Saturday, October 31, 2009

Theme of the week: unintended consequences

Jeremy Siegel defends the Efficient Markets Hypothesis: When you are at Wharton as I was during my undergraduate years, it is hard to escape the aura of the school’s most famous finance professor Jeremy Siegel. Even before I was interested in the stock market I had read his now somewhat controversial book Stocks for the Long Run. As a result of the recent crisis and miserable track record of the S&P over the last 10 years, Siegel has had to deal with a significant amount of criticism. Many financial commentators now suggest that buy and hold is dead. Those who disagree point out that Warren Buffett has used a buy and hold strategy that has made him one of the world’s richest men. The problem with using Buffett as an example is that Berkshire is now so large that the portfolio is very inflexible and thus is forced to employ a buy and hold platform. Entering into or exiting a material position is a major undertaking that has the potential to dramatically affect the price of a stock, especially considering the way value investors react when they hear Buffett is buying or selling. I personally believe in buying and holding a basket of equities. However, that basket needs to change over time based on where the value is. Whether the allocation changes by sector or by country over time, my own philosophy is that being nimble is preferable. The idea that serious investors should buy and hold an index or a basket of the same stocks is an outcropping of the EMH that detracts from returns and sets investors up to be slaughtered when there are broad market declines.

Having said all that, I commend Siegel for being critical of the Fed and its role in the financial meltdown. Many of the leading academics in this country seem afraid to rock the boat but Siegel definitely pulls no punches:

The misreading of these economic trends did not just reside within the private sector. Former Fed Chairman Alan Greenspan stated before congressional committees last December that he was "shocked" that the top executives of the financial firms exposed their stockholders to such risk. But had he looked at their balance sheets, he would have realized that not only did they put their own shareholders at risk, but their leveraged positions threatened the viability of the entire financial system.

As home prices continued to climb and subprime mortgages proliferated, Mr. Greenspan and current Fed Chairman Ben Bernanke were perhaps the only ones influential enough to sound an alarm and soften the oncoming crisis. But they did not. For all the deserved kudos that the central bank received for their management of the crisis after the Lehman bankruptcy, the failure to see these problems building will stand as a permanent blot on the Fed's record.

However, after all of the criticism of the Fed he somehow validates Bernanke’s most absurd vision; the belief that the US had entered into a Great Moderation in which the business cycle would no longer be have its deleterious up and downs:

Our crisis wasn't due to blind faith in the Efficient Market Hypothesis. The fact that risk premiums were low does not mean they were nonexistent and that market prices were right. Despite the recent recession, the Great Moderation is real and our economy is inherently more stable. (Emphasis mine)

This seems to be a direct contradiction of his previous statements about the Fed’s lack of understanding of the world. Further, I completely disagree that our economy is more stable. Let me count the ways:

(1) I know all of the government stimulus is only “temporary” (kind of like how Japan’s 20 years of bridges to nowhere has been temporary) but an economy so dependent on government spending is unequivocally not more stable. Building an economy based on fiscal irresponsibility creates a house of cards situation in which the removal of one card can bring the entire system crashing down.

(2) The financial system is even more concentrated and the previously too big to fail firms are now even bigger. I don’t think I even have to mention the absolutely insane amount of notional derivatives held by the largest banks in the US. Somehow I don’t equate those positions with stability. As Nassim Taleb has pointed out recently, the current system is far from being robust and is actually more fragile than before.

(3) I have read a number of conflicting arguments regarding whether or not our trade imbalances with China and the Asian Tigers had a hand in creating the Great Recession we are still living through. I am not an expert on international monetary flows or trade, but intuitively this dynamic in which the US imports far too much and then our creditors use the dollars they receive to buy our debt does not seem to add to stability in any way.

In any case, Siegel closes his piece with a warning that all investors should pay attention to. People all over the world are re-risking their portfolios at lightning speed. But, as mentioned in the three items above, it is tough to argue that the US has taken the right steps to correct the structural imbalances or the perverse incentives that got us into this mess. What that says to me is that we are setting ourselves up for an even bigger fall:

But this does not mean that risks have disappeared. To use an analogy, the fact that automobiles today are safer than they were years ago does not mean that you can drive at 120 mph. A small bump on the road, perhaps insignificant at lower speeds, will easily flip the best-engineered car. Our financial firms drove too fast, our central bank failed to stop them, and the housing deflation crashed the banks and the economy.

The emerging markets are hungry: Now that the acute concerns regarding the economic and financial crises have abated (more like swept under the rug by money printing), we now get back to reality. Lest we not forget, the world faces a number of headwinds that don’t have to do with how much Goldman is paying in bonuses this year. Remember global warming? The huge Chinese stimulus plan has not made that little, tiny, insignificant problem go away. And what about global food stocks? If people in emerging countries are really going to consume more meat in the coming years then we have to find a way to feed them. I read somewhere that it takes around 5 pounds of grain to produce a pound of meat. So this isn’t a situation in which there is a one for one tradeoff. We will need significantly more grain to feed all the emerging carnivores. This is why Jim Rogers suggests that we forget about advanced degrees and become farmers. The scary thing is that the UN in its most recent food report claims to be relying on future human ingenuity and innovation to take care of the problem. Maybe it will happen, but to me it sounds like an excuse to not start tacking the dilemma immediately with the hope that a game changing technology can bail us out. This article in the NY Times illustrates what a tall task that may be, especially if the desire to protect habitats and wild life are added to the equation:

In 2003, 123 nations committed themselves to “a significant reduction of the current rate of biodiversity loss” by 2010. According to scientists at a recent United Nations-sponsored biodiversity conference, that target will not be met. Biodiversity loss keeps accelerating, and extinctions are occurring at a rate that’s 100 times what it was before humans dominated the earth. Species are going out like candles in the dark.

The “cautiously optimistic” authors of the United Nations food report believe that humanity will somehow be able to produce more food while still honoring the value of other species by protecting their habitat. And it’s true that this is not a zero-sum game. A 70 percent increase in food production doesn’t necessarily mean a 70 percent reduction in habitat.

But the Food and Agriculture Organization also warns that agricultural acreage will have to grow by some 297 million acres, a little less than three times the size of California. Add to this the ongoing rate of habitat destruction — including deforestation, often for fuel but usually for producing more food — and other threats like the growing production of biofuels, and it is hard to argue that there isn’t a profound conflict between what our species will need to survive by 2050 and the needs of nearly every other species on this planet.

The question isn’t whether we can feed 9.1 billion people in 2050 — they must be fed — or whether we can find the energy they will surely need. The question is whether we can find a way to make food and energy production sustainable in the broadest possible sense — and whether we can act on the principle that our interest includes that of every other species on the planet.

Shhhh, don’t let anyone know who is too big to fail: I have some sympathy for members of the Obama administration and Congress. They are surrounded by powerful bank lobbyists and well-heeled financial titans who will stop at nothing to protect their own interests. Plus, these people are not shy about contributing to the campaigns of many of our leaders, so of course the desire to get re-elected comes into play when assessing the need for financial reform. Additionally, the too big to fail banks are so large now that they own the government. When you owe the bank $100K, the bank owns you. But when you owe the bank $100B, you own the bank. So, it should not be a surprise when somewhat comical attempts at legislation are proposed. You can just tell that the people crafting these reforms are dancing between attempting to protect taxpayers, not killing the financial firms (and thus turning off the campaign contribution spigot) and trying to enact a little justice to satisfy the populist resentment that continues to grow. As a result you get illogical ideas like the one that suggests that the $10B+ banks should create an insurance fund only after a major player fails. Relative to making the banks pay into the fund in the good times, as David Reilly points out, any proposal that forces banks to pay when one has failed (a situation in which the other banks would likely be too stressed to help) is completely illogical. Additionally, in a response to the most recent proposal unleashed this week, in a guest post on Simon Johnson’s Baseline Scenario, Harvard professor and author David Moss points out the most fatal flaws:

Unfortunately, these reforms may ultimately be undermined by one very significant weakness – the explicit requirement in the bill that the identification of systemically dangerous financial firms by federal regulators remain entirely secret, and never be revealed to the public. This is the bill’s Achilles heel.

The decision that there be “no public list of identified companies,” as the bill currently reads, stems from a belief that secrecy about the identity of these firms will limit moral hazard. However, after more than a year of costly bailouts, the federal government’s implicit guarantee of major financial firms is, sadly, rock solid. To try to make it magically disappear by refusing to name the most systemically dangerous firms not only won’t work, but will severely jeopardize the effectiveness of the regulation itself.

To maintain the pretense of secrecy, the bill includes some very unfortunate compromises:

● First, the bill does not require the systemic regulator to adopt a consistent (or universal) set of tough standards for all systemically dangerous firms, presumably to avoid compromising the secrecy surrounding these “identified” financial institutions.

● Second, the desire to hide these firms’ regulatory status (as systemically dangerous) means that they cannot be assessed fees in advance to cover their share of a resolution or stabilization fund; instead, the bill envisions ex post assessments on a much larger pool of firms, including a great many that are not systemically dangerous. (This would be like charging renters to cover the fire losses of homeowners.)

● Third, the attempt to ensure secrecy requires that all of the regulators’ reports to Congress themselves remain strictly confidential, thus weakening – and perhaps crippling – the essential process of democratic oversight.

Perhaps most disconcerting, all of these compromises will most likely be for naught, since the desired secrecy seems almost impossible to achieve. Virtually everyone already knows the identities of the most systemically dangerous firms; and, beyond that, leaks are inevitable.

The US housing market--the gift that keeps on giving: Those of you who are not familiar with Mark Hanson of Hanson Advisors are missing out on probably the most granular and realistic commentary and data on the state of the US housing market available in the blogosphere. If you believe even in the slightest that a housing recovery is needed for a sustainable economic recovery then I suggest you start following his blog. If you think housing has bottomed and the US is in the middle of a V-shaped recovery induced bull market for stocks, then stop reading here and put your head back into the sand. For everyone else who is willing to take the blue pill and see just how deep the rabbit hole is, bookmark his site and pay close attention to what he says about foreclosures, option arm resets, and the perverse way the government’s attempts to re-inflate the housing market are impacting prices:

So, on one hand the Gov’t through massive spending as managed to cause a rush to buy low-end houses by first-timers and investors. This was done at the right time and is a success, no doubt.

But on the other hand they put out HAMP, which prevents foreclosures and is keeping the very low-end supply that is in such high demand off of the market. In fact, the low foreclosure counts are undermining the housing market at this point in time, which is why house sales are falling at the same time you are hearing stories of 30 bidders for each foreclosure resale and sellers not dealing with buyers who require financing in favor of cash buyers, even at a lower price.

Keeping troubled borrowers in houses and good buyers away is a perfect example of an unintended consequence of government action that will push out a true recovery indefinitely. As a matter of fact, because of the neutralizing effect that housing market government stimuli vs. HAMP has, if hundreds of billions were not thrown at the market, we would likely be sitting right where we are now anyway…tax payers would just be that much richer.

HAMP and the other mod initiatives and foreclosure moratoriums have effectively served as the longest foreclosure moratorium seen yet. Millions of underwater, over-levered zombie renter-homeowners squatting in their house because of a loan mod simply ensure the housing market remains a heavy and volatile asset class for years.

Who thinks the US dollar carry trade is going to end badly? (Raising hand): Hat tip to Steve Keen’s Debtwatch for posting the link to this article in The Age. If you are unfamiliar with Steve Keen, he is Australia’s version of Nouriel Roubini in the sense that he could also be called Dr. Doom. Not only is he incredibly bearish on the Australian banking industry (which looked like a good short in the July and now looks like an incredible short), but also thinks that the country is likely to see a property value bust not so dissimilar to the one the US has experienced. Given all of this, it is no surprise that the recommended reading on his site have a bearish tone. The following article suggests that a huge amount of foreign portfolio investment into Australia (financed by cheap borrowing rates in the US and UK) has poured into bank shares and has caused them to run up much more than the ASX has. What happens if that carry trade reverses and people who are effectively short US dollars have to buy them back? Well, the implication is that it would cause people to flee from Australian securities and would crush the AU dollar. It’s as though we haven’t learned a thing from this crisis and the housing bubble in the US. Free money distorts so many things it is impossible to anticipate the global magnitude of the unintended consequences of money printing in the US.

US and British commercial banks can borrow from their central banks at a rate less than 1 per cent. The equivalent RBA rate is 3.25 per cent and many pundits are forecasting the rate could go to 3.75 per cent before the end of 2009. This will increase the differential between Australian and British and US interest rates and make the scope for speculative profits even higher.

Since the beginning of the year, $64 billion has poured into Australia in the form of direct and portfolio (share) investment and foreign lenders have switched $80 billion of foreign debt payable in foreign currencies to Australian currency. Most of the portfolio investment ($41 billion) has gone into bank shares. Banks now represent 40 per cent of the value of shares traded on the stock exchange, and while shares in the big four bank shares have increased by about 80 per cent (as measured by CBA shares), the Australian Stock Exchange Index has risen by only 30 per cent.

Foreigners have shifted out of Australian fixed interest debt and into equities because as interest rates go up, the capital value of fixed debt declines. By driving up interest rates to curb inflationary expectations and the prospect of a housing price bubble the RBA is in far greater danger of creating a stock exchange asset price bubble as well as an Australian dollar bubble. Once foreigners believe interest rates have peaked, the bubbles are likely to be pricked as financial speculators attempt to realise their gains. This could lead to a stampede out of Australian denominated securities.

(Picture courtesy of