Saturday, October 3, 2009

Fantastic weekend reading

Does it make sense to create an EMF to supplement the IMF? From what I have read the IMF has a dubious track record when it comes to lending money to emerging market countries during crises. Apparently, the IMF asks for crippling limitations on government spending that (in the name of restoring fiscal discipline) often cause deeper and more painful downturns. This tough love philosophy was used quite extensively during the Asian debt crisis in the late 1990’s. So, the question is where does the IMF go from here? According to Simon Johnson, many countries don’t trust the fund and believe that it is likely to play favorites based on the geographic location of the countries that exude the most power within the fund:

The relationship of the G20 to the IMF is extremely delicate – smaller countries are already beginning to complain, and with some reason. If the goal is to rebuild the legitimacy of the IMF and to encourage countries to trust it to lend fairly in a crisis, this is not going very well. The rules around who will be supported and on what basis are becoming increasingly murky and not rules-based - e.g., Eastern Europe is almost certainly getting deals that would never have been offered to troubled countries in Asia.

It would be better for emerging markets to form their own Fund (let’s call that the EMF). They have plenty of “hard” currency in hand to do so and no shortage of economic expertise; $1 trillion of paid up capital would be more than enough to get it started (and this would also take the pressure off China with regard to its “excess” reserves).

The EMF can cooperate with the IMF but also operate independently – and just as much (vaguely) under the auspices of the G20. This would go a long way towards restoring emerging market and developing country confidence in the international financial system – and towards assuring they will get timely and appropriate help in the event of another world crisis.

Since the US dominates the IMF, similar to creating special drawing rights as an alternative to US dollars, an EMF would further limit the power and standing of the US. I’m not sure that this would be such a bad thing. The effectiveness of US-led policies when it comes to emerging market countries has been neutral at best and maybe even quite negative in some cases (for example the Chicago boy’s interventions in South and Latin America). Accordingly, aside from limiting US quasi-imperialism, an EMF might be better able to address the specific needs of these countries. Maybe I am unique, but these days I would be much more comfortable if the administration were focused on fixing the plethora of potentially game-changing problems in the US than on dictating international foreign policy. Over the last decade, many emerging markets have become much more sophisticated when it comes to monetary and fiscal policy. Let them have the opportunity to govern themselves and have access to emergency funds dedicated to emerging markets.

Krugman on climate change: With kick the can down the road becoming the official policy of the Obama administration and Congress, is it really any surprise that the US can’t pass any impactful legislation to protect the earth? Similar to the view on the increasing government deficit, the stance on new climate change laws seems to be that we will deal with it when the economic crisis is over. To some extent I understand the sentiment. When 17% of the US working population is either under- or un-employed, it is hard to justify focusing on topics that do not seem as immediate. However, more than with financial regulation and health care reform, the decisions we make today could have a significant impact on the quality of life of our children and grandchildren.

Look, I am not a scientist. If global warming were a myth I would have no ability to evaluate it. However, there seems to be enough evidence that humans are affecting the earth in a very negative way that even if the people that believe we are close to Armageddon are way off base, it makes sense to do something to limit our impact. This should be done sooner rather than later, even if it means increasing the price of fossil fuels and having a permanently lower GDP in this country. I would be willing to accept a slightly worse quality of life so that our children can have a future. Think of it as a hedge more than a direct bet on what the future will hold. The problem is that the we have people who are willing to bet that the argument that global warming is caused by humans is a fallacy and those that would rather put off reform until the actual threat was more proximate. This is a deadly combination and makes it hard to believe that we will get meaningful laws passed any time soon:

But the larger reason we’re ignoring climate change is that Al Gore was right: This truth is just too inconvenient. Responding to climate change with the vigor that the threat deserves would not, contrary to legend, be devastating for the economy as a whole. But it would shuffle the economic deck, hurting some powerful vested interests even as it created new economic opportunities. And the industries of the past have armies of lobbyists in place right now; the industries of the future don’t.

Nor is it just a matter of vested interests. It’s also a matter of vested ideas. For three decades the dominant political ideology in America has extolled private enterprise and denigrated government, but climate change is a problem that can only be addressed through government action. And rather than concede the limits of their philosophy, many on the right have chosen to deny that the problem exists.

So here we are, with the greatest challenge facing mankind on the back burner, at best, as a policy issue. I’m not, by the way, saying that the Obama administration was wrong to push health care first. It was necessary to show voters a tangible achievement before next November. But climate change legislation had better be next.

Some golden nuggets from Mauboussin of Legg Mason: I haven’t read Mark Mauboussin’s newest book, but I absolutely loved More Than You Know. For anyone interesting in behavioral finance, it is a very easy to understand but enlightening book. Right now I am going through some of the memos he wrote before the financial crisis. He has an uncanny ability to put relatively complex ideas into terms that anyone can understand. For those of you without access to those past memos, at least you can read his books and interviews like this one from Time. Here is a little excerpt that I happened to like:

Let's zoom in to the level of the individual. How do you approach investing differently, knowing what you do about the psychology of decision-making?
One theme is contemplating different outcomes and attaching probabilities to those. There is this notion called the inside-outside view. The inside view, which is how almost all of us plan, is that when you're thinking about the future, you gather all the information around you and do your analysis and go from there — whether you're launching a new product, putting an addition onto your house or forecasting the markets. The outside view asks the question, what happened when other people were in this situation? It looks at things from a larger statistical sample. Almost always the outside view gives you an answer that's more pessimistic than the inside view. An analyst sent us a report about that said I think they can grow 25% a year for the next 10 years. The analyst looked at the category, at international expansion — he had a story — but the question is, how many companies in history have ever done that? The psychology of this is that there are all these illusions that we have, like the illusion of superiority and the illusion of control.

Speaking of which, you write that money management is one of the best examples of the illusion of control in the professional world ...
I was hoping no one would read that. Well, honesty never goes unpunished. Could you give me a good reason then why investors wouldn't be better off with index funds?" By and large, investors would be better off with index funds. The question to me is, if you are an active manager, what makes you think you can do better than others over time? We like to think about four distinct building blocks. One is thinking about capital markets more properly. Sometimes markets are efficient and sometimes they aren't. The insight is knowing what mechanisms lead you from efficiency to inefficiency. The second is being very disciplined in valuation, in figuring out if there are differences between fundamentals and expectations. The third thing is competitive strategy work, being able to apply tools from microeconomics and strategy to figure out which companies are going to do better or worse down the road. And then finally there is all this stuff on decision-making. Very few people are willing to allocate the time to grasp the things they need to know to make good decisions consistently.

I love those four building blocks. Talk about a great foundation for any investor. If you can master those I promise you that you will be on the road to being a successful investor.,8599,1925976,00.html

You know it’s bad when 1/5th of your loan book is nonperforming: There is a concept in banking that used to be relevant but these days has been replaced by a much more dubious one. Of course, I am referring to prompt corrective action, which, in the case of the FDIC, used to mean that the FDIC was proactive in terms of shutting down insolvent institutions before the losses got out of hand. Well, these days this practice has been overwhelmed by "extend, pretend and hope." Extend the time before taking action while pretending that the bank is well capitalized while hoping that it can earn its way out of the cycle or the economy will get better. Well, so far that has not been working so well as the FDIC continues to suffer massive losses and associated hits to its insurance fund as a result of its current policy. Maybe the FDIC doesn’t have the human or financial resources to close down all the banks it should. But, a good place to start may be banks with 20% or more of their loan books overdue. Just a suggestion...

The number of U.S. lenders that can’t collect on at least 20 percent of their loans hit an 18-year high, signaling that more bank failures and losses could slow an economic recovery.

Units of Frontier Financial Corp.,Towne Bancorp Inc. and Steel Partners Holdings LP are among 26 firms with more than one-fifth of their loans 90 days overdue or not accruing interest as of June 30 -- a level of distress almost five times the national average -- according to Federal Deposit Insurance Corp. data compiled for Bloomberg News by SNL Financial, a bank research firm. Three reported almost half of their loans weren’t being paid…

For banks with 20 percent of loans overdue, “either they’ve got a massive amount of capital, or the FDIC just hasn’t gotten around to them,” said Jeff Davis, an analyst with FTN Equity Capital Markets in Nashville. Lack of staff and money are slowing shutdowns, he said.

Determining which banks to close is “more of an art than a science,” said William Ruberry, spokesman at the Office of Thrift Supervision, which regulates four of the 26 lenders. “Examiners and the supervisory people have a lot of information that’s not public, and they know the circumstances of an institution and everything that goes into it.”

2 things to note here. First, the idea that the FDIC just hasn’t had time to get around to shutting some of these banks is disconcerting. However, this is nowhere near as troubling as the contention that closing banks is more art than science. A bank is either insolvent or it is not, right? I know it is not that black and white but come on. It seems unlikely to me that any bank with 20% nonperformers is well capitalized but I guess it is possible in very specific cases. The point is that if the real value of an bank’s assets are worth less than its liabilities, it probably makes sense to close the bank regardless of the other non-public considerations.

A flood of liquidity does not a sustainable rally make: In his a piece this week, Albert Edwards of Soc Gen tries to debunk the idea that risky assets will inevitably continue to go up in price solely as a result of the availability of cheap liquidity and investors’ hunger for yield:

Many clients believe it is inevitable that "excess" liquidity will continue to drive risk assets higher. The broken nature of the banking intermediation means that surplus reserves are not being funnelled into the real economy and therefore must, it is believed, inevitably cascade foaming and invigorating over risk assets. And all the while interest rates remain close to zero this process is expected by many to continue apace, driving risk assets higher.

This is wrong. It is the cyclical upturn that is sucking money into risk assets. This is exactly what happened in Japan in the 1990's. Japan enjoyed many decent economic and profit recoveries which regularly pushed equities and other risk assets substantially higher. But the underlying fragility of any cyclical recovery amid a secular balance sheet recession meant there were frequent lapses back into recession. This eventually drained hope away from zombie investors who then became sellers-on-rallies, rather than buyers-on-dips.

The problem of course, is what happens when the punch bowl is taken away? If stocks for example were bought with no consideration of valuation or underlying business fundamentals, eventually the market weighing machine will reverse the upward momentum. The risk is that if a recovery hasn’t taken hold by the time the liquidity dries up or interest rates back up as a result of frivolous government spending, risky asset prices could plummet. So, the next time you think about moving up the risk curve on an investment, make sure your rational is not that the Fed will be able to push up asset prices indefinitely.

Gold is starting to worry me a bit: Nothing against Alice Schroeder or The Snowball fame, but when even she is writing about buying gold for her portfolio, I start to worry there is a bubble forming. The bulls argue that gold is both a hedge against inflation and against financial collapse, but since it does not provide any cash flow, it is impossible to determine the value of its hedging properties. In other words, $700 an ounce may reflect the true value of the protection gold provides and $1000 an ounce may represent a speculative bubble. There is just no way to know. I personally own shares of GLD but I am becoming increasing less comfortable with the position, at least in the short run. Anyway, here is Schroeder’s thought process that reflects a lot of what the bulls case embodies:

In all the talk of inflation because the Treasury is printing so much money versus deflation because it may not print enough, there is one type of inflation that is rarely discussed. This is the mega-inflation caused by a sudden currency devaluation. Currency is like any financial innovation, an obligation secured by assets. When the obligation is perceived to have increased far beyond the level justifiable by the assets, which in this case make up a country’s economy, a bubble has formed.

As in any bubble, those who recognize this need to act well in advance. Historically, governments have taken action to prevent currency flight when the owners of a severely overvalued medium of exchange start selling so much that it adds to the pressure on its price. They make private purchases of gold illegal, or tax the exchange of currency.

Right now, the American economy is worth less than the value implied by the market value of its obligations. How much less, no one knows. But gold bugs will tell you, privately, that this is why they are buyers. Might as well stock up, they say, before gold becomes a controlled substance.

I haven’t, so far, but the temptation is rising by the day.

Latest from Mohammed El-Erian: The continuing theme from the Co-CEO of PIMCO is that we are entering the new normal but many market participants are fighting the inevitable process. Both people in the public and private sector are trying to get back to bubble times even though the world has been unmistakably changed. Those were great times for some and many people became anchored to the returns and debt-fueled realities that were present in the investment world. My guess is that the severity of the situation will eventually force these laggards to face the consequences of our past foolishness, even if they have to be dragged into the new normal kicking and screaming:

The signs of inappropriate reversion are multiplying. Confusing temporary factors for sustainable ones, a growing number of analysts have extended the ongoing stimulus/inventory bounce to a V-like recovery next year and beyond. The momentum for meaningful financial reform is stalling in spite of clear evidence that financial activities have far outpaced the regulatory infrastructure. And some banks are returning to the bad habits that almost destroyed them.

This reversion is intimately linked to the inadequacy of the anchoring analytical frameworks. Appropriate frameworks provide important protection against the short-termism that can contaminate markets and policymaking. By contrast, ill-designed frameworks can encourage short-term thinking, leading to market and policy overshoot on the way up and down.

Today’s lack of appropriate anchoring frameworks appears to be exacerbating short-termism…Given all this, we would be all well advised to follow the admonition of Mervyn King. Last month, the governor of the Bank of England stated bluntly: “It’s the level, stupid – it’s not the growth rates, it’s the levels that matter here.” Investors have not yet accepted his insight that the absolute levels of income, debt, wealth and unemployment, not just the rates of change, are what matter today. They need to, and soon.

That quote from Mervyn King is an absolute classic. Even if the data is less bad the truth remains that the overall levels of things like unemployment are terrible. Until we start seeing sustained improvement anyone who is betting on a rapid return to prosperity is likely to be quite disappointed.

(Picture courtesy of