who wants to invest themselves, needless to say we believe we can, and have, do much better. Not because of stock picking prowess, but asset allocation decisions, especially hedging against risk or avoiding it in many situations. The graph above over the past few years shows why that can be pretty effective. Nevertheless, sound advice.
John Hussman gives a very good way to look at the opportunities and risks in the current market as well, and some sound advice about approaching this with a long term focus but careful attention to the risks. Investing now does offer good long term returns, but you may be able to do better later. Some exposure is certainly warranted and John gives a good explanation as to why. Known by many inaccurately as a “Perma Bear” he is certainly no mindless cheerleader.
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European Banks: Too Optimistic?
Lance on Nov 17 2008 | Filed under: Economics, International Equities, Risk
Given the carnage in the banking sector overseas it seems pretty hard to justify the idea that people are too optimistic about any financial sector or group overall, but maybe markets still are? Let us forget the specific problems we have been discussing about European financials including them being even more leveraged than here in the US, the fact that they own a bunch of US mortgages, that they have financed their own housing bubbles, that they have much larger exposures to Emerging market debt, including Eastern European mortgage debt.
Instead let us look at what expectations for them are now. From Citigroup (pdf.)
What we see here is that expectations for profits and loan growth are far higher than past crises show are likely. The question we have to ask is whether it is as bad as those past events? I don;t know, but if it is as bad as it appears expectations are still too high.
Key points:
Earnings (of course) collapse, driven in part by soaring bad debts. However, these periods also suffer massive shrinkage in loan books and (more modest) shrinkage in deposits and total balance sheets. Pre provision operating profit also tumbles, in part reflecting this balance sheet shrinkage. Applying even the least damaging of these episodes (Hong Kong 1997-2002) to the current sector would see loan books halve and earnings, equity and operating profit all fall c40% from current forecasts.
[...]
To be clear, none of our economists forecast depression or deflation in Europe, but as recent IMF analysis demonstrates, recessions preceded by financial crisis tend to be long and deep. We might find ourselves rereading this report in a few years time and thinking that we were way too bearish to even raise this spectre. Or we might not.
My suspicion is that the specific problems mentioned earlier make these outcomes far more likely than many people wish to admit.
Hat Tip: Alphaville
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Peter Schiff’s Payback
Lance on Nov 17 2008 | Filed under: Asset Allocation, Risk, economy
The insufferable Peter Schiff has a video going around, which frankly, is just brilliant. He may be unpleasant at times, but he nailed this thing, and took mounds of abuse while doing so. More importantly, I KNOW HOW HE FEELS!
The resentment, irritation, condescension and, at times, outright hostility to my Cassandra act makes me wish I had a video of my own. Sigh…
Oh well, it pays to remember that Cassandra was right. I was never as sure of myself as Peter, but risk management isn’t about knowing you are right, but knowing what could go wrong and whether it is likely enough to act upon.
Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.
Downsizing
Lance on Nov 03 2008 | Filed under: Advisory services
This has fortunately not been an issue for clients at our firm, as losses have been relatively small to non-existent. However, it has been an issue for the many folks looking to become clients. We are having to approach this carefully and with some sympathy.
They want to work with us because we have avoided the carnage. Those most likely to be looking our way have suffered a great deal. We are looking at it on a case by case basis. At minimum we can give them some good advice about next steps, even if we are not going to have an ongoing relationship.
In essence we need to step up to the plate even though we cannot afford to take every potential client and make sure that people have what they need to move forward intelligently with or without our direct involvement.
Hat tip: Greg Mankiw
Todays Links: The View from Here
Lance on Oct 14 2008 | Filed under: Risk, Valuation, today's links
Yesterday was one fo the best days ever for the stock markets:
What does it mean? I think it ultimately depends on factors unrelated to the move itself. Econompic provides us with some context:
Obviously large one day moves in and of themselves tell us little about what is to come. So, let us at least look at what the market is priced to deliver longer term.
Stocks are not cheap, they just seem so because they have been extremely expensive for a very long time (and thus we have had a decade of poor returns.)
Nevertheless, they are around fair value, which is somewhere around 1000 on the S&P 500 depending how you figure it. That should result, without any expansion in P/E ratios (adjusted for the business cycle) in returns of about 3-6% above inflation (referred to as real returns) over the next ten years. This assumes approximately a 50% earnings payout as dividends (3.3% dividend yield) plus earnings growth of between 0- 3% above inflation. For an example of this calculation I suggest this short piece from Ed Easterling (pdf.)
Assume an inflation rate of 3% and nominal returns would be 6.3%-9.3%. Not bad.
Of course a lower valuation (about 677 on the S&P 500) would result in about a 4.5% dividend yield. That means real returns of about 4.5% to 7.5% and once again assuming inflation of 3% nominal returns of 7.5% to 10.5%.That would represent an adjusted P/E of about 11. That is certainly characteristic of bear market bottoms, but that may be a few years off, or not. Either way, if we are about at the bottom then returns are reasonably attractive from here.
Of course returns could be higher if P/E ratios increase. That would reduce the contribution of dividends but increased appreciation would more than make up for it. Of course, that sets us up for lower returns once that process reverses or stalls, thus leaving us without increased appreciation and lower yields (once again, the pdf explains that very well.) They could be lower if they decrease.
Earnings are likely to decrease dramatically over the next few quarters. So further downside is very possible, but not a given.
According to Morningstar Jeremy Grantham thinks the markets is cheap and is buying in earnest. Reading the piece I don’t see him saying that. In fact this statement is completely at odds with what he actually says in the piece:
So, add Grantham to the list of sage investors who see this as a huge buying opportunity. The list includes Marty Whitman and Dan Fuss
I was actually going to do a piece comparing the views of Grantham and Whitman, both men I respect very much. Controlled Greed already noted the divergence, how did Russ Kinnel miss this? Oh, and I like Russ Kinnel, I just disagree with this characterization. I side with Grantham (and my explanation above is a simplified version of Grantham’s own method of establishing return estimates) whose views are better represented at Barron’s.
Henry Blodget likes the plan to inject capital into the banks. While not exactly how I would have designed it, it is close enough for government work. He does ask a key question, why doesn’t the plan include forced writedowns? As investors this is important for several reasons:
It removes the fear that banks and bank investors will be hammered by future writedowns It turns the banks’ attention 100% to putting the new equity to work It attracts private capital (because investors won’t worry about getting sandbagged) It eliminates the death-by-a-thousand-cuts scenario that killed Japan. To put some numbers on this: So far, US financial institutions have taken about $650 billion in asset writedowns. Nouriel Roubini and others have put the total expected writedowns at $1-$2 trillion. This suggests that banks still have $350 billion-$1.350 trillion in losses to take. Losses in this range could wipe out common shareholders, the government, and the financial institutions….unless the banks can easily raise additional equity to offset the losses.
The government may be hoping that 1) the writedowns are done, or 2) the banks can just slowly write off the rest of their crap assets against earnings over the next several years (thanks to the elimination of mark-to-market accounting). Given the magnitude of the projected losses, this seems like wishful thinking.
Alternatively, the government may plan to just keep injecting more and more capital until the writedowns are finally done. If this is the plan, however, other private-market investors are unlikely to follow suit.
So we have one remaining and important question for Messrs. Paulson and Bernanke: What about the future writedowns?
Exactly.
Doug Kass is worried about Muni Bonds. I am worried about everything, but there is an answer, get a discount which reflects that. Where? Maybe this is the answer.
Yves Smith notices Charlie Munger is in a foul mood when it comes to Wall Street. I have to agree that the financial sector needs to shrink. I have long argued that financial intermediaries should not be such a large part of the economy, and is merely a product of leverage, not a dollar for dollar addition to our nations productive capacity and wealth. By in essence increasing the money supply over and over again our financial sector increases the share of wealth they get to collect a toll from. Note, the fantastic increases in leverage has not resulted in increase in economic growth, it has resullted in the financial sector appropriating a larger and larger proportion of that wealth.
Paul Farrell’s Lazy Portfolio’s have done better than the market:
The Kirk Report observes:
At a minimum, these passive lazy portfolios will provide a benchmark for you to compare your own returns to. Also, if you’ve not already proven that you can time the market effectively and consistently beat these passive strategies, then you have no excuse but to implement them until you do.
Good advice, though our clients have done a whole lot better than that, so obviously there are better options.
Have you suffered large losses? Sometimes misery enjoys company, especially when the other guy is in much worse shape than you. Imagine an icelander-Iceland Plunges 77% On Re-Open
Of course you could have been advised by Nicholas Taleb, who has done even better than we have, up massively I like this quote:
We refused to touch credit default swaps. It would be like buying insurance on the Titanic from someone on the Titanic.
Of course his strategy is intended as a hedge, not an entire portfolio, but I am impressed.
Paul Kedrosky gives his view on where this is all leading. I agree with much of it, and find the rest reasonably likely:
- We are going through a credit crisis sparked by the subprime meltdown. It is broader than that, however, really the tail end of an orgy of leverage and credit creation dating back at least 15 years
- The unwinding of all this credit bubble will take longer than most people expect, and the damage will continue to be broader than most expect. Beyond banks and financial institutions, it will include many municipalities, some large-cap tech names reliant on major debt-financed network buildouts, a host of debt-financed non-financial companies, and some sovereign nations. Total cost: Bridgewater’s $2.7-trillion looks close enough to me .
- S&P forward-year earnings forecasts will come down faster than at any time in recent history. We will see 20% average estimate reductions across the board, leading to a further revaluation of the markets. After all, at S&P 1010 we are trading at 19x trailing earnings, and 18x forward, neither of which are inexpensive historically speaking. Admittedly, the above is not the non-financial S&P P/E — ex- financial and consumer stocks we are more like 14x — but it is a distinction that will get blurred as we go into this recession.
- We are already in a recession that will last well into the the fourth quarter of next year.
- Unemployment may touch 9% in the U.S. at trough.
- Obama will win the U.S. presidency.
- Housing will fall 10-15% further in U.S., and we are only beginning major declines in Canada, U.K., Australia, and elsewhere.
- U.S. consumers will become much more aggressive savers, both through debt reduction and direct saving. Similarly, future fiscal stimulus will largely be saved in service of this overdue need to fix domestic balance sheets.
- U.S. long yields have to rise, making curve steepener trades feel appropriate.
- Commodities will stay under pressure for the next two years,and then reverse savagely as developed countries emerge from recession at very similar times. We have newly resynchronized the global economies, which will have immense consequences.
- Coming out the other side, we will see a barbell economy, with growth and investor interest at the mega-cap consolidator end, and at the entrepreneurial smaller end. The latter will be driven by major developments in clean technology, in particular, which was just given a two-year window to gestate before the major economies worldwide turn higher and begin driving energy prices straight up.
David Merkel is hopeful, but skeptical. He feels that not only do we need to delever, we will. That means a lot more difficulty. This plan shuffles the issues, and maybe that is an improvement, but the issues remain. If you don’t read David regularly, start.
Treasuries got clobbered. Many bonds seem attractive right now, except treasuries. Kind of the opposite of returns in recent weeks. Yields are low and the world is likely to be awash in them (as if it already wasn’t) in the future.
Lastly, surprise, surprise, Nouriel Roubini is still very pessimistic. I have been with him all the way, I hope it isn’t quite as bad as he thinks:
Nouriel Roubini, the professor who predicted the financial crisis in 2006, said the U.S. will suffer its worst recession in 40 years, driving the stock market lower after it rallied the most in seven decades yesterday.
“There are significant downside risks still to the market and the economy,” Roubini, 50, a New York University professor of economics, said in an interview with Bloomberg Television. “We’re going to be surprised by the severity of the recession and the severity of the financial losses.”
The economist said the recession will last 18 to 24 months, pushing unemployment to 9 percent, and already depressed home prices will fall another 15 percent. The U.S. government will need to double its purchase of bank stakes and force lenders to eliminate dividends to save them from bankruptcy, Roubini added. Treasury Secretary Henry Paulson said today he plans to use $250 billion of taxpayer funds to purchase equity in thousands of financial firms to halt a credit freeze that threatened to drive companies into bankruptcy and eliminate jobs.
“This will be the first round of recapitalization of the banks,” Roubini said. “The government has to decide to intervene much more directly in the provision of credit and the management of these companies.”
[...]
“The stock market is going to stop rallying soon enough when they see the economy is really tanking,” Roubini added.
The U.S. unemployment rate stood at a five-year high of 6.1 percent last month. Home prices in 20 U.S. metropolitan areas fell 16 percent in July from a year earlier, the most since records began in 2001, according to the S&P/Case-Shiller home- price index. Bank seizures may push home prices down further, scaring away buyers in coming months, after U.S. foreclosures rose at the fastest rate in almost three decades in the second quarter, according to the Mortgage Bankers Association.
Roubini said total credit losses resulting from the meltdown of the subprime mortgage market will be “closer to $3 trillion,” up from his previous estimate of $1 trillion to $2 trillion. The International Monetary Fund estimated $1.4 trillion on Oct. 7. Financial firms have so far reported $637 billion in losses, according to data compiled by Bloomberg.
Summary:
Stocks are not cheap, but long term investors finally have a market priced to deliver reasonable returns. Neverthess, stocks not only could become cheap, the market is facing many risks, including the possibility of much lower earnings than are now expected. Some exposure to the market may be warranted, but scaling back in over time makes more sense than going all in at this time.
Hat tip: as always, some of this is from Abnormal Returns. Even if not, go there.
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Are We Making Things Worse?
Lance on Oct 12 2008 | Filed under: Economics, Federal Reserve, economy
Yves Smith hits a theme I have been harping on, the Federal Reserve, and central banks in general, are making things worse in may ways by destroying the incentive for banks to lend or borrow from one another. She quotes James Bianco of Arbor Research:
The Fed’s massive and numerous liquidity facilities are making things worse. The problem is more than banks unwilling to lend to each other, they are also unwilling to borrow from each other. Banks can get all the funding they need (and then some) from their central bank so they do not need to seek a loan from another bank. I believe it has gotten so bad that they don’t even bother to make a decent market for inter-bank loans anymore. No reason to, they don’t need them anymore as central banks have replaced them.
I would suggest more subtle factors should also be emphasized besides how this distorts rates on loans. If banks do not need each other then they don’t communicate. Thus the hard work of investigating what counterparties real credit risk is goes undone. The market is shunting that off to governments. Furthermore, banks have no incentive to arrive at a believable accounting of their assets, they can wait and hope for a bailout rather than find a way or terms that other banks will accept.
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JP Morgan, Lehman and Nightmares
Lance on Oct 05 2008 | Filed under: Federal Reserve, Government policy, economy
I am often asked about individual bank stocks, especially JP Morgan. Generally my answer is that Bank of America, JP Morgan and a few others look to be likely survivors, but how profitable they will be I am really unsure.
JP Morgan is a special discussion, because I point out a rather astonishing fact, they have a notional exposure to around 90 trillion in derivative contracts, or did last March (pdf.) 58 trillion of it swaps of some sort. Probably credit default swaps (CDS) are the majority. Which means…what? I don’t know, and frankly if anybody really does they aren’t telling me. In essence I am left telling people that I have to treat that as a “black box.” Not exactly confidence raising. Personally there are better ways to make money than hoping a company with 90 trillion in derivatives exposure has a handle on it in my book, but then again, I am admitting that I have no idea what I am talking about, and cannot find anyone else who does either.
Warren Buffet often speaks of defining a circle of competency when investing and staying inside it. It doesn’t matter how big the circle is, just knowing when you are inside it. Well, 90 trillion in derivatives exposure is outside of my circle of competency to assess.
The nightmare is what if it is outside of JP Morgans circle? I suspect it is, and the massive exposure of two other banks as well (Citibank and Bank of America have approx. 38 trillion apiece.)
What makes me wonder about it today? Personally I have always felt that there was a good chance that JP Morgan was who was being saved when the Fed brokered the acquisition of Bear Stearns. Bear goes under and JP Morgan would have to come up with huge payments on CDS contracts. Also, I suspect that Bear was a counterparty for a large number of derivatives, which if Bear was insolvent might not have all been paid up. Or maybe not. Then I see this over at Barry Ritholtz’s:
“Lehman Brothers Holdings Inc.’s main lender and clearing agent, JPMorgan Chase & Co., caused the liquidity crisis that led to Lehman’s collapse, creditors said.
JPMorgan had more than $17 billion of Lehman’s cash and securities three days before the investment bank filed the biggest bankruptcy in history on Sept. 15, the creditors committee said in a filing Oct. 2 in bankruptcy court in Manhattan. Denying Lehman access to the assets on Sept. 12, the bank “froze” Lehman’s account, the creditors claimed.
JPMorgan, the biggest U.S. bank by deposits, financed Lehman’s brokerage operations with daily advances, while money market funds and other short-term lenders provided overnight loans, according to bankruptcy court documents. When JPMorgan shut Lehman off from funds, Lehman “suffered an immediate liquidity crisis that could have been averted by any number of events, none of which transpired,” according to the filing.
The creditors asked the judge in charge of the case to let them interview a witness and request relevant documents from JPMorgan and to pursue possible legal claims. U.S. Bankruptcy Judge James M. Peck is scheduled to hold a hearing Oct. 16 on that request, the creditors said.”
Hmmm, so Lehman may have been torpedoed by JP Morgan? Hardnosed but not weird, until this little tidbit in the update:
Ron Kirby notes: “I wrote about a very strange occurrence – the reporting of J.P. Morgan “transferring” 138 billion dollars to Lehman, after Lehman had already filed for Chapter 11 bankruptcy early last Monday morning…It is highly likely [or a certainty on my planet] that J.P. Morgan was INSOLVENT and was “BAILED OUT” last Monday, September 15, to the tune of 138 billion dollars. This would explain why the Fed and Treasury dictated that Lehman fail – to disguise or otherwise obfuscate the recapitalization of or illicit transfer of 138 billion to A MUCH SICKER, TEETERING ENTITY, J.P. Morgan Chase.”
The link is filled with some rather out there speculation (and I have no intention of confirming or discrediting it) but this is a very odd transaction. Immediately after sending Lehman 138 billion they received 138 billion from the Federal Reserve. What were they off loading? Meanwhile they allegedly cut off Lehman.
Back to Bear. Was allowing JPM to take over Bear and the Fed guaranteeing most of their debt a back door method of recapitalizing a banking behemoth? Are the acquisitions that JPM has been making under very favorable terms a sign of strength or weakness? Gifts from the Federal Reserve to recapitalize them? How much trouble is in that book of derivatives?
I have already pointed out the problems in Europe, problems which the failure of AIG would have exacerbated due to their massive involvement in the CDS market. Is it possible that JPM was also heavily exposed to a failure by AIG? With 90 Trillion in nominal exposure it is hard to imagine they were not. With that much exposure who could possibly be more of a candidate for the “too big to fail” label. Could the Fed be manipulating these events to save them without causing the kind of panic that Bear and the later victims have caused?
I don’t know, which is the real tragedy. Nobody knows what the exposure of anybody is, so we are all left guessing. The Federal Reserve, our government, the financial institutions themselves are all busy obscuring rather than bringing things to light. In order to avoid panic by showing us all how deep the problems are, they are busy spreading suspicion, distrust and panic by keeping everybody, including financial institutions they have to deal with, in the dark. The hope of generous terms from the government keeps banks from admitting what their books really look like, or to try and sell in an orderly manner what they have. Who needs to expose your books to potential lenders when the Federal Reserve will take a used car as collateral and at a lower rate.
How bad off are these institutions? We have no idea. We are left with our imagination and our nightmares.
Another Reason To Not Like The Plan
Lance on Oct 02 2008 | Filed under: Economics, economy
I have argued in the past that the Federal Reserve’s policies may be helping in some ways, but hurting in others. Way too much borrowing and lending is running through the Fed which is drying up lending between banks. It also reduces the need for banks to find reasons to communicate and trust each other, keeping the atmosphere of mistrust alive.
On a similar note one of Yves Smiths commenters left this comment, which is well worth pondering when thinking of the bailout plan being considered:
One of the most critical functions of the banking system is converting short-term deposits into longer-term loans for businesses. Much of the working capital market, for decades has come via money market funds (MM). Joe public or Joe CFO deposits money into a MM. That MM loans it to a bank (usually by buying paper, and usually at a medium duration) and then that bank loans it out to business for inventory, payroll or whatever. The MM has converted Joe’s demand deposit into a fixed-duration loan.
The problem we’re having is that people are fleeing commercial MM for treasury MM. Those are buying treasuries and thus converting the money to the desirable medium duration BUT that money is loaned to the Fed, and the Fed doesn’t make working capital loans. So the deposited money that had been made into working capital has been diverted into the Fed and lost to working capital.
The Fed is kind of trying to address this by loaning out money via various auction/discount windows. BUT, those loans have been overwhelmingly overnight - a particularly nasty demand deposit because it goes back so fast. For a bank to convert that to a 90-day loan it’s got to win 90 auctions in a row - a very risky deal with a crunch on. So the Fed undoes the duration conversion, and then some, converting the liquidity into a form that the banks can’t make into useful-duration loans.
Right now we have both commercial and treasury MMs. Deposits have shifted from commercial MMs to treasury MMs, and consequently we have less working capital (a commercial MM product) and better credit for the Fed (a treasury MM product). But, treasury MM rates are now very low and the gap between treasury and commercial fairly high, which creates an incentive for depositors to put money into commercial funds, producing some working capital.
When Paulson dumps out his 700 billion in treasuries it’s going to be at the short end. That will drive up rates for short-term treasuries. This will obviously draw even *more* deposits into the treasury MMs. That means even less in the commercial MMs and thus less working credit, the eventual commercial MM product. Hence Paulson’s billions remove working capital by competing for the deposits that could get used to make working capital loans. That 700 billion is going to go to fairly long-term mortgage securities. So Paulson’s billions divert credit from working capital to long-term mortgages - from where it’s most needed to where it’s most wasted.
Even if the giveaway adequately props up the banks, which I doubt, they still can’t make working capital loans, because the raw material they used (commercial MM deposits) will be desperately short.
I think it’s very telling that in two days of hearings and two weeks of discussion we have yet to see *any* detailed mechanism for how Paulson’s plan will increase the supply of, say, inventory loans. It’s not that every economist in the world is an idiot, it’s just not going to help. I think people have fallen into the fallacy that if it costs a lot it must be valuable. Paulson’s plan falls into the category of very expensive way to hurt ourselves.
In Summary
Lance on Oct 02 2008 | Filed under: Economics, Federal Reserve, Housing Market, economy
Tyler Cowen states his basic views on the crisis. My response in italics:
1. Glass-Steagall repeal was not a major cause of the financial crisis, nor was government-induced “minority lending.”
I agree on the first, the second charge has some validity, but only in terms very different than the typical charge.
2. We should use regulation to move more of the currently unregulated derivatives markets to the clearinghouse model.
Bingo! Especially Credit Default Swaps.
3. The crisis represents a massive conjunction of both market and governmental failure.
Check.
4. I would not nationalize banks as ongoing concerns, at least not short of a far more extreme emergency than the current status quo.
Check.
5. The modified Paulson plan was better than nothing — especially after the market had been scared — but far from my first choice. In any case the plan would have been revised almost immediately. The Paulson and Dodd plans were never that far apart.
I disagree. No plan was better than the plan as advertised, though Michael has pointed out that it gives Paulson the opportunity to do some useful things.
6. My first choice is to induce and if need be to force more information revelation, identify the insolvent banks, close them up, and give the battle-tested FDIC a much greater role in the whole process.
This is the critical step, and we need to move as quickly as possible and begin a process of financial triage.
7. In the meantime the Fed should not worry much about inflation.
I agree. Deleveraging is inherently deflationary.
8. The critical deregulatory mistake was allowing excess leverage. Many deregulations get blamed but in fact contributed little to the problem.
I couldn’t agree more.
9. Everyone says that letting Lehman die was a big mistake but I’m not yet convinced. Maybe a bracingly high TED spread is what we need.
I am with him here.
10. Libertarians are overrating the moral hazard argument, as many equity holders have been wiped out.
True as to past actions, but they are not overstating the moral hazard of buying the bad assets at a price that might actually add meaningful capital into these institutions.
11. If someone is pushing conclusions and not identifying the potential weak points in his or her arguments, be suspicious. Also beware of anyone pretending to offer you simple answers.
Who can argue with that? This crisis will not be solved, but worked through. We will be struggling with this for years, not months.
12. I have a long and complicated view on the relevance of Austrian Business Cycle Theory which resists easy summation, but markets could have and should have been more cautious in response to Greenspan’s easy money policies.
Exactly. Whatever poor incentives were in place, whatever regulatory elements were lacking or unfortunately in place, that is no excuse for their behavior, their excess risk taking, the leverage employed or the dishonesty about their books.
13. Insolvent hedge funds and the commercial paper market remain outstanding issues which are not easy to address.
Insolvent hedge funds should die on the vine, the commercial paper market is a tough nut to crack.
14. I agree with Arnold Kling about relaxing capital requirements though at this point I don’t expect it to help much.
Check.
15. The crisis is complex and has many causes; there won’t be a simple or quick solution.
I agree. There is no solution, just trying to keep the ship from going down. We at best will be able to muddle through.
Arnold Kling responds to Tyler and adds several key elements which you will recognize from my comments:
In hindsight, I think that the crisis was caused by
a) creation of the secondary mortgage market (50 percent)
b) low down payment mortgages (30 percent)
c) the “suits vs. geeks” divide (15 percent)
d) other (5 percent)
Read his explanation of each. I can find no real complaint with them. I am going to highlight his suits vs. geeks divide. As someone on the geek side of this i admit to being biased:
My point about suits vs. geeks is that too many people did not understand the risk characteristics of these loans. I disagree with James K. Richards, who claims that the risk modelers got it wrong. The risk modelers told Richard Syron of Freddie Mac not to plunge into subprime lending with so little capital. The risk modelers at Goldman kept that firm from making the sorts of mistakes other companies made.
The decline in house prices was not a Black Swan. It was a highly plausible scenario. The problem is that the suits did not grasp the impact that such a decline would have on mortgage securities. The clueless suits include regulators, which explains why the crisis took them by surprise. It also explains why I do not trust them to come up with the best solution.
Decent, upstanding people say that we have to trust Ben Bernanke, Henry Paulson, Barney Frank, and other leaders. The public are considered rubes for not respecting the establishment. In this case, the public happens to be right. The suits are clueless.
I agree. These are smart people, but I don’t believe they understand what they are dealing with. Unfortunately the people who do are not qualified to make policy or hold office. This is a very troubling issue.
Risks:
The economic ship faces a number of icebergs. Oil markets are taking wealth out of the country. House price declines are taking paper wealth away from ordinary families. On the horizon, there could be an adverse shift in the terms of trade. The number of hours that the average American has to work to earn enough to buy a bottle of French wine, a pair of Italian shoes, or a Chinese-manufactured product could (should?) be much higher than it is today.
In this context, the consolidation in the financial sector is a relatively minor issue. The only policy challenge is to keep banks functioning. There are many ways to do that which do not involve speculating in mortgage securities.
Dead on.
Housing:
We need housing units to be occupied, at whatever rent or price clears the market. We need owners to be legitimate, meaning people who can afford reasonable down payments and mortgage payments. Getting from here to there is not easy, but I suspect that the more government intervenes, the longer and more painful the process will be.
I share that suspicion. The government at best should encourage dissemination of workable solutions and getting rid of legal obstacles to people taking advantage of them.
I do not think that the private sector is blameless. I do not think that the public sector is blameless. I do think that lobbying and corruption are endemic in the mortgage securities business. We ought to be trying to let that cesspool gradually dry up, rather than throwing taxpayer money into it.
I find it unsettling that Congressional leaders would announce that they have a deal and then fail to pass a bill. It used to be that the definition of having a deal was having the votes to pass legislation. It didn’t used to be a form of bluffing.
I find it unsettling that the establishment is promoting fears of another Depression. It used to be that worries about another Depression were confined to obscure books written by crackpots and lunatics. Today, the fear of a Depression is being promoted by the establishment, while those of us who are trying to remain calm and measured are treated as crackpots and lunatics.
My only disagreement is with the last statement. I have already discussed ways in which we are being frightened unnecessarily. I do believe that if not a depression, a severe and lengthy recession and sluggish growth for long afterward is a real possibility, if not probable.
It seems the three of us are not that far apart.
Strategery Capital Management LLC
Lance on Oct 02 2008 | Filed under: Humor
A new distressed debt leveraged hedge fund has been launched:
When Are We Being Chicken Littles?
Lance on Oct 01 2008 | Filed under: economy
Let us look at one of the ways that we are being panicked unnecessarily, and why incidentally we can help many of these financial institutions in the fashion I discussed in my post on a potential alternative plan. In my next post we will discuss ways in which we are not being misled, and why we in my mind should do something about this.
In my previous post I discussed the balance sheets of our most highly leveraged institutions. Let us look at them a little closer. Let us go back to Lehman Brothers as a textbook case of what has been happening and why some of what we are being told is exaggerated.
It is no accident that the dominoes in the investment banking world have fallen in precisely the order of their gross leverage. Bear Stearns, Lehman and then Merrill. The next domino is Morgan Stanley in terms of both leverage and market pressure. We see the same pattern in Europe.
So let us look at Lehman Brothers.
Just prior to their collapse Lehman reported 600 billion in assets. Think about that number and reflect on why our government buying 700 billion in assets is such a tiny number relative to the problems we are facing. This is just one institution.
So why would an institution with 600 billion in assets be in trouble?
First, what are those assets? They include mortgage backed securities, commercial real estate and a host of securities including treasury bonds and bills. Most of those assets were not going to disappear.
The problem is that Lehman had only 20 billion in shareholder equity. What does that mean? It means it had liabilities of approx. 580 billion! To put it in plain english, they owed that much to various creditors in the form of customer obligations, counterparties, preferred stock holders, subordinated debt and senior bondholders. To figure out how much equity that the common stockholders had in the company you take 600 billion, subtract 580 billion and you get 20 billion. Given what happened to their stock price, and the lack of buyers for the company investors felt that 600 billion in assets was a bit fishy, subsequent accounting seems to have borne that out.
That does not mean that the assets were not substantial. The problem is that when one has 600 billion in assets and only 20 billion in equity your leverage is 30 to 1 (600 divided by 20 equals 30.) Therefore if the assets were written down by only a bit more than 3% it would wipe out the equity and make them officially bankrupt (3.4% of 600 billion is 20.4 billion.) In fact, it seems they were bankrupt.
So, were customers or counterparties at risk? Should this have led to a systemic problem? Not really. Those 600 billion in assets are worth something, in fact they are worth quite a lot. In Lehman’s case the equity plus various bondholders added up to 143 billion. So, the markdowns would have to exceed 143 billion before customers or counterparties were at risk. That would be exceedingly unlikely. What our treasury was concerned about was not customers or counterparties, but the bondholders! The goal there, with Bear Stearns (and with far more justification, Fannie and Freddie) was to protect the bondholders from the risk of default.
That is right folks, that is who your tax dollars bailed out in Bear Stearns and each other case, bondholders. We should be sickened.
So what does an institution in Lehman’s case try and do to shore themselves up? Raise capital so that their assets are even larger than their liabilities. They can issue stock, sell preferred stock which pays interest but it is only paid if they have the cash to do so, etc. The problem with Lehman was they were so weak that investors wouldn’t pay them enough per share issued to raise the amount of capital they needed. Preferred stock is only attractive if people believe you will stay in business as well and you are likely to be able to pay the dividend. Lehman was pretty much shut out of all the traditional methods of raising capital.
Is this an institution the plan I proposed would apply to? Possibly not. The key would be to force them to mark their assets lock stock and barrel to market, possibly sell the problematic ones at fire sale prices and see if the resulting write downs left enough cushion of shareholder equity and debt holders to eat through to keep the capital injection safe in case of default. The key is that stock and bondholders before accepting such a deal would have to see that the action would improve their situation enough to risk being wiped out in the case of stockholders, and having to stand in line for payment in a default situation in bondholders case.
Stockholders would never agree to such a deal unless they felt there was no other way, so it would be the bondholders who would hold the key. If the capital would be sufficient to allow the company to survive, they would go along with it. If all it would accomplish was for a failing institution to go on losing money a while longer they would just ask for bankruptcy. The balance sheet would be the key.
From the taxpayers standpoint, the treasury would make the same calculation. If a sufficient amount of capital would leave too thin a cushion of bondholder liabilities to cover us in the case of default, we allow them to go into bankruptcy or call in the FDIC (for banks) to liquidate.
Let us go back to Hussman:
Look at the insolvent balance sheet again. The appropriate solution is not for the government to purchase bad assets with public money. The only way such a transaction would add to the institution’s capital would be for the government to overpay for those assets. Rather, the government should either a) provide new capital, taking a claim in front of the company’s bondholders and stockholders, or b) execute a receivership of the failed institution and immediately conduct a “whole bank” sale – selling the bank’s assets and liabilities as a package, but ex the debt to bondholders, which preserves the ongoing business without loss to customers and counterparties, wipes out shareholder equity, and gives bondholders partial (perhaps even nearly complete) recovery with the proceeds.
Let’s now look at Morgan Stanley:
For example, consider Morgan Stanley’s balance sheet as of 8/31/08. Total assets were $988.8 billion, with shareholder equity (including junior subordinated debt) of $42.1 billion, for a gross leverage ratio of 23.5. However, the company also has approximately $200 billion in long-term debt to its bondholders, primarily consisting of senior debt with an average maturity of about 6 years. Why on earth would Congress put the U.S. public behind these bondholders?
Why indeed?
The answer is the credit markets. When Lehman failed one systemic risk was a problem, that is the risk that without knowing who was in what kind of shape nobody wants to be the bondholder left holding the bag. Hence the run on money markets following Lehman’s collapse.
The answer isn’t to bail Lehman or others out, it is to clarify for the market who is and isn’t solvent. That however will have to wait for another post.
The key point to be made, is that the nonsense about systemic risk due to customers and counterparties not being made whole with a cascade of defaults is not true, and there is no excuse for our media, our politicians and others to try and panic us into believing otherwise. We can survive a large number of failed financial institutions, even if it is not pleasant.
I should also point out that our commercial banks are not as leveraged as the investment banks, so they are far less problematic.
My favorite proposal for helping financial institutions
Lance on Oct 01 2008 | Filed under: economy
I do believe we should be doing something as a nation, through our government, to avoid the not insignificant chance of a total financial meltdown. I have seen several things proposed that I find interesting, and I will get into them and other longer term issues in coming days. I had hoped to address this all comprehensively, but time just isn’t allowing that, so let us do so piecemeal.
Today I would like to endorse one proposal that aligns exactly with my thoughts on this, which is we need to recapitalize banks in a more effective, less arbitrary manner while protecting taxpayers and homeowners as well.
John Hussman (a long time favorite of mine) has written an open letter to Congress that unfortunately few Congressman or women are likely to read, and it reminds me of the Chilean experience McQ posted about here. Nor is it being debated in the press. This is sad, so hopefully whether the new bailout bill passes or not, we can see our approach restructured along these lines eventually:
1) Public funds must function to increase the capital of distressed financial companies, not simply to take bad assets off of the balance sheet at market value (which may improve the “quality” of the balance sheet, but does nothing to improve the capital cushion and therefore little to avoid future runs on the institution).
2) In return for these funds, the government should NOT take equity (which is a subordinate claim and also creates potential conflicts of interest), but instead should take a SENIOR claim that precedes not only the stockholders but also the senior bondholders in the event the company defaults anyway. Congress may need to make some modification to existing bankruptcy law or provide for expedited bondholder approval to do this, but essentially, the government’s claim should be subordinate only to customers in the event of default, and senior to both stockholders and bondholders. However, it should also be countable as capital for the purposes of satisfying bank capital requirements.
3) Ideally, the rate of interest on such funds should be relatively high (which will encourage these firms to substitute private financing as soon as possible), but actual payment should be made once the firms are again profitable so that the payment burden does not weaken them during the present recession.
4) The bill should allow for expedited bankruptcy resolution for these institutions, so that in the event of failure, the “good” bank (all assets and customer liabilities, but excluding debt to bondholders) can be cut away and liquidated to an acquirer as a “whole bank” sale. For nearly all of these institutions, the debt to bondholders is far more than sufficient to absorb any losses even in the event of bankruptcy. The current difficulty is that the bankruptcy process itself draws out the process of taking receivership, cutting away the good bank so that it can be sold to an acquirer, and delivering the proceeds as a residual to bondholders. Streamlining that process is one of the best ways to ensure that the failure of one institution does not have “systemic” effects.
5) To assist homeowners, the bill should allow for a reduction of mortgage principal during foreclosure, but the mortgage lender should also receive a Property Appreciation Right (PAR) that gives the original lender a claim on future property appreciation up to that original mortgage amount. In other words, the homeowner receives a substantially lower mortgage balance and payment burden now, but the lender stands to be made whole over time through property appreciation rather than immediate burdens on the homeowner to make payments.
I think number 5 is key. It helps people who want to stay in their home, but the PAR allows for the bank to have a more valuable asset on their books than the value of the renegotiated mortgage itself. Note: the PAR needs to stay with the property, so if it is sold the buyer still owes the mortgage company. It would be an assumption in other words. This way the pain is shared by homeowners and financial institutions, while market pricing still is allowed to work.
One of the issues which has bothered me throughout this crisis has been the bailout of senior bond holders in most of the interventions so far. The rationale has been that customers and counterparties were being protected, bond holders merely were being brought along for the ride. Lucky them.
However, that has not been true in any of these bailouts with the possible exception of AIG. If these institutions had been liquidated in an orderly manner there were more than enough assets to cover counterparties and deposits. John does a good job of educating us as to why that is true and expands upon that in his letter, so read the whole thing. More on that can be found here in, September 29, 2008 - You Can’t Rescue the Financial System If You Can’t Read a Balance Sheet:
1) as the assets of a financial company lose value, the losses reduce the asset side of the balance sheet, but also reduce shareholder equity on the liability side;
2) as the cushion of shareholder equity becomes thinner, customers begin to make withdrawals;
3) in order to satisfy customer withdrawals, the financial company is forced to liquidate assets at distressed prices, prompting a further reduction in shareholder equity;
4) go back to 1) and continue the vicious cycle until shareholder equity goes negative and the company becomes insolvent.
Let’s return to the basic balance sheet of a typical financial company before the writedowns:
Good Assets: $95
Questionable Assets: $5
TOTAL ASSETS: $100Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $3
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $100Now let’s write down the questionable assets - not all the way to zero, but to $2:
Good Assets: $95
Questionable Assets: $2
TOTAL ASSETS: $97Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $0
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $97This shortfall of protection on the liability side of the balance sheet is what causes a run on the institution, because once shareholder equity is gone, the only way to get at the debt to bondholders is for the company to declare bankruptcy. The concern has been that continuing bankruptcies would throw the whole financial system into disarray, especially for investment banks having lots of counterparty relationships with other institutions. But the reality is that for nearly all of these institutions, the cushion of debt to bondholders has always been more than sufficient to protect customers from losses even in the event of bankruptcy.
What the financial system has needed most has been for Congress to streamline the bankruptcy process for investment banks, so that in the event of failure, the “good bank” (assets and liabilities, ex the debt to bondholders) could be cut away quickly and liquidated to an acquirer, leaving the proceeds as a residual for the bondholders. Indeed, that’s exactly how it works for regulated banks. What investors overlooked in last week’s panic was that we actually saw the largest bank failure in history – Washington Mutual – with absolutely no losses to customers or the U.S. government, precisely because the good bank was seamlessly cut away and sold to J.P. Morgan, wiping out shareholder equity, preferred equity, and subordinated debt, with partial repayment to the bondholders. Snap – just like that.
Now, let’s go back to the previous balance sheet. The Treasury plan seeks to buy up those questionable assets and thereby protect the institution against failure. Problem is, suppose the Treasury buys those questionable assets at their going value of $2. Here’s the result:
Good Assets: $95
Cash Proceeds from Sale of Questionable Assets to Treasury: $2
TOTAL ASSETS: $97Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $0
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $97Does this transaction protect the institution against failure? No! If you buy the bad assets off the balance sheet at their market value, nothing changes on the liability side! You may have improved the “quality” of the balance sheet, but you’ve provided no additional capital. At best, you’ve allowed the bank to liquidate its assets more easily to meet continuing customer withdrawals in the vicious cycle described above.
The only way that buying the questionable assets will increase capital on the liability side of the balance sheet is if the Treasury overpays for them.
Hussman also makes a good point about Warren Buffett’s investment in Goldman Sachs:
As a side note, a lot has been made of Warren Buffett’s investment in the senior preferred stock of Goldman Sachs. But it’s notable that Buffett invested in Goldman only upon the conversion of Goldman to a bank holding company, which puts it under a different regulatory structure that gives it access to the Fed window. Goldman’s balance sheet has $40 billion of shareholder equity that would have to be drilled through before getting at the preferred. Evidently, Buffett believes that Goldman’s asset mix is diversified enough, and light enough in mortgage assets, that Goldman won’t take a major haircut on its entire (largely hedged) portfolio of assets.
Buffett’s investment may reflect confidence in Goldman, particularly with a government backstop on whatever questionable assets it does own, but if anything, it suggests that the government should have gone the same route – namely, provide capital in return for a financially viable security that is senior to common shareholder equity, have it accrue a relatively high rate of interest, and allow it to be repaid early (Buffett’s preferred is callable by Goldman) as soon as the financial institution can secure cheaper financing.
Instead, the government is taking on financially non-viable securities and warrants on common equity, while failing to improve the capital position of these financial companies at all (unless it overpays). Taxpayers will not make money here.
As Congressman Scott Garrett noted to taxpayers on Sunday, “This morning we should be very much alarmed. Obviously, Washington is not listening to your wishes. Those who used to work for Goldman Sachs will support this deal. Those who have blocked reform in the past will support this deal. I will not support this deal.” I couldn’t agree more. This is not a good deal, because it will waste taxpayer money without addressing the fundamental solvency problems.
That last comment is very important. There are many problems with the current approach from a ethical, ideological (from all parts of the spectrum) and long term viewpoint. All of which might make sense anyway of the plan were in any way likely to be a good short term solution. The problem is that it isn’t.
I’ll put up a few twists on John’s proposal in the coming days, which some will find more or less appealing. However, it should be cautioned, none of this will likely avoid pain, a recession or poor asset performance for some time. This will be years in the fixing, and it will be a drag on growth for some time. Shuffling the burdens to allow for price discovery and functioning markets will avoid disaster, closing weak institutions, which needs to begin in earnest, will allow healthier institutions and new market participants room to grow. It will not change the fact that the losses exist, that they will have to be paid for, that the nominal and real wealth of the US will have shrunk, that consumers and our own economy will need to delever (reduce debt) and all the pain which that entails.
Hooray for Mental Health!
Lance on Oct 01 2008 | Filed under: economy
If you support the Paulson bailout plan that is. The New York Times has coverage.
The Senate proposal would cost more than $100 billion and extend and expand many individual and business tax breaks, including tax credits for the production and use of renewable energy sources, like solar energy and wind power.
The bill would also extend the business tax credit for research and development, expand the child tax credit, protect millions of families from the alternative minimum tax and provide tax relief to victims of recent floods, tornadoes and severe storms.
In a delicious bit of soon to be civics geek trivia, the Senate worked around the Constitutional restrictions against voting on tax legislation not already considered by the House by attaching the bailout plan along with a tax extender bill to the Mental Health & Addiction Act (which passed the House several months ago).
You gotta love our government.
In addition to the Paulson plan details, various tax cuts and dealing with the AMT it includes a very helpful proposal, increasing government insurance on bank deposits from 100k to 250k.
European Fallout
Lance on Sep 30 2008 | Filed under: International Affairs, economy
Yves Smith has picked up on a pet peeve of mine. In the midst of our crisis we have heard all kinds of cat calls about the failure of the “American Model” of financial capitalism, especially from Europeans.