Thursday, December 23, 2010

Discussing SURW on “The Contrarian” (Episode 1)

Thursday, November 12, 2009

Congress and the Fed: An Epic Game of Chicken

With the Federal Reserve worried about its independence, it has a Faustian bargain to make: keep its independence, or keep interest rates low.

Essentially, many in Congress would like to see the Fed keep interest rates lower for longer than it might if left to its own devices, in order to stimulate employment. It is a frightening prospect that pressure is being brought to bear on Chairman Ben Bernanke to keep monetary policy loose—the same Chairman who once wrote that the Fed could drop money from helicopters, if necessary, to prevent a severe deflation.

If the purpose of Fed independence is to keep monetary policy independent from politicians, who always prefer inflationary policies, it is essential that Ron Paul’s bill, which seeks to audit the Fed (a necessity) is not used as a backdoor method by Congress to gain control over monetary policy.

Bernanke is in a tough position. He wants to maintain the Fed’s prerogatives to set monetary policy. However, to do so, he may be tempted to bend to the will of Congress and keep interest rates lower than he might otherwise in the absence of external pressure.

If power is the ability to influence, then Congress, in practice, has huge power over the Fed if it’s Chairman allows himself to be tempted to make the Faustian bargain of keeping interest rates low, in return for the maintenance of Fed independence. If Bernanke does not show backbone, Congress would not even have to pass a bill giving itself more power over monetary policy. It would simply have to threaten to do so every time it was unhappy, holding the Fed hostage to political whims. To his credit, Ronald Reagan supported Paul Volcker’s inflation fighting stance, however unpopular with Congress. Chairman Bernanke should be similarly supported by President Obama in the area of monetary policy independence.

Distrubingly, the New York Times’ Edmund Adrews noted on November 11.

Voters had become suspicious and unnerved by the Fed because of its trillion-dollar efforts to bail out the financial system, Mr. Frank warned. If the Fed really wanted to survive the disgruntlement in both parties, he continued, Mr. Bernanke would have to step back and let him devise a compromise.

Reluctantly, the Fed chairman agreed to reduce his own visibility on the issue and let Mr. Frank take the lead.

This is exactly the wrong approach for Chairman Bernanke to pursue. Rep. Frank is a shrewd politician. The scenario which is unfolding should be a familiar one to Chairman Bernanke if he has ever been pulled over for a questionable “traffic violation.” It’s good cop-bad cop. “We’ll help you, just stop fighting us.” Congress does not want to help the Fed. Like any institution, it wants to expand the sphere of its own authority. Can anyone guess who will have more power under any compromise bill? House Financial Services Committee Chairman Barney Frank.

Compromise on monetary policy is a fool’s errand.  Instead, the Chairman Bernanke should take a hard line, conceding that the Fed over-stepped the bounds of prudence in supporting problem banks and agreeing to tighter strictures in that area, while vehemently fighting to protect the Fed’s prerogatives in setting interest rates. If the Chairman does not, long-term inflation, and indeed, hyperinflation could result.

Otherwise, if Bernanke succumbs to the temptation of appeasing Congress by keeping interest rates artificially low (which is what most members of Congress really want), he will have given up his power without a fight, and more importantly, compromised the integrity of the very currency whose value he is mandated to protect.

Bureaucracies have a bad record when its comes to a question of the public interest vs. the perpetuation of the bureaucracy. Unfortunately, it looks like Bernanke may have already made his choice. Earlier this week, multiple Federal Reserve officials gave speeches around the country, openly stating that the need to spur jobs was worth the risk of inflation. This is a clear message to Congress: “We’ll do what you want, just leave us alone.” It’s also a clear message to investors. More inflation is coming.

The Fed needs to educate Congress and to fight for prudence. Higher prices hurt ordinary citizens when their dollars don’t go as far. When citizens can afford less, it hurts demand for good and services, reducing GDP growth and employment. It’s a simple argument, and it’s the right argument. The Fed should make it.

Disclosure: Author holds a long position in GLD

Wednesday, October 07, 2009

The Dogma of Low Interest Rates Is Wrong

In The Unintended Effects of Bad Policy (May 18th), I wrote that:

 

[L]ow interest rates often have the opposite of their intended effect. Extremely low interest rates can vacuum liquidity out of nations. Japan has been referred to as a nation where loose monetary policy was like “pushing on a string.” There was no push. It was a pull. Liquidity was sucked out of the country as the Yen became the world’s carry trade currency of choice. Borrowing in a currency is the opposite of investment. It is liquidity-draining to the carry trade currency nation. For all of the talk about using monetary policy to dampen the business cycle, no result could be more damaging or procyclical.

 

 

Americans may finally realize that there is a free lunch after all—we will be supplying it as speculators borrow in our low-yielding currency to invest elsewhere.

 

Yesterday that debate was conclusively laid to rest with the latest numbers from the NSX on net flows into ETFs.

   
• YTD, $25.264 billion has flowed out of U.S. Equity Long ETFs.
   
• YTD, over $13 billion has flowed into U.S. Short and Short Leveraged ETFs.

Conversely,

   
• YTD, over $17 billion has flowed into Global Equity Long ETFs and less than $1billion has flowed into Short and Short Leveraged Global Equity ETFs.
   
• YTD, over $24 billion has flowed into Commodity ETFs and less than $0.5 billion has flowed into Short Commodity ETFs.

Capital goes where it is treated best, like customers for fine dining. When meal sizes are anemic and interest rates are low, customers leave and head for more hospitable, higher yielding environs, or commodities.

Economists take it as unquestioned dogma that low interest rates are stimulative. Of course, ultra low interest rates are not stimulative to the real economy, they just increase asset prices. Rather than accept conventional arguments using faith based reasoning, a far more scientific approach is to examine the evidence.

I would argue that extremely low interest rates suck investment funds and liquidity out of nations. You heard it here first, and the evidence is clear. Money has flowed out of U.S Equity ETFs and into Global ETFs.

Many argue that the U.S. could never share Japan’s experience of a quarter century bear market in which stocks dropped over 75% with interest rates at or near 0%.

If we do not wish to share such an experience, why are we repeating the same policies which led to such results? What policies did Japan pursue? Near zero interest rates, the propping up of zombie banks, and the arbitrage of replacing of managerial competence at financial institutions with political competence aimed at securing taxpayer charity.

Does this sound familiar? Money flowed out of Japan starting in the early 90’s and into economies such as ours. The tech boom was supercharged by a massive Japan-funded carry trade. We may be funding such a boom in emerging markets and commodities right now to our detriment. Liquidity and investment funds will continue to flow out of the U.S., as they have, if we do not change policies which are contradicted by logic and clear evidence.

The public needs to understand that good policies are not about slogans, or personalities—they are about sound quantitative practices based upon clear arithmetic. As Keynes said of inflation, less than 1 person in 100 may understand it, but turning the dollar into a carry trade currency is unsound, procyclical, and will suck liquidity and investment funds out of the U.S. to our long term detriment.

For the investor, global macro is about understanding the global flows of capital and the drivers behind them. Sound advice is to follow the money.

Disclosure: Long EEM, FXI, PGJ, FCHI, HAO, EWZ, GXC, GLD. Positions may change at any time.

Challenging the Low Interest Rate Religion

In The Unintended Effects of Bad Policy (May 18th), I wrote that:

[L]ow interest rates often have the opposite of their intended effect. Extremely low interest rates can vacuum liquidity out of nations. Japan has been referred to as a nation where loose monetary policy was like “pushing on a string.” There was no push. It was a pull. Liquidity was sucked out of the country as the Yen became the world’s carry trade currency of choice. Borrowing in a currency is the opposite of investment. It is liquidity-draining to the carry trade currency nation. For all of the talk about using monetary policy to dampen the business cycle, no result could be more damaging or procyclical.

The test of such a statement would be a country which is raising interest rates, while the rest of the world keeps them low. This week, Australia has provided us with such a test. Their central bank has raised interest rates, and so far, Australian equity markets have moved higher

I would argue that their central bank’s decision to raise rates will incentivize capital to move from countries with anemic interest rates to Australia, which will (everything else being equal) benefit their economy and equity markets. Currently, central banks around the world operate under the erroneous assumption that anemic interest rates are stimulative. I have argued that ultra low interest rates increase asset prices rather than stimulate the real economy. Australia should benefit from its rate increase. Of course, only time will prove the point.

Hopefully, the world’s central bankers and economists are taking note.

Disclosure: Long EFA. Positions may change at any time.

Thursday, September 17, 2009

The Decline of the Empire Will be Cheered

In The Unintended Effects of Bad Policy (May 18th), I wrote that:

Sunday, July 19, 2009

A Roadmap to Turn Around Problem Banks

The key to financial stability and reform at major banks is simple. The President, through his force of stature, could go to the nation’s most successful and conservative banks, such as Hudson City Bancorp (HCBK) and request that some of these banks’ executives and loan officers be placed in leadership positions at problem financial institutions. Of course, the incompetent executives they replace would have to be fired.

Most well run banks would naturally view losing talented executives as a raiding of their ranks, and rightly, as a penalty, rather than a reward, for their excellent performance. The government could issue to these well-run banks modest amounts of stock options in problem banks where their former executives have been placed as partial recompense for the loss of talented executives and the strengthening of competitors.

In addition, as Carl Icahn rightly points out, retention bonuses should only be paid to executives that a rational business enterprise would want to retain. This rules out the vast majority current of executives at many major financial institutions (let them find work elsewhere after they have destroyed their current employer!). However, few would object to paying performance-based bonuses to executives who have left healthy, thriving banks and insurers for those in need of their managerial expertise, as a public service to the country. The debate about compensation at financial institutions in which the government has a stake could then become rational.

Reckless managements must be replaced by those with a proven track record for performance. The current strategy of many incumbent CEOs is to engage in an arbitrage, whereby intelligent and conservative risk control is replaced by political lobbying aimed at keeping their jobs and getting access to government coffers when they fail in their fiduciary duties. This must stop. Getting the best managers to work for the worst banks and insurers is the key to real turnarounds and lasting financial stability.

Thursday, May 21, 2009

Government Intervention: A Vision for the Future

“The wise and correct course to follow in taxation and all other economic legislation is not to destroy those who have already secured success but to create conditions under which every one will have a better chance to be successful.” (Calvin Coolidge)

Primitive human societies were characterized by the few taking from the many. Modern primitive societies are characterized by the many voting to take the property of the few.

As we have seen in the Middle East, true democracy is not just about majority rule, but an abiding respect for the rights of minorities. Foremost among these rights is the right to property.

What is deeply immature about post-1929 America, is that our government is obsessed with dividing up money through societal wealth transfers rather than with enlarging societal wealth. This response has become a costly habit, one which the rest of the world has broken after its disastrous flirtation with communism. It is also an inherently unstable policy framework.

Taking property from bondholders and giving it to union workers at Chrysler is gangsterism, not government. This idea we have in America that some can win on a long term basis by requiring others to lose is ridiculous. Either we all win, or we all ultimately lose. The UAW thinks it has found a new path. Donate to politicians and abridge fundamental constitutional rights.

America was founded on the proposition that all rights emanate from God in a state of nature, and that no government can abridge those rights, since those rights are dervied from God, not men. In Europe, the idea is that the government decides how much you can keep. We have seen the results—awful, structural, permanent unemployment, even in good times.

No one has the right to take property from one group and to give it to another. Americans may argue that if we vote for such a paradigm, that it is “right”. I ask such polemicists, If we voted to strip a minority group of civil rights, would that be ethical, just because we have voted on it? Why is it automatically ethical to take away people’s property? “Well,” they say, “high taxes are an accepted part of modern life!”.

I ask them, at what point are taxes antithetical to a free society,? At a 50% rate, at a 90% rate? Quite literally, at a 50% rate (local, state and Federal combined in places like New York City) out of every 10 days, for 5 of them, you work for the government. We don’t call it slavery, because in those 5 days, you can do whatever you want.

Was this the intention of the Framers? Can such a situation ever lead to prosperity? Are we so profligate in our bureaucracies that we cannot make provision for the poor without such high taxes? The answer is that a tax rate approaching 50% is not about making provision for the poor, the elderly, or the disabled. That is the great lie of our age. This latest crisis has brought payola out into broad daylight. The money is going to financial institutions, unions, car companies, and hundreds of other groups which have been generous to politicians. Do these entities have a divine right to our money?

The solution is for the government to start doing its job and to protect our rights. Once government is granted the right to dispose of a majority of prosperity with impunity, we cease to live in a free market. Market participants realize that the way to wealth is not through pleasing consumers, but in getting access to the public purse. Shrink the size of that purse and rational behavior will put the focus back on serving people’s needs, not stealing their money,

If the true goal of democratic society is to create prosperity, while educating our children and making provision for the poor, we can probably do so with a 20% flat tax rate, with no deficit spending. However, if the goal is affirmative action for the rich, the stupid, and the greedy combined with a modern empire and with permanent war, 50% will eventually look low. And it will destroy our society, just as surely as the British Empire and Rome collapsed under their own weight.

We must say yes to success and remember the values which made us great. We never wanted to be an empire. Our strength was in understanding, as the Austrian School reminds us, that free enterprise is not a system, but is a spontaneous phenomenon that occurs when people with full human rights are allowed to exchange freely with one another. Children will do it with marbles, unprompted. A keen understanding of mathematical economics will never suffice for a rudimentary knowledge of human nature. As Rev. William John Henry Boetcker (not Lincoln) pointed out:

You cannot bring about prosperity by discouraging thrift. You cannot strengthen the weak by weakening the strong. You cannot help small men by tearing down big men. You cannot help the poor by destroying the rich. You cannot lift the wage-earner by pulling down the wage-payer. You cannot keep out of trouble by spending more than your income. You cannot further the brotherhood of man by inciting class hatred. You cannot establish sound security on borrowed money. You cannot build character and courage by taking away a man’s initiative and independence. You cannot help men permanently by doing for them what they could and should do for themselves.

Either we all win together, or we all ultimately lose. as Americans, we all succeed best when we enlarge the pie, rather than seeing its size as static and spending time divvying it up amongst ourselves to get unfair portions.

What is the solution? The solution is not to end democracy, as some have suggested, since it deteriorates when the many realize that they can take from the few. The solution is to create an “algorithmic democracy.” Total optionality within an envelope that is set in stone. We need amendments to our constitution which are unamendable and guarantee basic freedoms from tyranny. There should be a maximum constitutionally allowed tax rate, along with constitutionally mandated balanced budgets where are unamendable.

Then, the true scope of rational, ethical government, as a strong referee in a fair game, while making provision for the needy, would emerge. We would be forced to only spend on those things which are essential. The government would quickly learn the words, “we cannot afford this” and prioritize according to needs, not wants.

Only when we stop the primitive focus on taking from each other, can we enlarge real societal wealth and return to growth and to prosperity. We must remember who we are as a people, how we once acheived success as a nation, and in remembering, know how we will do it again.

What Were the People of California Thinking?

Californians are insane. They just voted down their best hope of avoiding insolvency. When you’re in a sinking boat, stop blowing holes in it. So now the U.S. government should take care of them when they decide to spend more than they have? People in states which balance their budgets prudently should subsidize those who do not?

Does democracy mean that the thrifty should subsidize the profligate? Perhaps Californians will not have any incentive to pay their bills unless bonds are secured and creditors can start seizing state government land. In such scenario, tax increases and spending cuts might commence rather quickly.

Everyone should have the right to bear the consequences of their actions. The people have voted for insolvency. Why should the U.S. Treasury give them money? The problem is not a lack of money in California, it is a lack of virtue on the part of voters. No amount of money will ever appease those who insist on spending money they do not have. Every capital infusion is exhausted by a new level of profligacy.

Of course, as we have seen, I suspect that political support for a bailout will come not just from Californians, but also from those bondholders dumb enough to lend to them. Of course, rather than bear the cost of such idiocy, they are hoping to enjoy the higher interest rate of a California debt obligation while enjoying the security of the U.S. Treasury in a bailout. It will be yet more affirmative action for the rich and stupid.

Again, our U.S. government deficits are subsidizing vice and penalizing virtue. Nothing good will come of it.

Monday, May 18, 2009

The Virtue of the Republic

“The aggregate happiness of the society, which is best promoted by the practice of a virtuous policy, is, or ought to be, the end of all government…” (George Washington)

“Only a virtuous people are capable of freedom. As nations become more corrupt and vicious, they have more need of masters.” (Benjamin Franklin)

Call me old-fashioned, but I have one message for policy-makers: charity is for poor people.

Disclosure: Harry Long does not own shares in any of the companies mentioned in this article, but he may in the future.

The Unintended Effects of Bad Policy

There is a reason why credit spreads widen. It is to more adequately compensate savers for taking risk. Adequate compensation for risk forestalls panic by providing an incentive to those with liquidity to supply it. In contrast, extremely loose monetary policy is procyclical and drains liquidity from economies. How can extremely low interest rates and quantitative “easing” create such a counter-intuitive result?

Widening banks’ net interest margin by dropping rates to near zero at the low end of the curve will temporarily create accounting profits at banks. However, as inflation takes hold, this seeming “quick fix” will decimate the real economic value of financial institutions’ mortgage portfolios and any bonds with a duration of over 10 years. Even with a full suspension of mark-to-market, the real economic book value of many insurance companies and banks may be catastrophically eroded (Buffett observed this years ago with insurance firms during stagflation). This could have the effect of removing liquidity from the system at precisely the point our economy needs it.

Moreover, we cannot afford for the government to be glib about the value of the dollar. Dangerously, given China’s recent push for IMF SDRs, the Treasury does not understand that America’s profligate borrowing cannot rest on a nebulous concept of our specialness. Our ability to fund our deficit rests squarely on our ability to borrow in our own currency. Once that option is taken away, all bets are off. Policy flexibility will no longer exist. The tipping point will have been reached.

Even if we can continue to borrow in dollars, our policies may have counter-intuitive effects. As a country, we need to understand the dynamics of non-linear effects surrounding interest rates. Just as at some point, higher interest rates no longer compensate the lender for increased risk on the part of the borrower, but actually increase defaults, low interest rates often have the opposite of their intended effect. Extremely low interest rates can vacuum liquidity out of nations. Japan has been referred to as a nation where loose monetary policy was like “pushing on a string.” There was no push. It was a pull. Liquidity was sucked out of the country as the Yen became the world’s carry trade currency of choice.

Borrowing in a currency is the opposite of investment. It is liquidity-draining to the carry trade currency nation. For all of the talk about about using monetary policy to dampen the business cycle, no result could be more damaging or procyclical.

Policies which create macroeconomic imbalances make it harder for good institutions to chart their own course. The buffeting forces of procyclical policies simply become too great. What institution, no matter how well run, could survive a debt crisis, hyperinflation, the decimation of its bond portfolio, and a sinking economy?

The very credit spreads that the government seeks to narrow may burst at the seams if the Fed and Treasury maintain their current course. Perhaps that is what it will take for lasting liquidity to be restored to our financial system. We may actually need to take our medicine. However, Americans may finally realize that there is a free lunch after all—we will be supplying it as speculators borrow in our low-yielding currency to invest elsewhere.

Sunday, March 29, 2009

Ratings Agencies, Public Policy and the Structure of Incentives

The recent debate over whether issuers or investors should pay ratings agencies totally misses the point. Both models create incentives for potential distortions of ratings behavior.

As many have pointed out, when issuers pay, there is a clear incentive to make the initial rating higher than it otherwise might be. No one would debate that.

However, the investor pays model creates incentives for distortions of ratings behavior which could be just as damaging. For instance, in an investor pays model, the initial ratings may be lower, on average. However, the ratings agencies would be incentivized not to downgrade debt. Doing so would create losses for bond investors. These same investors could steer business to ratings agencies which are more amenable to not downgrading debt.

Perhaps even more disturbing, as large institutions such as PIMCO or CALPERS would probably be paying among the highest fees in an investor pays model, there could be distortions in debt markets tied to their holdings, which may become statistically less likely to be downgraded. In such a scenario, the strategy of smaller players might be to imitate their portfolios, not because they are evil or dumb, but out of a rational urge to safeguard capital. The dangerous herd instinct of our capital markets would be further intensified and the very bubbles regulators are trying to stop could develop.

Bottom line, each model incentivizes distortions in behavior. This realization has led some to point out the salutary effect of competition. I would counter that it is precisely the urge to increase market share that has the effect of incentivizing raters to scrape the bottom of the barrel when rating debt. In a stable market share situation, with rational actors, there is no incentive to engage in ratings “grade inflation.” The prospect of renewed competition incentivizes new competitors and established players such as S&P (MHP), Moody’s (MCO), and Fitch to engage in product differentiation through ratings inflation. Certainly, new entrants cannot compete effectively on heritage, brand name, quality of databases, or the experience of personnel. In a situation in which firms essentially choose their regulator, the normal prescription of increased competition does not apply. It exacerbates the problem, and allows firms to pick the most lax ratings agency possible, from a wider menu of options—which is precisely what rational actors will do.

To be clear, all of the ratings agencies have made mistakes. I am merely trying to highlight the structure of incentives in the oft-proposed investor-pays model. I also own shares in MCO and MHP, so I am not a disinterested party. While we have had a healthy public debate about the issuer-pays model, I do not feel that the media, the ratings agencies, or regulators have given sufficient thought to the very real shortcomings of alternatives. All policy should be measured against the alternatives. Are we prepared to substitute one set of well-understood incentives, for another with wholly unexperienced effects? Are we prepared to exacerbate the incentive for ratings inflation with renewed competition that will only increase it?

Disclosure: Harry Long owns MCO shares directly, through partnerships, and through trusts. To the best of his knowledge, he and certain of his family members own MCO and MHP shares through partnerships and trusts. Such ownership may change at any time.

Wednesday, November 19, 2008

An Optimum Government Policy to Aid the Financial Crisis

What would an optimum government policy for helping the financial crisis look like? On each side of the political spectrum, we can all agree that it should be transparent, targeted, provide patient capital to the financial markets, help with deleveraging, and minimize government payouts.

The number one thing the government would need to do is create market incentives for investors to provide patient capital to the debt market. Otherwise, most investors may keep their wallets zipped.

Residential real estate, the heart of the problem, could be clearly targeted in a transparent way by a relatively simple policy which would provide much needed, non-taxpayer money. Congress should approve the creation of a new class of super mortgage REITS. What would this new class of mortgage REIT look like? To help in the deleveraging process, enhance stability, and provide totally solvent, patient capital:

   

1. The super REITs would not be allowed to use any debt leverage whatsoever. All capital would be raised as equity from stockholders. No debt could ever be raised.

   

2. The super REITs not only would be exempt from taxes at the corporate level, but their dividends to investors would not be subject to any tax whatsoever in perpetuity at the state or federal level.

   

3. The super REITs would only be allowed to originate residential mortgages or buy mortages/MBS.

   

4. In order to receive the above benefits, they would have to be started 12 months after a bill is passed allowing their creation and raise all of their equity capital within that 12 months.

   

5. In order to prevent leverage from migrating from one place to another, banks and insurance companies would not be allowed to own shares in these companies, directly or indirectly.

What would the objections be to such a plan? Some might argue that this is a tax handout. However, the government’s TARP is a $700 billion handout. Members of Congress are calling for more multi-billion dollar stimulus plans. Any money that could be raised in the private sector would directly save the U.S. taxpayer money, even if it would mean forgoing future tax revenue.

Another objection might be that these super REITs would reinflate the housing bubble. That is a reasonable concern. That is why I propose that these super REITs would only be able to be started and raise all of their equity capital 12 months from the passing of such a bill. It would be a targeted free market solution. Not the Wild West.

Some might object that their tax status would give this new class of REITs advantages over other financial institutions/funds. This argument neglects the fact that our current tax code incentivizes the use of debt in our economy by making interest payments tax deductible, increasing the incentives for debt leverage in our system. The whole point of the bill is that it creates a tax advantage to using no debt at all, virtually assuring the solvency which is so lacking in much of the financial system.

Essentially, the adoption of the proposal would be a more free market approach to incentivize non-leveraged private capital to help the financial system deleverage by buying the very assets the TARP was originally created to buy, while simultaneously creating new sources of non-leveraged, patient capital to originate residential mortgages in a transparent, targeted, politics-free fashion.

Thursday, September 18, 2008

AIG Bailout Signals End to American Values

There is an old-fashioned way that companies used to win business—by taking it from someone else. Yesterday, the U.S. government penalized a variety of insurers and other financial institutions who behaved with intelligence, shrewdness, and honor towards their shareholders and customers.

By ‘doing the right thing’ (a passé concept in Washington?), these companies rightfully deserve to win customers from a company whose balance sheet resembled more a highly leveraged hedge fund than a well-run insurer. To those who would argue that derivative counterparties would have been “unfairly” penalized by AIG’s (AIG) collapse, let us be clear—we are not talking about innocents, we are talking about highly sophisticated (but clearly not very bright) players in the derivatives markets.

Traditional theory in Economics of the Law posits that it is most efficient for actors best able to exercise a prudent standard of care to bear the liability of loss. Simply put, it costs less money for derivative counterparties to examine a company’s balance sheet and refuse to do business with any companies they deem imprudently run than to bail out the derivative counterparties later. If they do choose to do business with companies that are badly run [such as AIG], they should bear the full risk of loss, without any government “affirmative action” for such sophisticates.

What has been lost in all of this is that there is no shortage of capital in the financial world. The main assumption behind government intervention and capital infusions is that money is the problem. That problem is not a lack of capital—it is a shortage of managers who will not squander it.

Insurers such as Berkshire Hathaway (BRK-A), Progressive (PGR), CNA Surety (SUR), and my favorite, the tiny Fremont Michigan Insuracorp (FMMH.OB), have behaved honorably. They deserve to win the spoils of war—the business of a behemoth competitor who has behaved foolishly.

By bailing out AIG, the U.S. government is threatening to destroy the very competition that has led to our nation’s glory during the American Century.

If business is a morality play, and the government helps write the script, every character, in the end, should get what they deserve. This has been the central American cultural value since the founding of our republic. It has been the driving force behind democratically elected government, an independent judiciary, and progress itself. If everyone gets what they deserve, good behavior is rewarded. It has been precisely the rest of the world’s failure to adopt such an ethos until recently that has made our way of life the envy of the world.

Ironically, countries such as India and China are starting to embrace many of the values that have made the US great, while we turn our backs on those values. Other countries are discovering something central to what the US is, even as we risk forgetting it. Free markets, vigorous competition, and capitalism are not systems—they are values.

Indeed, such terms are merely a name we give to actors engaging in commerce with one another of their own free will. Choosing winners and losers is not the government’s job in a free society, but the beginning of the end of the American way of life.

Parents let their children bear the effects of their behavior out of love, not indifference. We let companies fail, because we want or country to succeed. Otherwise, we will be no better than Japan whose permissiveness and propping up of failed banking enterprises after their own real estate collapse has only lead to pain and to stagnation, not success. Can we expect to take similar actions and expect success?

Just as every American generation looks to immigrants to rediscover the truth of the American dream, let us look to China and to India to rediscover everything that was once great about us which we are so casually throwing away.

AIG, in the full view of the world, became a great enterprise, and then destroyed itself with greed and stupidity. It is the last firm in the world that deserves one cent of taxpayer money. But in a free society, no firm does. We are left then, with our goodwill, which we should reserve for the countless other firms which did the right thing. At the very least, they should have had AIG’s business. 

Disclosures: Harry Long owns FMMH shares directly, through partnerships, and through trusts. To the best of his knowledge, certain of his family members own FMMH shares through partnerships and trusts. Harry Long and certain of his family members own shares in SUR, a CNA Financial company. Such ownership may change at any time.

Wednesday, July 16, 2008

A Long-Term, Structural Solution to the Banking Crisis

For years, there have been well-argued criticisms of fractional-reserve banking. The term merely describes the current system in which depositors have a legal claim on all deposited funds, of which only a fraction thereof are held in reserve by the bank in case of withdrawals, the rest being invested by banks in mortgages, loans, etc.

Until recently, few alternatives have been viable. However, financial disintermediation, with funds being held directly by investors, has increasingly become the norm. What would an ideal banking system look like?  How could it maintain the flow of investment dollars into the economy, which banks currently provide? Surprisingly, it might be a natural evolution of the status quo. If embraced by policymakers, evolutionary reforms could be a free market solution to exaggerated booms and busts in the banking system. Increasing risk segmentation and removing leverage could both lower risk and increase the flow of stable investment funds into the economy. More importantly, it would eliminate much of the need for government intervention and the socialization of risk by the Federal Reserve, FDIC, and GSEs, at least in the current form.

Simply, what would be the underlying philosophy and structure of a viable, realistic, and improved alternative?

Markets should reflect intrinsic value, not excesses or deficiencies in capital. Why not have a special class of closed end funds or REITs which are not allowed to use debt leverage do their own due diligence on high-quality mortgages and invest therein? Such structures could be managed by banks and utilize bank loan officers, while removing leverage from the financial system and providing stable sources of bank fee income. Banks would still be able to actively engage in their current functions of mortgage lending, monitoring payment, and foreclosure management without the attendant risk of leverage.

Then, investors who wish to take mortgage risk can do so, while people who want a simple checking account with low risk can have that as well, with their money kept in a vault, or in non-leveraged, high quality money market accounts in treasuries, AAA corporate, AAA municipals, etc.

In this manner, the insidious grip of leverage is removed from the banking system, and people can choose to only take intentional risks, rather than inadvertent, unintentional risks associated with the current system.

Under the status quo, as we have seen with IndyMac, depositors’ savings can be invested in high risk, overvalued real estate mortgages/loans without their knowledge, comprehension, or support.

IndyMac depositors did not consciously decide to invest in high-risk mortgages. However, in economic essence, because the bank took their deposits and turned around and invested in such assets, that is precisely what occurred. If the depositors decided to invest in a closed end fund or mortgage REIT with the explicit understanding that such risks were being taken, that would be acceptable (especially if such structures did not employ debt leverage, as is the current common practice). However, they made no such decision. Most depositors simply wanted a place to store and manage liquid funds and the paying of bills.

The viability of reform really goes back to the theory of the firm, which holds that transaction costs create the needs for certain firms, so that often disparate functions are under one roof. Loan origination can go hand-in-hand with the management of mortgage funds while allowing such funds to be held directly by investors, not a leveraged bank. Why not have a system in which people can buy high quality money market funds, but do not deposit money in banks accounts whose funds are then used by the bank to invest in mortgages? It is the precise dual, simultaneous use of deposits by banks and the concurrent legal claim on them by depositors which is so destabilizing to the financial system.

Mortgages are long term in nature, while deposits (other than CDs) can be pulled at a moment’s notice. Why would we allow a system where short-term liabilities are systematically allowed to fund long-term holdings of investment assets? 

Reserve requirements are a function of the expected liquidity preferences of depositors. That is a fancy way of saying that since psychology and economic stress underlies liquidity preferences, that reserve requirements are least adequate when the financial system is under the most stress.

Therefore, banks are always vulnerable on a structural level to collapse. To say that trust underlies banking solvency and arguing that such a situation is acceptable is rather akin to arguing that trust is sufficient to maintain the safety of skyscrapers, bridges, or tunnels. Structural integrity is paramount, not psychology.

Policymakers must support robust, high quality structures which promote sustainable growth and stability. The current system does neither. Booms and busts are inherent to all leveraged systems. Banks are no exception.

Fractional-reserve banking benefits neither society, nor depositors, nor bankers. It is important to maintain investment capital in any healthy economy. Leverage in the banking system does not sustain such a flow of capital, but puts it at risk. Non-leveraged structures can provide more robust, sustainable, and less cyclical flows of investment into the economy. Such a system would merely be an evolutionary development from the current trend towards financial disintermediation from banking institutions to individuals, investment funds, and markets themselves.

Segmentation is the increasing global trend of the last century. Why not allow people to explicitly segment their risk tolerance? The system I’ve outlined above would do that. It would therefore eliminate the need for the socializing or risk in the form of the FDIC. Those who want simple, high quality money market risk can have it, others can have their funds in a vault, and those who wish to take on more risk for a higher yield might do that as well through closed end funds or REIT structures which invest in mortgages.

Thereby, the duration of the investments would be matched by the liquidity constraint, forestalling panics, forced liquidations, and the inefficient, inadvertent taking of uncontemplated risks. Money market mutual funds would invest in short-term obligations, and hence have a mutual fund structure, while closed end funds and REITs could lock in the underlying investments on a longer-term basis, as they do now.

The widespread adoption of industry standards for an unleveraged class of high quality mortgage REITs and closed end mortgage funds which hold mortgages would be a welcome development to consumers from much of the dangers of the current banking system, while providing banks with unleveraged, low risk fee income which would free bank shareholders and employees from the dangers of leveraged balance sheets. In such a model, banks would come to resemble asset management firms with multitudinous branches, high touch, in-person customer service, vaults, wire transfer operations, and mortgage funds.

We need reform now. The current banking system has spawned a variety of patchwork government fixes which do not address the underlying issues of structural stability and soundness. Government intervention is a band aid on a banking system which is hemorrhaging capital and needs an aggressive, evolutionary change in structure.

Most importantly, an unleveraged system which matches the durations of assets and liabilities would dampen financial cycles by not removing capital from the system precisely when it is under the most stress and needs investment funds. Capital would be constantly available and controlled through the markets, not highly-leveraged financial institutions, central banks, politically motivated legislators, or government interventions, which only worsen financial cycles.

Friday, July 11, 2008

Fannie & Freddie: Affirmative Action for the Rich and Stupid

Recent responses by policymakers to insolvency risk at Fannie Mae (FNM) and Freddie Mac (FRE) are entirely wrongheaded.  Not only do financial markets realize that credit protection supplied by Fannie Mae and Freddie Mac might be fictional in a full-blown mortgage crisis, but also that their guarantees of mortgage-backed securities create distortions in interest rates which destabilize markets. Even worse, logic suggests that these GSEs are making real estate more expensive,  not more affordable, to American homeowners. Fannie Mae and Freddie Mac are prominent causes of the current financial crisis, not part of the solution. 

The market has clearly come to terms with the fact that since Fannie Mae and Freddie Mac are not government backed, but government sponsored, that their historically lower cost of capital is not warranted. The collapse in their stock prices and the rise in their borrowing costs is evidence of this.

As Fannie Mae’s annual report states:

Although we are a corporation chartered by the U.S. Congress, the U.S. government does not guarantee,  directly or indirectly, our securities or other obligations.

This wouldn’t be particularly relevant except for the fact that Fannie Mae and Freddie Mac then turn around and, in the words of Fannie’s Annual Report:

...issu[e] and guarant[ee] mortgage-related securities that facilitate the flow of additional funds into the mortgage market.

Yes, you read correctly—guarantee.  With highly leveraged balance sheets, these guarantees are clearly at risk without government intervention.

But why are such promises dangerous? 

It is incredibly illogical for a society to encourage any concept of credit insurance by any entity,  since it encourages the charging of relatively lower interest rates which do not reflect the true probability of default.

Therefore, the solution is for mortgage-backed securities issued by Fannie Mae and Freddie Mac to carry interest rates denoted by the risk, not an interest rate which partially reflects the credit risk and partially reflects an almost meaningless promise to pay in the event of widespread defaults on the underlying mortgages, sans government intervention. It is precisely at the point when one would need such credit insurance, a crisis, at which the insurer would be least able to pay, since homeowners tend to default in a highly correlated fashion.  

Therefore, since the promise of credit protection may be illusory in times of crisis, it heightens distortions in interest rates and creates credit shocks rather than dampening shocks to the financial system. When optimism abounds, market participants overestimate the true credit protection that Fannie Mae and Freddie Mac are able to provide with their leveraged balance sheets.  They bid up mortgage-backed securities bundled by these firms to unrealistic levels, do not correctly discount the risk that the GSEs might not make good on their promises of credit protection, and narrow credit spreads.  This creates a debt bubble, as we have seen, and heightens market instability.

In contrast, the former unquestioning confidence in such credit protection has been replaced by a view that it could be meaningless without explicit government guarantees. Rather than increasing market efficiency, the real possibility of meaningless promises is destabilizing and inefficient.  

Policy makers forget that in today’s world, capital is everywhere to be found. Investors do not need highly leveraged institutions to provide the shabby semblance of credit protection. Investors crave more information in tandem with more simplicity in order to decrease uncertainty and to better evaluate credit risk. Risk is not the issue. Uncertainty is the issue.  

The logical solution is for investors to bear the full credit risk without any semblance of credit protection (after all, isn’t that what investment means, bearing the risk of loss?!) and to charge an interest rate which is compensation for the risk assumed. This spoiled, ridiculous concept that we can eliminate risk by having it born by financial institutions which are themselves highly leveraged is the adult version of the tooth fairy.

If the GSEs are allowed to collapse, interest rates will immediately adjust, as they have started to, to account for the real credit risk of the underlying mortgages. These higher interest rates, in the longer term, will drive investment in residential mortgages better than any GSE. Such a free market solution would make mortgage securities easier to value, free from the uncertainty that leveraged GSEs introduce into the financial system. 

Anyone who argues that we have insurance in the physical world, which generally works quite well, and that therefore insurance in the financial world is no different, is living on fantasy island. Despite the musings of the chaos theorists,  there is absolutely no correlation for an insurer between snow damage in Alaska and between car accidents in Florida. In the financial markets,  the effect of leverage creates correlations between totally divergent assets and geographies. Real estate may be local in nature, but because mortgages are usually handled by large national financial institutions (whose bankers, like lemmings, seem to get the same dumb ideas all at once when they do something dangerous like talk to each other on the phone, or golf at the country club), correlations become national and potentially international in scope. 

Humans, unlike weather systems, behave like sheep. And there is nothing real about real estate in any country in which it’s financed primarily be debt. As we have seen, it is then a financial asset which derives a large part of its value from the cost of financing. And if the cost of financing is distorted by promises to pay which may not be kept,  the reliance on such unkeepable promises should not be encouraged in the financial system.  

Furthermore, it unintentionally acts against the original purpose of the GSEs, which is to make housing more affordable. Even if the government decides, as recently suggested in the media, to explicitly back Fannie Mae and Freddie Mac’s obligations,  this will perpetuate the very distortions in the bond and real estate markets which have lead to the current subprime crisis.

By distorting interest rates downward, it makes the price of real estate more expensive—and accomplishes exactly the opposite of the GSEs original purpose,  by making real estate less affordable to the very people GSEs are meant to help. Politicians are behaving disingenuously when they claim that propping up the GSEs helps potential homeowners. The subprime crisis has done more to make real estate cheaper in this country than any government program.

Any bailout of the GSEs would not be about homeowners. It would be about charity to financial institutions and investors who have not behaved logically and stand to lose terribly due to sloppy decision making. I like to call it affirmative action for the rich and stupid. 

Disclosures: Harry Long does not currently have long or short positions in FNM or FRE. This could change at any time.