Friday, September 4, 2009

Reads for the weekend

Reasons to be bearish on bonds: No one has ever confused me for a fixed income analyst. However, the necessary assessment of the risk-return tradeoff applies for bonds as well as stocks. Within that context, it is hard for me to believe that the current low yields on government bonds compensates investors for the long term risks of interest rates rising substantially or meaningful inflation. Right now Treasuries are benefitting from being thought of a safe haven as well as the Fed’s purchases of these bonds in the name of quantitative easing. However, the thought of getting 3.4% on the 10 Year is not very appealing at all, especially given the presence of secular forces that should serve to push interest rates up. The writers at the Wall Street Journal seem to agree:

Bonds are like a seesaw: If the yield rises, the price falls. Rising worries about inflation, rising interest rates, or both could cause that to happen.

Atteberry has run the numbers on a few scenarios, and they aren't pretty. If the 10-year Treasury reverts to more typical levels over the next five years, investors will end up making just 1.1% a year over that time. That's before inflation.

A faster move would be even worse. If the bonds reverted to average yields within a year, he says, investors will lose nearly 16%.


The story for investment-grade corporate bonds is only a bit better. If these reverted to their 50-year averages over five years, investors would still make about 3.3% a year. Over one year they'd lose 9%. Again, this is before inflation, and any taxes.

I can understand why some people are willing to sacrifice incremental return for the implied security of government bonds. But with the deficit sky rocketing by the second it is tough to argue that absent Fed purchases these rates will stay anywhere near this low for very long.

The social cost of inflation: Hat tip to Simoleon Sense for posting this must read link to an article in City Journal. In it the author discusses how the lack of price stability can be incredibly destructive. On a very simple level, if a person’s wages and assets are rising as fast as the price of goods and services, then on balance there is a minimal negative impact of inflation. But what about people surviving on a fixed income? What about people who had decided to save $X for retirement and suddenly need $2X to survive? This is where inflation can hurt those who have no capacity to offset the loss of purchasing power. In addition, the author contends that asset inflation can lead society down a very shaky path:

During those fat years, a man could sit at home watching television and imagine that he was growing richer thereby. I remember an eminent professor’s telling me, with a barely concealed exultation, that he was making nearly $1,000 per day, week after week, merely by owning a very large house in a fashionable area: an amount that, needless to say, dwarfed any savings he might salt away from his salary. The government could not have been better pleased, for the majority of the population, who owned their own homes, felt prosperous as never before and attributed their affluence to the government’s wise economic guidance.

But asset inflation—ultimately, the debasement of the currency—as the principal source of wealth corrodes the character of people. It not only undermines the traditional bourgeois virtues but makes them ridiculous and even reverses them. Prudence becomes imprudence, thrift becomes improvidence, sobriety becomes mean-spiritedness, modesty becomes lack of ambition, self-control becomes betrayal of the inner self, patience becomes lack of foresight, steadiness becomes inflexibility: all that was wisdom becomes foolishness. And circumstances force almost everyone to join in the dance.

The problem is that when the music stops there are nowhere near enough chairs for everyone who was doing the dance. Then what are we left with? A lot of people who had become corrupted by greed and who will do anything to get the music playing again. I have to say that this seems to be a very displeasing but apt description of where we are in America today.

The other problem with MTM accounting: Mark to market accounting has been blamed for causing runs on banks and bank failures. In fact, the omniscient members of Congress found this method so appalling that they forced the FASB to revise the associated guidelines. Finally, we are seeing some backlash from the FASB that indicates misgivings about MTM being thought of as the culprit as opposed to just a messenger. People such as Karl Denninger are constantly calling for all assets to be marked to market and not marked to model (i.e. fantasy). Based on some recent FASB proposals, we just might get something like that. The problem, of course, is that in situations in which there are no buyers, it is very hard to determine fair value. Thus, in a bear market certain assets can decline dramatically in price even though the underlying fundamentals may still be good. However, as the Prudent Bear discusses below, MTM also produces commensurate trouble in bull markets:

The other more serious problem of mark-to-market accounting arises in bull markets. When I studied accounting, almost the first principle I learned was that assets are carried in the books at the lower of cost or realizable value. That principle is abandoned in MTM accounting. Traders are able to buy illiquid assets, establish a "market price" for them higher than the price they paid then, under MTM accounting, mark them up to the new "market" price and record the profit, no doubt receiving some juicy percentage of that profit as bonus. Naturally, this is an incentive for those traders to acquire or create more such assets, whose "markets" are controlled by a small circle of dealers, which can be used to provide an endless stream of mark-to-market profits. Little surprise therefore that the balance sheets of Wall Street's major investment banking operations, when times got tough in 2008, turned out to be full of illiquid and hugely overvalued rubbish.

Mark-to-market accounting has been blamed by many commentators for wiping out the capital of the major banks and investment banks, causing a huge financial crisis. What those commentators don't realize was that MTM's most serious role in the crash was in allowing traders and managers to mark UP positions during the boom, paying themselves bonuses for doing so. You can't blame Wall Street "greed." Traders like other people respond to the incentives put in front of them. It's up to accounting regulators to avoid incentivizing asset-watering and balance-sheet fraud.

It’s interesting to think that MTM distorts asset values on the way up and the way down. I am not sure if there is a better system, but the current arguments that call for a renewed focus on MTM are obviously not devoid of a number of potential pitfalls.

Similarities and differences between this recession the early 1990’s downturn: In this piece, Doug Noland of The Prudent Bear makes some interesting points about why this recession is very different from the one that began in the early 1990s. There were plenty of reasons to be bearish back then as well. Unemployment was creeping up and the government was running a large deficit (at least for those times). However, interest rates were much higher and that fact gave Greenspan a lot of room to cut rates and stimulate the economy out of the recession:

While the U.S. banking system was severely impaired to begin the nineties, this fact did not prove bearish for the economy, the markets or federal government finances. A historic “Wall Street” Credit Bubble was cultivated and then championed by the Greenspan Fed. This massive expansion of Credit created abundant liquidity for spectacular asset Bubbles, a dramatic inflation in government receipts and spending, and a consumption boom like the world had never experienced. And, importantly, the reflationary boom in Wall Street finance worked to repair and rejuvenate the bank Credit-creating mechanism – until last year's collapse left everyone (but the federal government) starved for Credit and liquidity.

So what about today? It’s not difficult for an increasingly speculative stock market to dream it’s 1991 all over again. Many believe the economy’s previous growth trajectory can be reestablished and the great bull market resumed…The bullish consensus believes economic recovery will work to cure housing and financial sector ills, as it did during the nineties.

I believe the bullish consensus is misguided. First and foremost, it is the Credit system driving the real economy - not vice-versa. Only massive fiscal and monetary stimulus was capable of stabilizing the system. Total non-financial Credit expanded $470 billion 1991. It is my view that the maladjusted U.S. “Bubble” economy will require non-financial Credit growth of at least $2.0 TN this year. With the banking system and Wall Street finance severely impaired, “federal” (Treasury, agency, GSE MBS) Credit will account for the vast majority of system Credit growth this year.

Noland argues that not even the Fed’s unprecedented actions will be enough to drive real credit growth now. And for an economy addicted to credit, the lack of the drug means low to no GDP growth. In his eyes, in the short run all the Fed and Treasury have done is stabilized a free falling economy and caused stock market participants to become more willing to speculate. Unfortunately, in the long run, what we have generated absurd fiscal deficits that will have to be paid off by future generations.

Heads they win, tails we lose: Hat tip to Zero Hedge for posting this link. Just another example of how the financial crisis has been an amazing boon to those special few banksters who were on the government’s good side. Not only are there fewer competitors out there now, but bonuses are also coming back strong and the drop in the share price apparently allowed companies to award stock options with low strike prices:

As shares of bailed-out banks bottomed out earlier this year, stock options were awarded to their top executives, setting them up for millions of dollars in profit as prices rebounded, according to a report released on Wednesday.

The top five executives at 10 financial institutions that took some of the biggest taxpayer bailouts have seen a combined increase in the value of their stock options of nearly $90 million, the report by the Washington-based Institute for Policy Studies said.

"Not only are these executives not hurting very much from the crisis, but they might get big windfalls because of the surge in the value of some of their shares," said Sarah Anderson, lead author of the report, "America's Bailout Barons," the 16th in an annual series on executive excess.

It is almost amusing how well this has worked out for some of the most well connected banksters. I’m not sure they could have drawn this up any better. And just when you thought there might be some potential justice in the world you learn this sobering fact:

The CEOs of those 20 companies were paid, on average, 85 times more than the regulators who direct the Securities and Exchange Commission and the Federal Deposit Insurance Corp, according to the report.

With all of that money on the line, it is very hard to believe that even the most well-intentioned regulator will be realistically able to do battle with these titans. I have said it before and I will say it again. If we learn nothing from the crisis and we just go back to a version of the prior status quo, we may be setting ourselves up for an even bigger fall next time (whenever that is). The most nauseating truth that emerges from this conclusion is that whatever the event is that precipitates the fall from grace of the banking oligarchy, the derivative impact on people on Main Street is likely to be even worse. So, in this case with justice comes even more pain.

Albert Edwards of Soc Gen on the continued threat of deflation: While we have not really seen deflation in CPI numbers, there are a lot of people out there who see somewhat hidden deflation that leads them to conclude that it is still a more proximate risk than inflation. One guy who has been in that camp for a while is Albert of Soc Gen:

My former colleague Rob Parenteau pointed out something interesting to me the other day. He noted the huge divergence between US economy-wide inflation as measured by the gross domestic product (GDP) deflator and a slight variant of GDP, the deflator for gross domestic purchases…

The key definitional difference between the two measures is that the latter includes recent savage import deflation (as GDP includes exports and excludes imports). Hence the gross domestic purchases deflator is a better measure of what is going on in the US domestic economy. With import prices down some 19% yoy and even a record 7.3% yoy if one excludes petroleum, no wonder the price of domestic purchases has already fallen into deflation. If anything, domestic purchases inflation leads trends in both GDP and core CPI, so this is significant news.

It’s interesting to note that there is very little mention of deflation among government officials and the talking heads. Maybe we won’t hear much about it until it starts showing up in CPI data and not the easily overlooked PPI numbers. According to Albert, one of the consequences of this is that despite the gigantic deficit and our foreign partners becoming increasingly reluctant to buy our bonds, the bull market for Treasuries may not end any time soon:

But what about massive supply of government bonds I hear you ask? Won’t that drive yields higher? Well it never did in Japan. But let’s cast our minds back to the early 1990’s US credit crunch (which seems so minor in retrospect!). What happened then is that US commercial banks bought US Treasuries aggressively at the same time as they contracted lending to the private sector. This continued well after the end of recession in early 1991…

In the US and elsewhere, where commercial bank exposure to government paper is still close to all-time lows, the unwinding of grotesque over-exposure to bubble sectors like real estate will continue to underpin the secular bull market in government bonds.

In other words, even with pathetic yields there could continue to be extreme demand for Treasuries as banks try to shore up their balance sheets and the safe haven trade refuses to abate.

One who got it right is still very concerned: Hat tip to The King Report for the link to this article in Times Online. Ann Pettifor was one of the select few who called the crisis even though when she published her book (The Coming First World Crisis) in 2006 she probably looked like a madwoman. (As an aside, it is interesting to me that being a successful economist is not so different from being a successful value investor. You are prone to being too early in your calls or investments, but in the end you are often proven right by the fundamentals.) Like many of those who saw the slow moving train wreck she is currently not a whole lot more optimistic. Why? Because, as I continue to highlight, NO STRUCTURAL CHANGES HAVE BEEN MADE.

“The economy is no longer in freefall and, as a result, there’s an enormous amount of complacency from politicians, in particular, about what will happen next. I believe politicians have given away the opportunity to restructure the banks and reconfigure the system.”

She likens Alistair Darling, the Chancellor of the Exchequer, to a high-wire artist. “He thinks that if he can just keep his eyes closed he will get to the other side. Yet underneath him is this vast debt that has not been cleared off the banks’ balance sheets. Many of the banks are still insolvent and this has not been addressed.”

She also discusses another theme that I think is way too often overlooked, especially by those who judge Bernanke and the Fed solely on the low CPI inflation rates during the boom period. Yes, maybe CPI inflation was subdued. But what about massive asset inflation? Just like the article in City Journal (cited above) alludes to, there are numerous problems that can arise from asset inflation that have nothing to do with CPI:

She was baffled by a recent letter to the Queen — from other leading UK economists — after she reputedly asked why nobody had seen the crisis coming. With a voice bordering on incredulity, she reads out a passage where the letter-writers say “inflation remained low and created no warning sign of an economy that was overheating”.

“What about asset price inflation? We repressed prices and wages but turned a blind eye to assets,” she says, adding that central bankers must monitor asset prices in the same way that they track high street costs.

Whether you think it is the Fed’s job to pop asset bubbles or not, the truth remains that Bernanke and Greenspan were completely blind to the existence of leveraged-inflated bubbles. This is why so many people (like Ann Pettifor) who predicted the crisis are so concerned that the same people who crashed the ship are still driving it.

Is higher education a bubble? Hat tip to Karl Denninger for posting this commentary in the WSJ regarding the continually soaring costs of higher education. I remember reading this article in The Chronicle of Higher Education when it initially came out. It was my first exposure to data that showed just how fast the cost of higher education had been rising. Now that I have done some more research on education, this concept of a self sustaining bubble in this arena is even more troubling:

Also, the rising levels of borrowing may ironically be contributing to the accelerating cost of college, say some college-finance experts. Loans can give colleges an artificial sense of a family's ability to pay tuition. To some extent, that false sense of security gets built into the assumptions schools make when setting prices, say experts. The idea is that as prices rise, families borrow more and more, spurring prices to rise further, which in turn requires more borrowing. Barmak Nassirian, associate executive director of the American Association of Collegiate Registrars and Admissions Officers, says this phenomenon is playing a role in why tuition grows at about twice the rate of inflation. "Instead of imposing tougher choices" on college costs, he says, it's "easier to raise prices...because this additional loan amount is made available."

The funny thing is that this is no different than any other debt fueled bubble we have witnessed. Of course this means that if the credit runs out, the bubble could burst. I’m not sure how that would affect the universities that became so dependent on their endowments that they are now forced to raise tuition and cut spending as a result of the downturn in the markets. Check out this article in Vanity Fair if you want to see how much Harvard is struggling. Now image what would happen if they had to reduce tuition as well. Not a pretty scenario. Here are some more comments from Rolfe Winkler of Reuters if you are interested.

(Picture courtesy of