US Government Debt – Non-Debate of Know Nothings

One of the most frustrating things about the US government, at least to anyone who actually tries to pay attention, is that there is never any debate and the statements made by the opposite parties seem to all be made without any attempt to actually understand the issues at hand.

If you have an interest in being informed about the US Government debt situation and the alternate courses of action for resolving the situation, there is now an alternative for you to listening to the non-debate by know nothing politicians.

Wharton is making a set of 15 essays from scholars in law and economics about the US debt history, applicable laws and the potential consequences of alternate strategies for resolution available.

This 250 page book is available free here.

These essays come from a conference hosted by Wharton in 2012.  Here is the introduction to the book describing the conference and the resulting essays.

The opening panel explored the functions of U.S. Treasury instruments and the Treasury market in the United States and beyond.  U.S. Treasuries play a unique role in the national and global economy. Richard Sylla put their current role in historical perspective,  observing that U.S. government debt obligations from their birth in  the revolutionary days have been much more than another means to finance the government: they cemented the political union, served  as a currency, backed the banking system, and helped attract foreign  capital.  William Bratton,  Richard Herring, and  Zoltan Pozsar then discussed the Treasuries’ role in the modern financial system,  including corporate finance, banking and shadow banking in the  United States and around the globe. While other reserve currencies and assets may eventually displace the U.S. dollar and the U.S. Treasuries, none are readily available at this time, and some that have  served as substitutes in the past (notably agency securities) ultimately rely on the credit of the United States.

The second panel considered constitutional, statutory, and contractual dimensions of U.S. government debt.  Michael McConnell opened with an examination of the U.S. Constitution as a fiscal  framework based on legislative control of taxing, spending, and borrowing. Howell Jackson then returned to the statutory debt ceiling  controversy, lifting the curtain on a plausible sequence of events had  the President and the Congress failed to compromise as they did at  the eleventh hour in the summer of 2011. In addition to Jackson’s  essay, this volume contains a policy brief by Jeremy Kreisberg and  Kelley O’Mara detailing the Executive’s options for honoring U.S.  government payment obligations with the debt ceiling unchanged. Richard Squire  concluded with thoughts on the market in credit  default swaps on U.S. government debt.

Peter Fisher gave the luncheon keynote, where he brought his perspective as former U.S. government debt manager, central bank official, and market participant to bear on the themes of the conference. Echoing the first panel, his remarks urged closer attention to the  sources of demand for U.S. Treasuries both at home and abroad. He  surveyed the experience of Britain in the 19th century and Japan in  the late 20th to identify some of the demand factors that help account for the ability of countries with very high debt burdens to avoid default.  The focus on demand in the U.S. banking, shadow banking,  and global financial systems suggests cautious optimism about the Treasuries’ prospects going forward.

The first afternoon panel revisited the questions of U.S. ability and willingness to pay, which has been debated heavily in policy and academic circles. A sovereign’s ability to pay is a function of its ability to generate revenues, which depends, among other things, on  the economy’s capacity to grow and on the government’s political  capacity to collect taxes. The line between ability and willingness to pay can be notoriously fuzzy. Deborah Lucas examined the structural sources and magnitudes of U.S. fiscal imbalances and the policy  changes needed to avoid them. While conceivable, default remains unlikely; however, risks from rising healthcare costs, slow productivity growth, a spike in interest rates, and contingent liabilities can tip  the outcome.  James Hines observed that while the United States imposes a smaller tax burden than other large wealthy economies,  its greatest unused tax capacity is in expenditure taxation that would  alter the current distributional bargain.  James Kwak put the U.S. fiscal challenge in historical and political perspectives, analyzing the  structural and policy steps needed to address the debt problem, and  the political capacity of the U.S. government to take these steps.

James Millstein suggested that asset sales—such as sales of mineral  rights—merit serious consideration as part of a package of debt reduction measures. His contribution drew on the history of sovereign asset sales, adapting it to the current needs of the United States.

The conference culminated in a panel discussion of a “thought experiment” laid out in Charles Mooney’s contribution: what if the  United States decided that it was in its interest to restructure U.S. Treasury debt? How might it go about it? What legal and policy options would the U.S. government have, what are the pros, cons, and  likely consequences of taking any of these steps?  His paper considers constitutional, statutory, market and transactional challenges to default and restructuring, and presents three options for a hypothetical  operation. At the conference, he laid out the strategy for across-the-board and selective exchanges of outstanding U.S. Treasuries for new  obligations, including the possible issuance of “Prosperity Shares,”  non-debt securities giving creditors a stake in future growth.  Donald Bernstein and Steven Schwarcz offered comments on the paper.  Bernstein was skeptical of recourse to the bankruptcy powers, and  pointed to the many hard policy challenges, including loss distribution and policy reform, that would remain unsolved even with  recourse to bankruptcy. Schwarcz noted further possibilities for restructuring, and obstacles to selective default. In addition, his contribution explored the problem of government financing through special purpose entities, and urged oversight to improve accountability.

Throughout the day, conference participants from different academic  disciplines and backgrounds engaged in lively discussion. We did not  strive for a policy consensus, nor did we achieve one. Our purpose in the volume, as it was in the conference, is to start a conversation  long overdue. We hope it will continue. If the conference convinced us of one thing, it is that the stakes in the future of U.S. government debt are too high to confine serious analysis and informed debate to legislative back-rooms and disciplinary silos.

Leverage

From Jawwad Farid

Firms employ external funds to finance business operations. External funds differ by the required or expected return that investors need, when (or if) the funds need to be paid back and the order in which they are paid back.
Leverage is the utilization of assets or funds, for which the firm has to pay a fixed charge or fixed return.
To start my latest business venture, I need 1,000 dollars. I can borrow 500 dollars from my friends and invest 500 dollars from my own account. The friends 500 dollars need to be paid back in two years and I need to pay them 50 dollars a year for lending me the money.

When it comes to using the 1,000 dollars, I have two choices. I can go the local hardware store and buy a new laptop for my business for 800 dollars or I can lease it from the same store for 20 dollars a month. The second option is very attractive since it leaves the bulk of the 1,000 dollars with me for later use. The business still owes 800 dollars to the store, but that obligation can now be settled over a three-year period.

Using leverage I did two things that would not be possible by using just my limited resources. I doubled the amount available for use by the business and then made the amount last longer.
Why is leverage important?
First, the level of debt determines the interest expense a business has to bear before it can pass on its earnings to shareholders. Interest expense is also a fixed cost and a business has to make interest payments irrespective of the level of production or profits.
Second, leverage increases the upside as well as the downside for a business. In profitable situations, leverage boosts the Return on Equity and in non-profitable situations it decreases the Return on Equity. Higher leverage leads to higher risk as well as higher return in good times. But in bad times, higher leverage leads to bigger dents in profitability and Return on Equity.

Ultimately, there is a tradeoff between the beneficial impact of leverage (the ability to earn more returns) and the risk enhancing effect of leverage (the impact on fixed costs due to interest payments). Businesses fail miserably when they misread this tradeoff.
Fixed & Variable Costs

Costs incurred by a firm can be divided into fixed and variable components.

Fixed costs are those that will occur irrespective of the level or volume of production (units produced). A firm will incur fixed costs even if nothing is produced. For example, if you have leased equipment for production, you will have to pay these lease payments irrespective of whether you produce or not.

Variable costs are those that are not incurred if no production takes place. They only occur when production begins; these costs vary with the level of production. For example, direct labor costs and raw material costs depend on the level of production.

The relationship between fixed costs, variable costs and the level of production is the Cost Function. Cost functions may be linear (directly proportional to the level of production) or non-linear (costs may increase more than the unit increase in production or vice versa).

Relevant range of production

Relevant range of production is a given range within which the business can operate without needing to change its cost function and more importantly, its fixed costs.

For example, Firm A can produce between 25,000 to 50,000 tennis balls per month given the current plant capacity. Fixed costs for producing anything between 25,000 and 50,000 are $ 90,000 per month. If a firm decides to produce more than 50,000 balls, it will have to install additional plant equipment as well as upgrade related facilities, which means that it will incur additional fixed costs. Therefore, in the example above, the ‘relevant range of production’ is 25,000 to 50,000 tennis-balls.

Concept Title:
Concept Description: Fixed and variable costs and their impact on leverage

Explanation:

Leverage relates directly to sources of funds (or assets) that have a fixed cost associated with use. We focus on two different types of fixed costs

Fixed expenses or costs that a firm incurs, which have an effect on the operations of a firm. For example, a business has to incur maintenance expenses to keep a plant operational or pay salaries or rent to keep the office open. These costs will be incurred irrespective of level of operations or production.
Fixed charges that result from taking on debt. Top of the list are interest expenses & lease payments. Once again, it doesn’t matter if anything was produced or not, these payments would still need to be made.

Fixed costs, financial or operational, increase the risk of a business. When a revenue downturn occurs, variable cost – cost directly related to revenues, also reduce proportional (the reason why they are variable costs). Fixed costs, however, remain at the same level. For a healthy business this may mean a big profitability problem or a switch from generating cash to consuming cash. If the revenue downturn is temporary, and adequate reserves exist, most businesses survive. For not-healthy businesses, the picture is not so pretty. A reduction in revenues may lead to change in control (management), credit downgrades, financing problems and even bankruptcy.

Operational and financial leverage help us understand how a business uses leverage. The key theme in both categories is commitment to fixed charges. Managers as well as investors need to understand these concepts to manage the downside risk of a business or investment.

Both these concepts use numerical data from the income statement. Remember, that most of the expenses shown in the income statement can be classified as being either fixed or variable. For a discussion on operating and financial leverage it is important to understand what fixed and variable costs are and how they interact to affect the operations of a firm.

The above is an excerpt from one of the free online courses at Financetrainingcourse.com.  Also accessible via an iPad app  FourQuants

Disclaimer Riskviews has no financial connection to Four Quants. 

How Much Debt is Too Much?

It seems limitless.  The amount of debt that a AAA firm can guarantee.  But it really isn’t.  It seemed limitless to AIG.  So limitless that they were willing to hire a bunch of traders to trade off the AAA of AIG to make an extra $25 or $50 million a year.  Eventually, AIGFP became a major part of the firm’s profits.  But to keep contributing to the growth of the earnings of AIG, they had to take on more and more.  To put the AAA more and more at risk.  Until, one day, it was too much.

So it seemed for a AAA country.  There seems to be no evidence that anyone thought that there was any limit to the amount of debt that the US could take on or guarantee.  At least not since Rubin was in charge at Treasury.  Wars and Tax cuts and Prescription Drugs and bank bailouts and auto bailouts and stimulus spending and taking on the debts of Fannie and Freddie.  No end, and seemingly no consideration that there was any limit.

Source: IMF World Economic Outlook

People also operated as if debt does not matter.  They were living high off of the “house as ATM” thinking.  Without thinking that they were adding debt.  Few people realized that if you have a $1 million house and a $1 million mortgage that you were not the same as someone without a house and without a mortgage.  The 100% leveraged house had tremendous percentage upside for the homeowner, but also tremendous downside.  Again, few realized that they were $1 million exposed to housing price fluctuation and that they were also exposed to a huge amount of earnings risk.  If their earnings went down, they were still liable for the mortgage.

It was all what Minsky called Ponzi thinking.  During the Ponzi phase to the economy, many people would make choices to expand their debt with the presumption that they would take out future loans to pay off the debt.  During this phase, some or if the phase lasts long enough, most of the investments are not at all self supporting.  New debt can only be sustained by future borrowing that is needed for both the payment of principle and interest.  Sounds crazy, but a significant amount of the mortgage debt that has given so much trouble was written on exactly that basis.

Minsky had two more phases.  The speculative phase is where normal investment activity in the economy could support the interest payments on the debt that financed it, but the loans would need to be rolled over to provide support for the principle.  Commercial real estate is usually financed on this basis, in good times and bad.

The hedge phase in where the business investments are able to support repayment of both principle and interest.

Minsky described the economy as shifting between the three phases.  He thought that the Fed had enough control over the banks to keep the economy from staying in the Ponzi phase for too long.  The Ponzi phase would often be accompanied by inflation so the Fed, even if they did not buy into Minsky’s theories, would move to put a stop to the extreme overleveraging of the Ponzi phase.  (But if you remember, they did not this time.)

So how much debt is too much?  Certainly when the amount of debt gets into the Ponzi stage, it is too much.  Personally, I like to keep my personal debt in the Hedge range.  But businesses and countries that are more eternal than RISKVIEWS may think it best to maintain a Speculative level of debt.

RISKVIEWS would suggest that businesses and countries need to look at their debt levels over a cycle.  So that they should avoid the excesses of Ponzi borrowing in good times and in fact stay closer to the Hedge end of Specultative borrowing in the best of times so that the borrowing increases in the worst of times does not push things into the Ponzi phase.

That is really the underlying issue that is facing the US and EU about sovereign debt levels.  They ran up too much debt in the good times, towards the Ponzi end of Speculative and the extra spending and lower income of the bad times have run them into Ponzi levels.  And at the bottom of the cycle, it is difficult to envision getting back to a lower speculative level.

‘This time may seem different, but all too often a deeper look shows it is not. Encouragingly, history does point to warning signs that policy makers can look at to assess risk—if only they do not become too drunk with their credit bubble–fueled success and say, as their predecessors have for centuries, “This time is different.”  from This Time is Different: Eight Centuries of Financial Folly, by Ken Rogoff and Carmen Reinhart

RECOVERING FROM CRISIS

By Jean-Pierre Berliet

The VBM process helps companies compare the value contribution of alternative strategies and select a course that would increase company value,

Weaknesses in its VBM process can prevent an insurance company from restoring its risk capacity through earnings retention or the raising of additional capital. Such weaknesses thereby limit its ability to resume growing and recover from a crisis

Access to capital is a critical strategic advantage during a financial crisis.

Companies with a strong reputation for value creation can raise new “recovery” capital without excessive shareholder dilution (e.g. Goldman Sachs). Others find it more difficult, or impossible, to access the public market. This makes them vulnerable to inroads by competitors or unsolicited tender offers. The primary purpose of VBM frameworks and processes is to ensure that companies consistently meet investor value creation expectations and survive crises.

VBM frameworks help managers compare alternatives, so that they can direct capital towards uses that would support the achievement of a sustainable competitive advantage, and also create value. This is challenging in the insurance industry because competitors can duplicate innovations in product features, service delivery, or operational effectiveness in relatively short times and can redirect capital at the stroke of a pen. Such competitive dynamics call for companies to compete by developing organizational capabilities that (a) are tougher to duplicate by competitors and (b) provide a pricing or cost advantage based on service quality, underwriting insights, investment performance, and risk and capital management

Because risk drives capital utilization in insurance businesses, the integration of ERM and VBM frameworks is required in order to develop strategies and plans that meet value expectations. Integration rests on (a) superior insights into risk exposures and capital consumption and (b) consistent risk metrics at the level of granularity needed to achieve a loss ratio advantage (possibly on the same level of granularity as loss ratios are calculated). In practice, these insights and metrics lead to decisions to reject businesses and strategies that will not create value. They provide a foundation for:

• Measuring capital utilization by line, by market, and in aggregate
• Driving a superior, more disciplined underwriting process
• Optimizing product features
• Maintaining pricing discipline through the underwriting cycle
• Pricing options and guarantees embedded in products fairly
• Controlling risk accumulation, by client and distribution channel
• Managing the composition of the book of business
• Driving marketing and distribution activities
• Optimizing risk and capital management strategies

Achieving superior shareholder returns is critical for a company to earn investor trust and maintain access to affordable capital. Having access to capital during a financial crisis may well be the ultimate indicator of success for a company’s VBM framework.

Anecdotal evidence suggests that insurance companies that consistently trade at significant premiums over book value have such insights about risk and maintain a highly disciplined approach to writing business.

The present crisis has increased the cost of capital dramatically, but not equally for all insurers. Capital remains most affordable to those with a strong record of value creation and adequate capital as a result of good risk management. Conversely, it has become prohibitive for those with a lesser record of value creation and who lost credibility as stewards of shareholders’ interests. The latter are at risk of forced mergers or liquidation, which may be punishment for not integrating ERM and VBM processes more effectively.

©Jean-Pierre Berliet

Berliet Associates, LLC

(203) 247-6448

jpberliet@att.net

Reconciling Risk Concerns

From Jean-Pierre Berliet

Discussions with senior executives have suggested that decision signals from ERM would be more credible and that ERM would be a more effective management process if ERM were shown to reconcile the risk concerns of policyholders and shareholders.

Creditors, including policyholders, and rating agencies or regulators whose mission it is to protect creditors, and shareholders are all interested in the financial health of an insurer, but in different ways. Creditors want to be assured that an insurance company will be able to honor its obligations fully and in a timely manner. For creditors, the main risk question is: what is the risk of the business? This is another way to ask whether the company will remain solvent.

Shareholders, however, are interested in the value of the business as a going concern, in how much this value might increase and by how much it might decline. For shareholders, the main risk question is: what is the risk to the business? Shareholders are interested in what ERM can do to increase and protect the value of their investment in a company. While both creditors and shareholders are interested in the tail of the distribution of financial results, as an indicator of solvency risk, shareholders are also very interested in the mean of these financial results and their volatility, which could have an adverse impact on the value of their investment.

Policyholders and shareholders’ views are different but not incompatible: a company could not stay in business if it were not able to persuade regulators that it will remain solvent and should be allowed to keep its license, or obtain from rating agencies a rating suitable for the business it writes.  Its value to investors would be significantly impaired..

Insurers recognize that the main drivers of their risk profile are financial risks, including insurance risk accumulations and concentrations, and the related market risk associated with their investment activities. They understand that resulting risks are best controlled at the point of origination through appropriate controls on underwriting and pricing and through reinsurance and asset allocation strategies that limit the volatility of financial outcomes. Stochastic modeling is being used more broadly by companies to understand how such risks accumulate, interact and develop over time and to evaluate strategies that enhance the stability of outcomes. Capital adequacy is the ultimate defense against severe risk “surprises” from insurance and investment activities. It is of interest to policyholders who want to be certain to collect on their claims, but also to shareholders who want assurance that a company can be viewed as a going concern that will write profitable business in the future.

Methodologies used by rating agencies on behalf of creditors describe in detail how the rating process deals with the three main drivers of a company’s financial position and of the volatility (risk) of this position. In response to rating agency concerns, insurance companies focus on determining how much “economic capital” they need to remain solvent, as a first step toward demonstrating the adequacy of their capital. Analyses they perform involve calculation of the losses they can suffer under scenarios that combine the impact of all the risks to which they are exposed. This “total risk” approach and the related focus on extreme loss scenarios (“high severity/low frequency” scenarios) are central to addressing creditors’ concerns.

To address the solvency concerns of creditors, rating agencies and regulators and the value risk of shareholders, insurance companies need to know their complete risk profile and to develop separate risk metrics for each group of constituents. Knowledge of this risk profile enables them to identify the distinct risk management strategies that they need to maintain high ratings while also protecting the value of their shareholders’ investment. Leading ERM companies have become well aware of this requirement and no longer focus solely on tail scenarios to develop their risk management strategies.

The Dirty Dozen

Guest Post from David Merkel

The Aleph Blog

I have been thinking about the the forces distorting the global economy.  In the long run, the distortions don’t matter, because economies are bigger than governments, and eventually economies prevail over governments.  Here are my dozen problems in the global economy.

1) China’s mercantilism — loans and currency.  The biggest distortionary force in the world now is China.  They encourage banks to loan to enterprises in order to force growth.  They keep their currency undervalued to favor exports over imports.  What was phrased to me as a grad student in development economics as a good thing is now malevolent.  The only bright side is that when it blows, it might take the Chinese Communist Party with it.

2) US Deficits, European Deficits — In one sense, this reminds me of the era of the Rothschilds; governments relied on borrowing because other methods of taxation raised little.  Well, this era is different.  Taxes are high, but not high enough for governments that are trying to create the unachievable “permanent prosperity.” In the process they substitute public for private leverage, and in the process add to the leverage of their societies as a whole.

3) The Eurozone is a mess — Greece, Portugal, Spain, etc.  I admit that I got it partially wrong, because I have always thought that political union is necessary in order to have a fiat currency.  I expected inflation to be the problem, and the real problem is deflation.  Will there be bailouts?  Will the troubled nations leave?  Will the untroubled nations leave that are the likely targets for bailout money?

4) Many entities that are affiliated with lending in the US Government, e.g., FDIC, GSEs, FHA are broke.  The government just doesn’t say that, because they can still make payments.

5) The US Government feels it has to “do something” — so it creates more lending programs that further socialize lending, leading to more dumb loans.

6) Residential real estate is still in the tank.  Residential delinquencies are at all-time highs.  Strategic default is rising.  The shadow inventory of homes that will come onto the market is large.  I’m not saying that prices will fall for housing; I am saying that it will be tough to get them to rise.

7) Commercial real estate — there is too much debt supporting commercial real estate, and too little equity.  There will be losses here; the only question is how deep the losses will go.

8 ) I have often thought that analyzing the strength of the states is a better measure for US economic strength, than relying on the statistics of the Federal Government.  The state economies are weak at present.  Part of that comes from the general macroeconomy, and part from the need to fund underfunded benefit plans.  Life is tough when you can’t print your own money.

9) The US, UK, and Japan are force feeding liquidity into their economies.  Thus the low short-term interest rates.  Also note the Federal Reserve owning MBS in bulk, bloating their balance sheet.

10) Yield greed.  The low short term interest rates touched off a competition to bid for risky debt.  The only question is when it will reverse.  Current yield levels do not fairly price likely default losses.

11) Most Western democracies are going into extreme deficits, because they can’t choose between economic stimulus and deficit reduction.  Political deadlock is common, because no one is willing to deliver any real pain to the populace, lest they not be re-elected.

12) Demographics is one of the biggest  pressures, but it is hidden.  Many of the European nations and Japan face shrinking populations.  China will be there also, in a decade.  Nations that shrink are less capable of carrying their debt loads.  In that sense, the US is in good shape, because we don’t discourage immigration.

From David Merkel

The Aleph Blog

This post is produced by David Merkel CFA, a registered representative of Finacorp Securities as an outside business activity. As such, Finacorp Securities does not review or approve materials presented herein. By viewing or participating in discussion on this blog, you understand that the opinions expressed within do not reflect the opinions or recommendations of Finacorp Securities, but are the opinions of the author and individual participants. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security or other instrument. Before investing, consider your investment objectives, risks, charges and expenses. Any purchase or sale activity in any securities instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Finacorp Securities is a member FINRA and SIPC.

RISK USA Conference – October 2009

Many, many good questions and good ideas at the RISK USA conference in New York.  Here is a brief sampling:

• Risk managers are spending more time showing different constituencies that they really are managing risk.
• May want to change the name to “Enterprise Uncertainty Management”
• Two risk managers explained how their firms did withdraw from the mortgage market prior to the crisis and what sort of thinking by their top management supported that strategy
• Now is the moment for risk management – we are being asked for our opinion on a wide range of things – we need to have good answers
• Availability of risk management talent is an issue.  At both the operational level and the board level. 
• Risk managers need to move to doing more explaining after better automating the calculating
• Group think is one of the major barriers of good risk management
• Regulators tend to want to save too many firms.  Need to have a middle path that allows a different sort of resolution of a troubled firm than bankrupcy.
• Collateral will not be a sufficient solution to risks of derivatives.  Collateral covers only 30 – 50% of risk
• No one has ever come up with a theory for the level of capital for financial firms.  Basel II is based upon the idea of keeping capital at about the same level as Basel I. 
• Disclosure of Stress tests of major banks last Spring was a new level of transparency. 
• Banking is risky. 
• Systemic Risk Regulation is impossibly complicated and doomed to failure. 
• Systemic Risk Regulation can be done.  (Two different speakers)
• In Q2 2007, the Fed said that the sub-prime crisis is contained.  (let’s put them in charge)
• Having a very good system for communicating was key to surviving the crisis.  Risk committees met 3 times per day 7 days per week in fall 2008. 
• Should have worked out in advance what do do after environmental changes shifted exposures over limits
• One firm used ratings plus 8 additional metrics to model their credit risk
• Need to look through holdings in financial firms to their underlying risk exposures – one firm got red of all direct exposure to sub prime but retained a large exposure to banks with large sub prime exposure
• Active management of counterparties and information flow to decision makers of the interactions with counter parties provided early warning to problems
• Several speakers said that largest risk right now is regulatory changes
• One speaker said that the largest Black Swan was another major terrorist attack
• Next major systemic risk problem will be driven primarily by regulators/exchanges
• Some of structured markets will never come back (CDO squareds)
• Regret is needed to learn from mistakes
• No one from major firms actually went physically to the hottest real estate markets to get an on the ground sense of what was happening there – it would have made a big difference – Instead of relying solely on models. 

Discussions of these and other ideas from the conference will appear here in the near future.

Black Swan Free World (8)

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab.

George Soros has said that he believes that the GFC is the beginning of the unwinding of a fifty year credit buildup.  Clearly there was too much leverage.  But does anyone know what the right amount of leverage for a smoothly functioning capitalist system should be?

There is always a problem after a bubble.  Many people keep comparing things to how they were at the very height of the bubble.  Stock valuations are compared to the height of the market.  Employment is compared to the point where the most people had jobs.  But these are often not the right comparisons.  If in the month of May, for 30 days, I had an outstanding offer for my house of $300,000 and on one day a person flew in from far away and offered $3 million, and if I never made that sale, do I forever after compare the offering price for selling the house to $3 Million?

People talk about a “New Normal”.  Possibly, the new normal means nothing more than returning to the long term trend line.  Going back to where things would now be if everything had stayed rational.

That may seem sensible, but this new normal may be a very different economy than the overheated and overleveraged one that we had.

Taleb suggests that the only possible transition from excessive debt is cold turkey.  If Soros is right and we are going to transition to a new normal that is more like 50 years ago than 5 years ago, there that will be a long bout of DTs.

What we are seeing in the way of debt is the substitution of government debt for private debt.  While Taleb is probably too harsh, the Fed does need to be careful.   Careful not to go too far with the government debt.  The Fed should be acting like the football player who passes ahead of the teammate, not to where they are standing right now.  The amount of debt that they should be shooting for is a level that will make sense when the banks fully recover and again take up lending “like normal”.  That will keep enough money flowing in the economy to soften the slowdown to the economy from the contraction of bank lending.

However, if the Fed is shooting to put us back where we were at the peak, then we are in trouble and Taleb’s warning holds.  I would restate his warning as “Using too much leverage to combat the problem of too much leverage…” But using the right amount of leverage is just what is needed.

But that does mean learning to live with much less leverage.  It means that we need to better understand how much leverage is the right amount.  And we need to stop blaming the Chinese because they hold so much dollars and want to lend them to us.  We need to develop a structural solution to the global imbalance that the Chinese balances are a symptom of.

Like some of our other problems, the purely market based solutions will not work.  China is not playing by the market based rule book.  They are a mercantilist economy that is taking advantage of the global market economy systems.  We need to stop whining about that and develop strategies that work for everyone.

Black Swan Free World (7)

Black Swan Free World (6)

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

Coverage and Collateral

I thought that I must be just woefully old fashioned. 

In my mind the real reason for the financial crisis was that bankers lost sight of what it takes to operating a lending business. 

There are really only two simple factors that MUST be the first level of screen of borrowers:

1.  Coverage

2.  Collateral

And banks stopped looking at both.  No surprise that their loan books are going sour.  There is no theory on earth that will change those two fundamentals of lending. 

The amount of coverage, which means the amount of income available to make the loan payments, is the primary factor in creditworthiness.  Someone must have the ability to make the loan payments. 

The amount of collateral, which means the assets that the lender can take to offset any loan loss upon failure to repay, is a risk management technique that insulates the lender from “expected” losses. 

Thinking has changed over the last 10 – 15  years with the idea that there was no need for collateral, instead the lender could securitize the loan, atomize the risk, thereby spreading the specific risk to many, many parties, thereby making it inconsequential to each party.  Instead of collateral, the borrower would be charged for the cost of that securitization process. 

Funny thing about accounting.  If the lender does something very conservative (in terms of current standards) and requires collateral that would take up the first layer of loss then there will be no impact on P&L of this prudence. 

If the lender does not require collateral, then this charge that the borrower pays will be reported as profits!  The Banks has taken on more risk and therefore can show more profit! 

EXCEPT, in the year(s) when the losses hit! 

What this shows is that there is a HUGE problem with how accounting systems treat risks that have a frequency that is longer than the accounting period!  In all cases of such risks, the accounting system allows this up and down accounting.  Profits are recorded for all periods except when the loss actually hits.  This account treatment actually STRONGLY ENCOURAGES taking on risks with a longer frequency. 

What I mean by longer frequency risks, is risks that expect to show a loss, say once every 5 years.  These risks will all show profits in four years and a loss in the others.  Let’s say that the loss every 5 years is expected to be 10% of the loan, then the charge might be 3% per year in place of collateral.  So the banks collect the 3% and show results of 3%, 3%, 3%, 3%, (7%).  The bank pays out bonuses of about 50% of gains, so they pay 1.5%, 1.5%, 1.5%, 1.5%, 0.  The net result to the bank is 1.5%, 1.5%, 1.5%, 1.5%, (7%) for a cumulative result of (1%).  And that is when everything goes exactly as planned! 

Who is looking out for the shareholders here?  Clearly the deck is stacked very well in favor of the employees! 

What it took to make this look o.k. was an assumption of independence for the loans.  If the losses are atomized and spread around eliminating specific risk, then there would be a small amount of these losses every year, the negative net result that is shown above would NOT happen because every year, the losses would be netted against the gains and the cumulative result would be positive. 

Note however, that twice above it says that the SPECIFIC risk is eliminated.  That leaves the systematic risk.  And the systematic risk has exactly the characteristic shown by the example above.  Systematic risk is the underlying correlation of the loans in an adverse economy. 

So at the very least, collateral should be resurected and required to the tune of the systematic losses. 

Coverage… well that seems so obvious it doed not need discussion.  But if you need some, try this.

Black Swan Free World (5)

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

Complexity gets away from us very, very quickly.  And at the same time, we may spend so much time worrying about the complexity, building very complex models to deal with the complexity, that we lose sight of the basics.  So Complexity can hurt us both coming and going.

So why do we insist on Complexity?  That at least is simple.  Most complexity exists to provide differentiation between financial products that otherwise would be pure commodities.  The excuse is that the Complex products are needed to match up with the risks of a complex world.  Another, even less admirable reason for the complexity is to create something that sounds like a simple risk relief product but that costs the seller much less to provide, by carving out the parts of the risk relief that are more expensive but less desirable or less well understood by the customer.

Generally, customers who are buying risk relief products like insurance or hedges have a simple objective.  If they have a loss they want something that will make a payment that will offset the loss.  Complexity comes in when the risk relief products are customized to potentially better meet customer needs. (according to the sales literature).

Taleb suggests that complexity also hides leverage.  That is ver definitely the case.  For example, a CDS can be replicated by a long position in a credit and a short position in a treasury.  A short position in a treasury is finance speak for a loan at a better rate than you can actually get.  And a loan is leverage.  THe amount of the leverage is the full notional amount of the CDS.  Fans of derivatives will scoff at the idea that the notional amount if of any interest to anyone, but in this case at least, anyone who wants to know how much leverage the buyer of a CDS has, needs to add in the full notional amount of all of the CDS.

Debt bubbles are vicious because of the feedback loop in debt.  If one borrows money to purchase an asset and the asset increases in value, then you can use that increased value as collateral to increase the debt and purchase more of the asset.  The increase in demand for the asset causes prices to rise and so it goes.

But ultimately the reason that may economists have a hard time identifying bubbles (other than they do not believe that bubbles really ever exist) is that they do not know the capacity of any asset market to absorb additional investment.  Clearly in the example above, if there is a fixed amount of the asset that becomes subject to a debt bubble, it will very, very quickly run into a bubble situation.  But if the asset is a business or more likely a sector, it is not so easy to know exactly when the capacity of that sector to efficiently use additional capital is reached.

Black Swan Free World (10)

Black Swan Free World (9)

Black Swan Free World (8)

Black Swan Free World (7)

Black Swan Free World (6)

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

DISLOCATION

Guest post from Mike Cohen

http://www.cohenstrategicconsulting.com/index.php

Dislocation: dis-lo-ca-tion (\,dis-(,)lō-’ka-shən): a disruption of an established order

The financial world has undergone a dislocation of epic proportions, one that is rivaled by only two such situations in our lifetimes: the Great Depression and to a lesser magnitude the interest spike and related chain of events of the early 1980’s. Financial institutions, and even more profoundly the world financial order, have been found to be standing on foundations of sand, and dynamics/financial behaviors/paradigms/systems that we took for granted are not effective, or at the very least stumbling along in a state of disarray and confusion.

As our ‘rose-colored glasses’ (spawned by over-optimism, greed, laziness, ignorance and unjustified trust) have been taken away and replaced with optical devices fitted with Coke-bottle lenses with Vaseline smeared on them, we are confronted with the critical endeavor of recreating nothing less than our way of life and arguably the most important underpinning of it, our financial system.

Our World Has Changed: This dislocation is different and more troubling than any other in history, in large part because it almost triggered the collapse of the world’s financial system.  The crisis we are faced with today was caused by widespread business practices where society’s hard learned lessons were ignored:

–       The financial system is based on trust (in people, in the system itself), and the resulting belief that it works; there has been a considerable amount of activity that almost any observer would describe as untrustworthy

–       Accurate, objective analysis is critical

–       Greed kills, sooner or later

Joseph Schumpeter, the famous Czechoslovakian economist, observed in the 1920’s:

Capitalism moves forward following a process of creative destruction. Inevitable cycles of expansion and retraction are not only survivable but are in fact the secret of capitalism’s extraordinary power to inspire innovation and progress.”

It would be completely inaccurate to describe the financial crisis that has occurred as the result of ‘creative destruction’. The root causes of this crisis are much darker.

How did we get to where we are?

–       Unjustifiably easy credit was offered to homebuyers who very logically couldn’t have been expected to be able to service their mortgage loans.  A substantial price bubble was created and inevitably burst, as many have before it, but this time the entire American society was hurt badly as opposed to individual investors in past bubbles.

–       Asset managers making ambitious claims about investment returns they said they couldn’t possibly achieve, and others committing outright fraud

–       Rating analysts not adequately analyzing securities, causing them to be overrated and underpriced

–       Investment bankers and others facilitating transactions built on elements that had not been properly vetted, and which have turned out to have crushing levels of risk and unforeseen financial liabilities

Macro Issues Abounded:

– The banking system almost collapsed, and may have had it not been for considerable government intervention, which has raised a host of other profound issues. An enormous amount of bad loans were made as the result of capricious underwriting, leading to huge amounts of bad assets on banks’ books and causing a paralyzing level of fear for making further loans.

– The financial markets ‘froze’. The flow of capital slowed to a trickle because lenders did not believe that borrowers were credit-worthy; ironically, the thought process evolved from lending money to anybody to lending money to no one. The markets are just beginning to thaw, a year later.

– Complicated financial instruments confused and overwhelmed the system, creating enormous risk. Counterparties, partners in transactions, did not understand these vehicles they were buying and selling (and in many cases how their counterparts were managing their own enterprises) … and the risks they were taking on. A certain notorious business operation has long held the notion that “Be close to your friends, and closer to your enemies”.

– The real estate market plunged into its worst cycle in decades, and possibly ever. This collapse was caused by a number of dynamics:

* Selling housing/making loans to individuals or companies whose financial positions were not strong enough to service their financial obligations

– The rating agencies have been called to task over their role in the current situation, and a number of vexing questions have been raised:

* How are they analyzing companies and investment vehicles?

* How are they to be paid for their rating services? Are there conflicts of interest imbedded in their client relationships?

* How will they be operating going forward?

* How will they be regulated?

– Consumer attitudes have been more negative than ever since they began being monitored in the 1960’s, although recently they have improved marginally as economic and financial stabilization is beginning to occur.  The widespread view is that the current situation is beyond a cyclical downturn and is perceived as a failure of the system. Uncertainty about the financial system, rising unemployment, restricted credit, and a depressed housing market have all contributed to plummeting consumer sentiment.

– Government responses in the form of rescue programs of various types are beginning to fix the problems within the financial system (banks and insurers) and key industries (automotive), and are gradually beginning to calm fears. Substantial efforts to revise the nation’s financial services regulatory infrastructure are underway, conceived to both address current issues and create a more shock-free system in the future. A number of vexing problems have arisen, however, that will be very difficult to solve:

* Well intentioned programs to interject capital to troubled sectors of the economy have been slow to take effect

* Massive budget deficits are building, which will lead to substantial debt servicing obligations in the future and consequentially depressed economic growth

* The government owns stakes in huge corporations (with the implication of socialistic-type government in the United States, for crying out loud!), and is being perceived as making broad decisions on which corporations will survive or fail.

* Understanding that things that can go wrong (either known or unknown), and making sure the adverse affects do not cause crippling and irreversible harm

* A fundamental question begging to be asked is “how did so many elements of this financial disaster occur that had aspects and implications of risk that no one either understood or quantified anywhere close to properly, or didn’t bother to look at?”

Animal Spirits Eating Green Shoots

Guest Post from David Merkel

http://alephblog.com/2009/09/01/animal-spririts-eating-green-shoots/

I have never liked Keynes concept of “animal spirits.” (I reread that piece, and though it is long, I think it is worth another read.  I try not to say that about my own stuff too often.)  Businessmen are generally rational, and take opportunities when they see them.  As for those that invest in the stock market, perhaps the opposite is true — panicking near bottoms, and buying near tops.

Most businessmen are risk-averse.  They do what they can to avoid insolvency.  But debt capital is cheap during the boom phase of an economic cycle, and businessmen load up on it then.  During the bear phase of the cycle, overly indebted businessmen pull in their horns and try to survive.  At bottoms, deals are too attractive for businessmen with spare cash to ignore — businessmen are rational, and seek deals that offer profitability with reasonable probability.

Unlike this article, I’m not convinced that the news does that much to affect behavior.  Movements in asset values are self-reinforcing not because of crowd opinion, but because of the accumulation and decumulation of debt and other financial claims.  As businessmen get closer to insolvency, they trim activity.  As their financial constraints get looser, they are willing to consider more investments with free cash.

As for the current situation, I am less confident of the “green shoots.”  Yes, inventory decumulation has slowed down.  So has the increase in unemployment, maybe.  Yes, financing rates have fallen.  We still face a situation where China is force feeding loans for non-economic reasons into its economy, and where the financial sector of the US is still weak due to commercial real estate loans, bank loans to corporations, and weak financial entities propped up by the US government.  Even residential real estate is not done, because of the number of properties that are inverted, and the increase in unemployment, which I think is likely to get worse.

Applications: I think it is more likely than not that there will be another crisis with the banks, and another round of monetary rescue from the government.  I also think that many speculative names like AIG have overshot, and the advantage now rests with the shorts for a little while.  Real money selling is overcoming day traders.

Be cautious in this environment.  After I put out my nine-year equity management track record, the next project is to dig deeper in the risks in my own portfolio, and make some changes.

Disclosure

This post is produced by David Merkel CFA, a registered representative of Finacorp Securities as an outside business activity. As such, Finacorp Securities does not review or approve materials presented herein. By viewing or participating in discussion on this blog, you understand that the opinions expressed within do not reflect the opinions or recommendations of Finacorp Securities, but are the opinions of the author and individual participants. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security or other instrument. Before investing, consider your investment objectives, risks, charges and expenses. Any purchase or sale activity in any securities instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Finacorp Securities is a member FINRA and SIPC.