Wednesday, October 29, 2008

1% Money

...And interest rates have been cut again.

  • 1998. Asian currency crisis. Rate cut. Dot com bubble.
  • 2001. 9/11. Rate cut. Housing Bubble.
  • 2008. Sub-prime crisis. Rate cut. ______ bubble.
Wish I knew what _____ in now, sell before the curve gets vertical.

Tuesday, October 28, 2008

Asset Bubbles, Cheap Money, and Leverage

Ami sent me an article about how the big banks are not re-loaning their TARP money to those in need. This doesn't surprise me, and it means the TARP money isn't expensive enough.

The whole idea of a capital injection is that it puts tax payers and banks on the same side. If we just buy toxic assets, banks that survive make a profit while we (taxpayers) have junk on our hands. If we buy equity in the bank and they are profitable, we get our money back and then some.

But our goal as tax payers is not to be speculators in distressed financial stock - it is to keep the banking system from melting down. So if a bank has enough money to go on a shopping spree with TARP, the "cost" of that equity isn't high enough. TARP bail-out money needs to be painful enough to existing equity holders that they'll use as little of it as they can.

I've done plenty of ranting about the various fire drills we've been through during the bail-out, but what about the bigger picture? Here's a thought: a return to "healthy" lending levels may not be healthy at all if our previous lending levels were way too high.

Right now the Fed is thinking about whether to further cut interest rates. Ignoring the important question of whether further rate cuts will do any useful short term good, I would suggest that too much capital isn't a useful thing. I am a fan of Mark Cuban's blog, and he says it better than I can in this post.

Cheap money means lower risk premiums, higher leverage, and it makes all sorts of great things possible:
  • Leveraged Buy-Outs. (Is this really useful? Ask the employees of Linens N' Things.)
  • High Leverage Ratios. (Worked well for Bear Sterns. Heck, it worked great for LTCM!)
  • The Carry Trade.
At some point cheap capital doesn't cause us to work more efficiently, it causes us to spend more time playing games with cheap capital.

We've had an internet bubble, a housing the way out of the mess really to lay the groundwork of another bubble?

Monday, October 27, 2008

ETFs for a Crazy Market

I like ETFs as a way to buy an index now (as opposed to an index mutual fund) for two reasons:
  • The ETF market place appears to be very competitive - you'll find more funds with lower expense ratios. Last year when I went looking for bond funds Van Guard was the only one offering a truly low-cost bond index. A number of larger players are in the ETF space, forcing expense ratios down.
  • When you buy an ETF, you get the price as soon as the transaction completes, which is to say, it's pretty close to what you want. When you buy a mutual fund, you put the order in during the day, the day closes, then the price recalculates, then maybe you eat the day's gain or loss. Normally this is a non-issue (and if you have a disciplined approach and simply buy mechanically at a set interval, then who cares). But if you are like me and have to make your buys by hand (I have a SEP-IRA, so no automatic anything) then there's really no reason to be eating a day's gain or loss in the internet age.
Of course, ETFs let you "trade" indices and I can't advocate that. If you want to gamble, you can at least get free drinks in Vegas.

Thursday, October 16, 2008

Solar Bubble

I have heard people say that clean energy is the next bubble - over-investment in solar, etc. will cause a bust.

The thing is, bubbles have gotten a bad name, just because this one nearly destroyed the world economy.

Consider the dot-com bubble. Looking back we remember the idiotic stock prices for companies whose business plan was "take random consumer good X, grab 1% of the market via, become bajillionaires", or better yet "lose money on every tranasaction, make it up in volume".

But there is another aspect to an investment bubble. A technology bubble simply means we have overshot and put too much capital to work on the new frontier, whether that be railroads, the internet, or solar panels.

One result of the mis-allocation of capital is chaos in the financial markets; if you look up bank panics on wikipedia, you'll see that what we have now is a period of relative calm compared to the second half of the 19th century, during which we have the bank panics of 1873, 1893, 1901, and 1907. One of the main cause of those first panics was massive overinvestment in railroads and the instability of stock prices linked to that sector. (Really rich people doing really naughty stuff is another cause.)

But another result is really cheap infrastructure! In the case of the 19th century, all the railroads you can eat and then some - in our case, really cheap fast internet. (You'll hear bloggers talk about "dark fiber" - that's fiber optic line put down during the dot-com bubble that still hasn't been used, waiting for someone to buy it at bottom dollar.)

The solar people are talking about reaching "grid parity" - that is, the day that solar becomes as cheap as fossil fuels. What would happen if we over-invest and they over shoot? Cheap solar panels for all! To me, this would not be a bad thing. A glut in production would help make solar significantly more competitive - we'd effectively have market-driven dumping of solar panels which would help drive a conversion to renewable energy (which I believe is in the long term very good for the US, and even the whole world).

The housing bubble is so destructive because we all depend on our houses having relatively constant value to keep our lives running. Sector bubbles are only destructive if:
  • The sector long-term over-extends. This did not happen in the dot-com bubble. For about a year I had a lot of friends emailing me about work, but the surplus of software labor got mopped up surprisingly quickly. The investors were right about the growth of the web, just not exactly right.
  • The asset price is tied to people's financial security.
On this second point, I see it like this: people's retirement security should not be tied to stocks, because stocks sometimes lose a ton of value very rapidly, and don't get it back for a long time. We used to say people should be 100% out of stocks by retirement age; then the 1982-2000 bull market tempted us with greed and complacency.

Food for thought: can you imagine what would have happened if we had gone through with Bush's (idiotic) plan to let people treat their social security taxes as a 401K (and invest it in stocks)?
  • For one thing, a lot of that money would have flooded into the stock market, pushing up peak valuations significantly higher than the 14k dow* we saw.
  • We would still have had the pull-back when the debt markets blew up. We would have just fallen a lot further.
  • That would mean an even larger contraction in bank would have been this credit crisis on steroids. Would we have survived it?
If there are two lessons for retirement finance from this whole mess, I think it is this:
  1. Given 50% of stocks held by those over 50 and the massive volatility in the market, I question whether it makes sense to give the average American more choice in how he or she allocates his or her retirement money. I'm all for freedom, but we have to ask: were we all better off when we got defined-benefit pensions? Have we just been tempted by the possibility of riches into accepting the risk of losing all of our retirement? When the market tanks, do a lot of people not say "thank God for social security"?
  2. The financial industry is really good at taking our money....see all of the fees and other such rip-offs that go along with 401ks. The only winners of privatizing social security would have been the mutual funds that got to take 2% of our retirement money every year.
I realize there are serious philosophical questions here about personal and collective responsibility...a crisis like this makes us re-evaluate our principles. This is good! Our previous principles might not be wrong, but it's good to question them and think hard about them; the rules of the finance game are set by all of us to meet a greater good - they are not immutable laws of physics. We all need to think hard abou what kind of world we want to participate in creating.

* I don't think the dow is a very good measure of the stock market (and the stock market is not a very good indicator of much of anything, except for the current market price of stocks), but the numbers (14k, above 10k, below 10k) are easy to remember.

Tuesday, October 14, 2008

A New Member of the Family

It was only a matter of time before a kitten followed Lori home from the vet's office. This is "Nubblet".

Nubblet really, really likes to sleep on my laptop keyboard - perhaps because the MacBook Pro runs pretty hot and keeps her nice an warm.

I'm on TV!

Saturday, October 11, 2008

$700 Billion is Not That Much

I admit to having ranted about the bailout and, in doing so, tossed around the number $700 billion like it is a really big number. And it is. It is more money than I have - roughly $700 billion more! But a few thoughts to put this in perspective:
  • $700 billion is about 5% of GDP, at least by last year's numbers. That's not that expensive; the average banking system collapse usually costs a country 13-16% of GDP, depending on whose research you look at, and sometimes a lot more.
  • The worse things get, the cheaper it becomes for us to bail banks out. This is the perverse nature of the world economy; because US Government debt is still considered the safest of the safe, every time the news gets worse (requiring more bailout money) the financing our government pays on bailout money gets even cheaper.
At one point the real return on T-bills went to zero - that is, people would loan the US government money for nothing! At that rate, we can afford to bailout the titanic with a bucket.

The scenario that scared me most about a year ago was that we would hit this crisis and a dollar crisis at the same time, and the fall of the dollar would make government financing very expensive. But that hasn't happened; this graph shows the Euro falling relative to the US dollar as things get worse. As much as people are worried that the US is in for some pain, they are more worried that Europe won't be able to apply the right medicine.

To quote Alex Bloomberg from "This American Life", the worse the US Government does, the more people want to loan us money. It's a strange, strange, strange world.

Friday, October 10, 2008

Let's Buy Us Some Banks

An apparent trend in the various bail-out plans in the US, UK, and Europe: whatever one country does, all of the other ones have to do. Ireland, for example, was one of the first to start guaranteeing all bank deposits, and their move started to pull cash away from the UK. In the end, every country will have to adopt the strongest safety net of any country to prevent a flight to safety.

It also looks like the US will actually buy some banks. This is a good thing for three reasons:
  • How much do we pay for a toxic MBS? No one knows. There is no market for them. How much do you pay for a bank? That's easy, there is a stock price. (It's not real high, but it does exist.)
  • If we are going to give the banks some money, what do we get in return? If we buy a piece of the bank, we get a piece of their profits should they survive. No taxation without representation, so to speak.
  • The only way a bank gets more capital to invest when we buy an MBS is if we pay too much! (If we pay the amount they have "on the book", then the buy-out looks like a net change of zero for them.) So when we buy toxic assets we have to overpay or hurt the bank. By buying the bank itself, the bank can do better.
Of course, this sort of sucks for current bank management and current bank investors. We should not care! The bank lobby hates the idea of tax payers having equity, and that alone is an endorsement in my mind.

The bank lobby, in trying to claim that buying the banks is a bad idea, say that this would scare away outside private investment. George Soros, who is the kind of outside investor we need, disagrees:

And of course I reiterate what I've said before...besides the problem of over-paying for toxic assets and not knowing what to pay for toxic assets, the government shouldn't own mortgages that are in high default - too much political pressure to not liquidate the houses by foreclosing. I hate to be in favor of foreclosures, but there is no light at the end of the tunnel until we work the sub-prime crud out of our system - delaying that process only makes it hurt longer.

Other ranty points:
  • McCain is crazy to want to lower corporate taxes - they just had record profits for years...why would they need lower taxes? Money doesn't grow on trees! They're not going to do more business with lower taxes, they're just going to pay less taxes.
  • I can't tell what McCain plans to do about houses from his web site. The devil is in the details: buying mortgages at face value is a terrible idea - it's a cash give-away to banks, just like TARP if TARP buys assets. (It appears that TARP will let the treasury buy assets or equity.) Buying the mortgages at face value is a bail-out to banks with poor lending discipline and, by artificially propping up home prices, stops the market from clearing to sane price levels.
The government does need to provide mortgage financing at good interest rates to credit-worthy borrowers, but banks need to eat the loss on their loans.

Monday, October 06, 2008

Another Good Financial Podcast

There is very little media on finance that is both accessible to a general audience, and comprehensive and thorough in its reporting.

"This American Life" has done a second finance podcast, and it's pretty good: Another Frightening Show About the Economy, which is a follow-up to The Giant Pool of Money.

Thoughts on today's market melt-down:
  1. The stock market has demonstrated clearly that it is ludicrously irrational. Who in their right mind liquidates their holdings when the Dow is down 400 points? (And yet clearly a lot of people thought that that was a good idea today...) A series of financial melt-downs (1987, 1998, 2000, etc.) have made academics question the idea that the market prices stocks efficiently. Hopefully today put the nail in the coffin of an academic model that was pure, simple, and pretty much wrong.
  2. Stocks have to occasionally go nuclear. If they didn't, we'd all buy more of them (since they return more than bonds), driving the price up until the yield was the same as bonds. That extra money you get from a stock is payment for being first in line to be kicked in the nuts when things go bad. Occasional spectacular crashes have to be expected.
  3. If these first two points seem to contradict each other (in point 1, I argue that markets are not efficiently priced, in point 2 I argue that they are), the contradiction comes from time. Over fairly short amounts of time, the markets can do just about anything. The kind of equilibrium of supply and demand that I describe in point 2 can easily be overwhelmed by massive panic, per point 1.
  4. Finally, if you are young and thinking "this bail out is going to cost me", there is a silver lining...stocks have been overpriced, for a while now; the out-sized returns delivered from 1982 to 2000 are due to people being willing to pay more for stocks (and thus the value of stocks being driven up by increased demand). That kind of growth is not sustainable forever - think pyramid scheme. The end result of stock returns due to "demand growth" is overpriced stocks. Stocks have to fall in order to be able to return decent returns. (During the fall, as demand evaporates, stock prices will fall, producing negative returns, even if the economic fundamentals behind the underlying companies are solid.)
I heard a scary statistic on NPR: 50% of equities are owned by people over 50. (This may not be true after today...who knows.) Stocks can be a great investment vehicle for people with a long time horizon, but I fear that too many years of smooth sailing has caused us all to collectively forget just what a stock is and how it behaves.

Wednesday, October 01, 2008

Why I Thought TARP Was Bad

TARP (the "$700 billion bailout bill") is now dead, and the markets had their hissy fit, then bounced back, and are now continuing to be grumpy. I was going to write a "top ten reasons TARP is bad" blog, but that's water under the bridge. But I've had enough people ask me why I didn't like it, let me try to spell out my (highly convoluted) thinking.

My main concern with the entire process of congress trying to get behind a bailout bill is that it's not really clear what problem they're trying to solve. The way I look at it, we have four groups of beleaguered souls:
  1. Home owners who are unable to pay due to the lack of refinancing. Home owners get in trouble if they either overpaid for the house and don't have equity (which means they aren't eligible for a loan large enough to refinance) or their credit isn't adequate in the current climate.
  2. Banks that, due to making poor investments (read: mortgages and their derived products) are no longer solvent.
  3. Companies unrelated to the housing market who are unable to get financing (short or long term) to do business because of problems in the more mundane parts of the credit markets.
  4. Everyone else (let's call them "tax payers") who have seen the value of all of their savings depleted due to a weak dollar. (This group is not usually mentioned as part of the crisis, but I think it is long to leave them out...the dollar has been severely bruised over the last few years, and the treasury spending half a trillion dollars or more is only going to make it worse. Tax payers lose twice - in the taxes they pay and in the value that is inflated away.
Groups 1 and 2 are fundamentally at odds with each other - every bit of relief granted to home owners makes insolvent banks that much worse off, and vice versa...either the home owners pay up (somehow) and the banks' mortgages are good, or they don't and they're not.

I believe that different action is required to address different problems. My issue with the treasury plan is that I don't see any scenario where buying things helps a lot. (That is actually not true - it's close to true though.)

If the treasuy buys distressed assets, then the question is "at what price". If the price is high, this helps solvency (if the toxic waste is worth what the banks thought it was, they're not insolvent), but the tax payers take it on the nose. The government's only alterantive would be to somehow force home owners to pay up - I don't see any way they can do would be water from a rock.

If the price is too low, then this is good for home owners (because the treasury can pass the savings on to the home owners by writing down the mortgage and refinancing) but it just locks in bank insolvency.

If there were some kind of middle ground, then theoretically the treasury could do both. That is, if banks wanted to sell at a lower price than is likely to be reclaimed from holding the assets, then there would be a win-win situation. But if it was likely that the assets would return to that price, we wouldn't be having this crisis. In other words, when it comes to sub-prime the problem is solvency, not liquidity. (If the problem was liquidity, then this could be solved with repos and other loans, and no permanent buying would be necessary.)

I am all in favor of the government buying and writing down mortgages to market price. In that case, TARP is problematic because it doesn't set a clear mandate for the treasury to do that - it lets Paulson pay as much as he wants.

I expect the government to be a very gentle bank -- I can't see the treasury foreclosing very effectively - the political blow-back would be too strong. So I think you can make an argument that treasury shouldn't own mortgage-derived products at all, but for now I'll say that if they do, they need to buy them so cheaply that they never have to put the screws to home owners to pay taxpayers.

There are two groups of economic thinking on the crisis: one group believes the fundamental problem is liquidity. (I am in this camp.) When liquidity is the problem, the solution to insolvent banks is to let them go bankrupt, wiping out equity and part of the junior debt. The assets are then resold to someone who can do something useful with them and business continues. This scheme effectively "clears" market conditions by punshing debt-investors in banks. To me this is more than just acceptable - it's necessary. If we have a policy of bailing out financial institutions in a way that protects debt holders, financial debt will be priced as if it has a government guarantee, and the next insolvency crisis will be a lot worse. All investors earn their returns by buying risk - bond holders bought risk and now they need to collect it.

The other group of thinking is that banks are undercapitalized. In this school of thought, liquidity won't help if there essentially isn't enough money to loan out. TARP could help this in that one solution is for the government to buy equity stakes in banks, something permitted by the bill. But then we get into a big set of problems: does the indication that using TARP is necessary indicate weakenss on a bank that causes a panic? Does the risk of government buy-in at a low price scare off needed private-sector investment? Does government buy-in at a high price protect equity investors that do not deserve protection?

My answer to this is: different solutions for different problems.
  • The fed should continue to use its balance sheet to provide liquidity to "mundane" credit markets (commercial paper and friends). If the fed needs a bigger balance sheet, I'm okay with that; that's one use of government money. Since everyone goes to cash and T-bills when things get scary, expanding the balance sheet seems okay to me.
  • Insolvent banks should be closed down and rolled up quickly and quietly to "clear" markets by wiping out equity and junior debt holders in the financial industry. It has to happen. When we look at the "bubbles" the real bubble was in financial services - that is, wall street making collectively too much mony off our GDP by taking a percent. That can't continue - the financial mechanism is over-built and needs to shrink, and that means losses for investments who bought at the top. No one would have suggested propping up - or Country-Wide!
  • Fanny and Freddie should be used sparingly to provide refinancing in some cases. In other words, the government should continue its policy of subsidizing mortgages. We've been promoting home ownership this way for a long time - we really can't stop now, at a time when mortgage financing is difficult to come by. Fanny and Freddie are a mess, but they're on the books like they always should hav been, so at least we can understand how much we're in for.
Financing would be aimed at home owners who would be able to pay their mortgage if financed at sane market rates (e.g. a fixed rate, not the ugly end of an ARM), and applied in cases where the banks can be convinced to write down the loan to bring the home owner above water.

These points aim to do several things:
  • Keep liquidity flowing to business. We're in for a recession -- that's inescapable and happens any time one sector is massively overbuilt; we couldn't not have a recession given how many people were involved in making houses. We really don't need more houses!
  • Help the market "clear" as fast as possible. There is only so much we can do because you don't know which mortages will be bad until more of them reset. But generally we should aim to let the market find its "real" price, rather than slow the decline. Only once bonds and houses are priced fairly will economic activity resume. (Just watch a home buyer in this market - the big fear is "what if we haven't hit bottom yet".)
  • Prevent a foreclosure spiral in housing prices. The danger is that foreclosures force housing prices to artificially "undershoot" to a lower-than-bottom price, which causes foreclosures that otherwise would not have happened. The government needs to ensure that there is enough mortgage lending to prevent this from happening due to a lack of credit.
So there it is. In my next blog I'll solve world hunger.