Saturday, July 30, 2011

Default: Won’t Happen. Downgrade: Fear Not; Our Best Generals Are In the Field!

Anyway, what’s a rating on US debt mean?

While one might think this topic is far too serious to find humor, let’s start with a quote from the posting “Isn’t it ironic.” It applies to all of us: “I doubt they’ll figure it out until they learn to laugh at themselves.” The posting goes on to say: “The quotes were included because you can’t make this stuff up.” With that introduction let’s look at some news.

This report is from THE WALL STREET JOURNAL (7/29/2011), but similar stories appear on Associated Press’s wire and in other newspapers. The article is entitled “Lending Markets Feeling the Strain.” It’s worth referencing because it contains reports similar to those summarized in the headlines presented below. However, this posting isn’t about the steps being taken by financial institutions. It’s about the downgrade. With all the doom-and-gloom predictions floating around, it’s good to first laugh at ourselves. Let’s start with a laugh.

With that in mind here’s the quote: “In recent days large Wall Street firms that dominate bond trading … have held conference calls to discuss the consequences of a potential default on the markets…..Executives of big banks have spent hours briefing regulators on their plans….In a similar vein, “SIFMA [Securities Industry Financial Markets Association] has told the Federal Reserve and the Treasury about its plans….

The Fed reports, “We expect to be able to give additional guidance to financial institutions when there is greater clarity….” One more for good measure, “The Office of the Comptroller of the Currency, which regulates the nation's largest banks with the Federal Reserve, is working on guidance to address issues arising from a failure to extend the debt ceiling."

Envision the discussions. Regulator to financial institution: We need to be sure you have a plan to conduct your business in an orderly fashion even though we don’t conduct our business in an orderly fashion. Once we figure out what we’re doing (i.e., get clarity) we’ll tell you what we think you should do (i.e., give guidance).

In an exchange like that, at some point someone has to burst out laughing. Unfortunately, it would probably be The Hedged Economist. Thus, in the posting “Who’s Crazy?” The Hedged Economist ruled out starting a bank. Bursting out laughing would be totally inappropriate. Further, someone would probably interpret it as laughing at them. If the regulators think one is laughing at them, one could lose one’s charter or end up regretting one ever had the charter. But, like was said above, “laugh at ourselves.” No one is laughing at anyone. We put well-intentioned, smart people in absurd situations.

Now, let’s get back to what the downgrade risk means.

DATELINE July 27, 2001 (One doesn’t even need events of the days before or after because they’re just more of the same from the perspective of this posting).

Just in, WALL STREET JOURNAL reports from the front!

The battle for financial survival heats up. In “Companies Bracing for U.S. Default,” one observer reports:

“While companies generally expect Washington to resolve the debt-ceiling impasse at the last moment, they are lining up extra sources of financing, and carefully husbanding cash just in case a deal falls through.”

But, “Pain From Debt Impasse Spreads in Markets” confirms not all is going well:

“Worries about the budget impasse in Washington and growing expectations the U.S. will suffer a credit-rating downgrade spread further across financial markets Tuesday.”

New defensive positions are being rapidly constructed. “Money Funds Dial Down Risk” reports on just one such defensive position.

“As European and American policy makers scramble to avert debt crises, money-market mutual funds are reducing risk and boosting their cash holdings in an effort to prepare for a wave of investor redemptions.”

But, fear not. In “Watchdog Sees Financial Weak Spots” our best generals report they’re preparing defenses and are sure they’ll be prepared for the crisis of 2008.

“Federal officials said the U.S. financial system remains vulnerable to shocks and called for better protection in several areas that exacerbated the 2008 financial crisis.”

“The Financial Stability Oversight Council (FSOC), a new body created by last year's Dodd-Frank financial law, said several areas could pose broad risk to the financial system, including a $2.7 trillion short-term funding market used by Wall Street firms and money-market mutual funds. It also warned the U.S. faces risk related to Europe's debt crisis and said U.S. financial institutions need to improve their balance sheets to protect against potential losses.”

They are, however, a bit behind the curve. The repo markets are already showing stress as reported in other stories on defensive positions.

But, FSOC fails to see they may be creating more systemic risk. Financial institutions are pushing back against new regulations, including requirements for banks to hold larger capital reserves. One way to manage reserve requirements is to hold more Treasuries, and to a lesser extent, government agency bonds. The FSOC said the new rules required by the Dodd-Frank law are necessary, and it suggested additional tightening was needed.

Yep, they’re ready for 2008.

Just to add humor I guess, Treasury Secretary Timothy Geithner added that "we must also work to ensure that our regulatory framework keeps pace with the evolving global financial system." But, he’s fighting the last war. Does he realize his Treasury and his irresponsible statements are a big source of the risk to our financial system this time? Doubt the Treasury is a source of the risk? Read on.

One of the markets of concern is the repo market. It’s a concern because it’s about a $4 trillion market that is like plumbing for the U.S. financial system. Why is Geithner concerned? Well, in the repo market, borrowers put up some of the safest securities available as collateral in order to borrow for a very short period, often overnight. As mention the FSOC estimates the short term market at $2.7 and seems to view it as the immediate concern. Treasuries and bonds backed by government agencies are the best collateral.

The collateral is worth more than the amount of the loans. That serves as a form of incentive for borrowers to pay back the loan. The collateral is also protection for the lender against default on the loan. The difference between the value of the collateral and the amount of the cash loans is the "haircut." You may recognize that word since it often came up during the liquidity squeeze of 2008.

The fear is that lenders might demand additional compensation in the form of more collateral for the risk associated with holding Treasuries and agency debt as collateral. That would force borrowers to put up more securities for the same loans. The result would be that banks, hedge funds and investors that rely on debt could be forced to cough up billions of dollars more in collateral.

You say: “Wasn’t better reserves, like Treasuries, what the FSOC was recommending? Aren’t they discussing increasing the collateral required in margin accounts, emphasizing better collateral like more Treasuries?” Well, yes. All those are the right steps for the crisis of 2008. But, this time the battle focuses on Treasury holdings as a source of risk.

Think this folly doesn’t matter? It does. According to Federal Reserve data, Bank of America, Citigroup, J.P. Morgan Chase, Wells Fargo, Goldman Sachs and Morgan Stanley together at the end of the first quarter held $1 trillion in US debt, agency securities and government-backed mortgage bonds. All US commercial banks hold $1.6 trillion. Why? For regulatory capital purposes, US Treasury obligations generally receive a 0% risk weighting, while debt associated with agencies such as Fannie Mae and Freddie Mac are typically at 20%. So, who is out of touch here?

But, you say, “Aren’t people moving to cash? That’s what the reports say.” Well, often the reports include short-run Treasuries in cash although reporters are tightening up their terminology in response to this new crisis. But, cash or money is usually defined along the lines of what economists call M1. That includes demand deposits at banks and dollar bills in circulation. Money market funds and companies are able to go to cash because of a clause in the Dodd-Frank law. The clause provides unlimited FDIC insurance to all funds in non-interest bearing accounts at US-insured institutions. The clause expires on Dec. 31, 2012. Yes, they’re in cash. But, the checking accounts are with the same banks that hold $1 trillion in Treasury and Treasury-backed debt. Does it create a potential liquidity trap? Does it focus reserve management on the asset that is the current source of systemic risk? Yes, to both.

Lest this all seem pessimistic, this Blog in a posting on Thursday, April 1, 2010 entitled: “Beware the risk-free return,” discussed sovereign risk in some detail. It pointed out: “Sovereign entities are not too big to fail. Default isn’t an absolute. There are a lot of ways sovereign risk can be expressed….It doesn’t take a genius to see that a risk-free rate of return is a myth.” We’re just coming to an understanding of that fact. Unfortunately, it might be a hard landing -- a potential hard landing not because it’s suddenly true. Maybe it’s a problem because it’s taking a likely downgrade to force the realization. Perhaps it’s a problem because it was the risk-free-return fiction that facilitated behavior that justifies a downgrade.

All of the steps reported in the dateline from the front are the logical adjustments financial institutions need to take given that there is no risk-free return. Other reports indicate the public is also making the adjustment. If you’re wondering why it’s such a threat, it’s explained in the posting, “Beware the risk-free return.” In the broadest sense, it’s because “much of the intellectual underpinning of modern financial economics has a risk-free cost of capital assumption built in.”

“The concept of a risk-free rate of return is like a cancer that has invaded modern financial economic theory. Usually, Treasury Bills are used as a quantitative expression of the mythical risk-free rate of return. Every time “risk-free” appears in a formula or in print, stop! Ask: ‘What does the author really mean? Are they really saying anything? What concept really should be used? What assumptions have to be made in order for the formula or phrase to make sense?’ All sorts of issues get brushed aside through the simple assumption that risk-free returns are an acceptable substitute for addressing some very volatile behaviors.”

Because so much of the financial system as well as the public have been forced to make the adjustment rapidly, the risk of over shooting is very real. Consequently the volatile behaviors referenced above as brushed aside are made more volatile. Further, they’re all going to surface at once. Other countries have experienced a downgrade from AAA (e.g., Japan in 1998, Australia in 1986, and Canada in 1995), but they weren’t the major reserve currency or the currency used the quote prices for as many commodities. So, the adjustment is much more of a global issue.

The broad acceptance of the fiction of Treasuries as a risk-free return has resulted in many systems built with the assumption hard wired in. They include systems in banks, trading systems, regulatory agencies including the Fed, option pricing models, futures pricing models, etc. Those systems are hastily being “un-hard wired.” There is a high probability someone will mess up and the financial plumbing will break down temporarily. It would seem this would be a bigger risk in the US since other countries, especially in Europe, have systems that already accommodate sovereign debt that no one would ever consider risk free.

That these changes are happening is one threat. The “culture shock” as people abandon one paradigm and adjust to another is another risk. It can freeze people in place or set off volatile behavior in totally unpredictable ways. But, a really big threat arises from the need to make the shift quickly and in a system already under stress. Stress that is arising from regulatory uncertainty and the hangover from the last shift from the housing-prices-always-go-up paradigm. It also doesn’t help that it has taken real concern about default to make the point.

There is also the risk that regulators won’t let financial institutions adjust to the new paradigm; it has costs for the government. They might just keep forcing and encouraging them to hold more Treasuries, the source of the risk. But, ultimately the greatest risk arises from how hard it is to dislodge a good fiction.

Governments and financial markets love a good fiction. But, let’s not dismiss the public. They like fiction too. How many people think the government or a financial advisor can save them from themselves? How many think they can escape the “The Only Truth About Finance?” We may just hang on to a comfortable fiction, deciding it’s easier to go down with the ship than abandon the fiction.

There is another risk. The song “Crazy” starts with, “I remember when, I remember, I remember the day I lost my mind.” Paradigm shifts aren’t easy; some people may find themselves muttering that line, hopefully, in jest. But, more than likely, they won’t feel that the next line fits: “There was something so pleasant about that place.”

Unfortunately, uncertainty is unavoidable; it’s there. It would be tragic if it takes a default, a truly disastrous event, to get people to recognize that fact. Let’s hope the risk-free-rate-of-return nonsense is abandoned without a default. In the short run, the downgrade will be bad enough.

Tuesday, July 26, 2011

The US Will Lose It’s AAA Rating.

So says Pimco's Mohamed El-Erian (July 25, 2011)

Let’s see? Well, the President, the Secretary of the Treasury, and the media say we will default if we can’t borrow more. True or not, and it’s not, an organization that says the only way that they can pay their debts is to borrow more just doesn’t sound triple-A to me, but I’m not a rating agency. There are reasons to raise the debt ceiling, but the ability to service our debt isn’t one.

You also have to wonder about an organization run by people who are either willing to make very irresponsible exaggerations or willing to pretend they’re broke. Then on the other extreme we have people advocating that we declare ourselves broke. When the extremist on the left (like Obama) and right (like Bachman) represent the country, AAA won’t last. It isn’t deserved. It’s just a matter of time.

So sad. Truly a post one wishes was avoidable.

Monday, July 25, 2011

Borrowing For Investment

Leverage is universal; borrowing just wide spread

As the discussion “Truth In Lending” tried to show, once the myths are cleared away, only one reason for consumer loans remains. For a consumer loan to make sense, having something for the time between when you want it and when you could save enough to buy it for cash has to be so great it swamps the substantial cost of the loan. The main cost being opportunity cost.

Similarly, only one reason for borrowing to invest makes sense. That reason is that the return from the investment is expected to be higher than the borrowing cost. At this level, opportunity costs are very focused on the tradeoff between borrowing for consumption and borrowing for investment. Yet, if one looks at some individual’s total balance sheet, one comes to suspect that the preference for immediate gratification drives some investment borrowing. It seems to be overarching. Numerous people are loaded up with consumer debt, and they have appreciable leverage in their investments, some of the leverage acquired by borrowing.

While in previous postings “leverage” and “borrowing” were used interchangeably, when discussing investing it’s better to be exact. Interestingly, leverage in investing doesn’t always require direct borrowing. In fact, leverage can be bought and sold. A decent discussion of leverage in investing would require a detailed discussion of the virtual plethora of methods of leveraging that are offered to investors. That’s more detail than could possibly be presented in anything short of a book, probably a multi-volume book. (That’s why this discussion of borrowing precedes the discussion of options as investments in the “On Investing” series, and options are just one method of leveraging).

So, one myth associated with borrowing for investing is that it is the only way to leverage returns. That thinking is commonly associated with buying stocks on margin. An individual puts up, or pledges, the stocks he or she owns in order to buy additional stock. However, anyone who has looked into establishing an account where options are allowed knows that a margin account is often required. They also know stocks aren’t the only collateral that will be accepted. They probably also figured out that if collateral is required for options, there must be a potential way leverage is involved.

There is an even simpler way to illustrate the distinction between leverage and borrowing. At the individual’s level, one must consider what is bought as the investment. For example, one person buys a stock of a company (or a closed-end fund) that has no debt. Another buys a stock (or fund) that has piles of debt and a high debt-to-equity ratio. Neither individual has borrowed any money, but one has an investment that creates a lot of leverage. This is because the borrowing is on the balance sheet of the company he or she owns rather than on the individual’s balance sheet. (A technical side note: a firm can have financial leverage – actual borrowing – or operational leverage. In non-technical terms, operational leverage is the ability to produce different levels of output, thus revenue, at about the same cost. Clearly, financial leverage is most relevant to this discussion of borrowing).

So, you say, you don’t own stocks. You think that excludes you from the “everyone” in the subtitle and frees you to “tis, tis” those evil bankers and Wall Street types for using leverage. Well, before you take your noble stand against leverage, ask some questions. For example, does your pension fund use leverage or have debt? Be sure to include unfunded liabilities as debt. How about any mutual funds you own or the assets they own? How about owning Treasury Bonds? Does the government have debt? Even a bank account is the obligation of a lender, the bank. But, I digress. Let’s get back to borrowing by individual investors.

Remember the statement above, “They have appreciable leverage in their investments, some of the leverage acquired by borrowing.” To take a realistic view of borrowing to invest one has to think in terms of the individual’s total balance sheet.

To improve the odds of the return exceeding the cost, it isn’t surprising that investors should, and do, borrow in the least costly manner (i.e., shop for the type of loan with the lowest interest rate). Looked at from that perspective, starting an IRA or 401k, or entering a pension plan, before paying off a mortgage is borrowing to invest. So would the first step in financial management, maintaining a rainy day fund.

Borrowing doesn’t require activating a new loan, just sitting in an existing debt position constitutes borrowing. The individual is in a state of “borrowed,” which may murder the English language, but it makes the point. Starting on a retirement plan before paying off one’s entire mortgage makes sense, especially given the current tax code. Maintaining a rainy day fund should be universal regardless of one’s debt position. So, it’s not surprising “wide spread” was used in the subtitle.

However, the quote about consumer and investment borrowing wasn’t mainly directed at unpaid mortgages. The more potentially harmful example occurs when borrowing is combined with confusion about what an investment is. The classic example is when a cash-out refi is used to “invest” in a consumer durable while leaving other consumer debt unpaid. “I’ve got a decent 401(k) and lots of home equity; so ‘investing’ some of the home equity in a new SUV is OK,” is erroneous reasoning that hurt a lot of people, and it didn’t help many, if any. Given the multitude of techniques available to investors to increase their leverage, it almost requires confusing consumption and investment before one finds oneself forced to borrow in order to get leverage.

There were two important words in that last sentence: “almost” and “forced.” The important thing to remember is that all borrowing involves risk. However, sometimes the risk is low, as in the case of a mortgage on a home where you want to live. Maintaining the un-amortized debt on a mortgage may be the least risky as well as the lowest cost way to “borrow” to invest. So, “almost” is important, especially when combined with “forced.” It depends on how one interprets “forced.”

Any form leverage involves multiple risks. Consequently, the alternatives to borrowing may introduce new risks that aren’t acceptable. For example, if one wanted to leverage real estate investment, one could buy a REIT with substantial debt. That could introduce liquidity risk. It involves sector risk dependent on what the REIT holds. If those risks are unacceptable, one might feel “forced” to borrow in order to get the increased exposure to real estate.

One of my favorite examples is people who want to increase their bond exposure. One approach is to purchase a mortgage REIT (or closed-end fund) that holds bonds which the REIT (or fund) pledges in order to purchase more bonds. Annaly Capital Management, Inc. (NLY), a very well-run REIT, is an example. It’s not a bad investment. It holds mortgage-back bonds, primarily federal government-backed mortgage bonds. It pledges those bonds in order to purchase more real estate-backed mortgages and mortgage-backed bonds. It’s not a high risk approach, but it’s not riskless. Since they borrow short, often in the repo market to get the lower short term rates, holding Annaly involves yield curve risk, market liquidity risk in the repo market, and its own trading risk (volatility) as well as the default and downgrade risk on the bonds it holds. If those risks are unacceptable, the investor may feel “forced” to borrow in order to buy additional bonds. But, in reality, borrowing is just preferable.

Nevertheless, it seems surprising that actual borrowing is used as widely as it is. It probably reflects a willingness to accept a risk the borrower understands. There are just too many other ways to leverage using techniques with less risk. Remember most of the alternatives were developed in order to control risk. Sure they can be used to increase risk or reduce it, but that’s because they give the investor control of the risk. However, control may also be a factor. A borrower has direct control over the leverage. Some, but not all, other techniques can involve delegating control of the amount of leverage.

It seems there is something else at work: confusion between, or relative levels of comfort with, cash flow management and balance sheet management. However, that’s a broad enough topic to just note for subsequent discussion.

A disclosure is in order lest this posting could be misleading. The posting is not a tip sheet. Rather it’s an introductory discussion of borrowing to invest. The Hedged Economist has had and may have positions in any of the assets mentioned.

Saturday, July 23, 2011

Blame The Recession On The Neolithic People

The evidence is in; start the trials; pass regulations reining in the Neoliths

The Fourth of July posting, “Whose Future Is It?” was supposed to be about independence. Somehow it touched off a round of the blame game as reflected in “It’s My Party, And I’ll Cry If I Want To,” “More Fireworks,” and “A Clearer View Of The Fireworks.” Well, with tongue firmly in cheek, The Hedged Economist wants to settle the issue once all for all. It was Neolithic Man.

The financial crisis is just an aftershock of boom-bust cycles started in Neolithic time. The culprit was the cycle described in the article “The Neolithic: Boom-time machine” from the ECONOMIST June 9, 2011.

It states, “THAT economic expansion leads to building booms seems to have been as true 6,000 years ago as it is now. When agriculture came to Britain, it led to a surge of construction as impressive—and rapid—as the one that followed the industrial revolution.”
“Until now, archaeologists had assumed that these were built over the course of centuries. Dr Bayliss’s [a modern archaeologist] work suggests they were the product of two booms, each just a few decades long—for the Neolithic seems to have seen its share of busts, too.”

Consider this an error correction. The Hedged Economist’s statement the bubble and bust were mass phenomena was correct. The intended meaning was the current “mass.” It never occurred that the mass was Neoliths. But, you have to wonder, did the Neolith’s have bankers and government officials to blame it on. If not, poor neoliths!

So, now that you know who to blame for business cycles, you can focus on things you can control.

Thursday, July 21, 2011

Truth In Lending

Consumer loans: Beyond the buzz

Just as it’s important to identify what is referred to as myths about home ownership (as is done in “On Investing Part 14”), it is important to identify myths about credit. It’s important for the same reason: believing in myths about credit can result in mistakes that are harmful (as harmful as those discussed in the second and third posting in “On Investing Part 14”). In fact, myths about credit lurk behind the mistakes people make when managing the leverage associated with purchasing a home.

Well, they aren’t the seven deadly sins, but there are seven hurtful myths. Not deadly, but the damage they do is real at both the personal and social level.

First, let’s look at the silliest myth: We are going to have a Consumer Financial Protection Agency. The Federal Government is going to run it. Whoopee! We’re all protected; it’s safe to become those passive, borrowing vehicles Government and Wall Street so want us to be. Ever note that vehicle and victim could be interchanged in that sentence and it still fits? Don’t kid yourself; it’s still your future you’re betting.

We’ve all seen what a wonderful job of managing its finances the Federal Government has done. Yep, let’s all look to them for guidance. Please give me the wisdom not to manage my finances as badly as the people who want to protect them do. Egad, they have the power to tax and enforce the taxes with guns and jail time. Yet, they still messed it up. So, let’s figure out what we can and let Big Brother protect something else. If “take your credit and shove it” is sometimes a rational response to lenders (as in “Whose Future Is It?”), “take your protection and shove it” sure sounds like something to consider.

Second, let’s address the most common myth. It’s the simplest. Many people believe that one can make oneself better off by borrowing. The truth is just the opposite when the borrowing is for consumption. If it’s for consumption, it doesn’t change income. Thus, with income the same and a debt to pay off, the borrower has succeeded in reducing his or her free cash flow. That is close enough to less-well-off to be interchangeable.

In fact, without an increase in income or a drop in what one wants, borrowing for consumption ALWAYS results in using money on items of less value. The reason is that with less income after debt service and the same wants, a smaller portion of those wants can be satisfied. Economists would say the person has to shift to a lower utility curve. In English we’d say the person now has to do without in order to adjust to having less money.

Third, to The Hedged Economist, one myth seems most tragic. It’s not the most common, but it involves otherwise financially sophisticated people. It is because it involves sophisticated individuals that it seems so tragic. Many people apply principals developed for investing to consumption decisions. They are totally inappropriate, and in most cases, wrong when applied to consumption.

For example, present value relationships are appropriate for investing. They do not apply to consumption. A dollar today can be invested with the result that it’s worth more than a dollar paid a year from now. However, there is no guarantee that a dollar spent today will result in more satisfaction, happiness, benefit, or whatever you chose to call it, than the dollar spent a year from now. If a year from now it’s a medical treatment for a potentially life threatening condition that is in question, the treatment has a pretty big benefit to most people: It would be rare to have whatever was bought be worth more than the treatment. But, it’s worse: absent the medical condition, one could still buy whatever it was that one borrowed in order to buy. Thus, what’s relevant isn’t having whatever was bought; it’s only having it a year earlier that counts.

Fourth, we need to note a myth that relates to the myth discussed above. If we don’t, the economist in me would explode. It relates more directly to an old economist favorite than do the other myths. It’s opportunity cost. There’s a double whammy associated with borrowing for consumption: in addition to the costs outlined above, there’s a cost associated with using one’s borrowing power. Think of it this way: by borrowing for consumption, one eliminates the possibility to use that borrowing power to invest.

Not only are they wrong to apply present value to the consumption, they are actually turning it on its head. The current consumption is not only probably worth less, the proper future consumption that it should be compared to is greater by the return the borrowed capital could generate.

Fifth, there’s one myth many advertisements try to conceal. Zero down and no interest for X time period is an effort to promote the idea that a consumer loan can be costless. It’s a lie. Note that nothing said so far makes any reference to the interest paid on consumer loans. Interest is a major drawback of consumer loans, but it’s not the only cost. The costs listed in connection with the myths discussed previously are above and beyond interest charges. Further, the zero down zero due for X time period is a shell game. The cost of capital to the lender is, on average, recaptured somewhere in the transaction.

Sixth, this myth concerns consumer credit rating agencies (TransUnion, Experian, Equifax), and credit scores like a FICO score. Nothing sounds more ridiculous than someone saying: “It’s safe for me to borrow. My credit score is pretty high.” It’s like always driving at top speed and saying that it’s safe to exceed the speed limit because your car can go that fast. Neither credit scores nor a car’s top speed are designed for that purpose.

One of the negative consequences of the Government’s requirement that consumer credit agencies make their files available to the public was that the public misinterpreted why the Government took the action. The public didn’t realize it was done in order to improve the accuracy of the histories. It never changed the fact that credit histories are designed to be of benefit to lenders, not borrowers. It’s classic narcissism to assume credit records are for consumers’ benefit. Just as it’s folly to assume a lender is going to focus on benefits to the borrower, it’s silly to assume the lender’s agent (the credit bureau) is looking after the interest of the borrower.

The simple fact is that credit scores have as much to do with a person’s likelihood of using credit as the likelihood of his or her being able to repay. One of the major uses of credit scores is to plan marketing campaigns. What’s really scary about this myth is, to the extent repaying is considered, the credit scoring system is totally indifferent to what the borrower has to do to repay. Whether the borrower eats cat food in order to repay or sells an asset is irrelevant. In fact, someone who would eat cat food before missing a payment would probably get a decent score.

Seventh, the final myth concerns consumer loans used to buy durables. As mentioned in the last posting, “The Many Roads To Broke,” “Borrowing can take one beyond just ignoring the only truth in finance and actually, in a sense, stand it on its head.” That’s always true of borrowing for immediate consumption. It gets tricky if the consumption is going to occur over time because durables are consumed over time. That confuses people. It doesn’t matter. All of the myths discussed above still apply as do the costs they can imply.

The myth surfaces with statements like: Borrowing for durables is OK: The durable is consumed over time and thus should be paid over time. That is analogous to arguing it is good to borrow today so that you can buy food over time. It just does stand up to any test of logic. It’s consumption. The benefit is consuming it. The saying requires viewing capital only as a parking spot for the ability to consume. Capital, well used, does more: It actually creates the ability to consume by producing things (that generates income).

It also surfaces with sayings like: such loans automatically create a forced saving. No, consumption is consumption: Saving is not consuming. Again, capital, well used, creates the ability to consume by producing things. The reaction should be the same when people say they’re investing in a car, house, Ipad, or any durable. Try responding by asking whether the investment will earn enough to buy the durable from what it earns.

There’s one saying this myth generates that’s factually as well as logically suspect. It’s that one should buy it now because the price will go up. First, note that it would have to go up faster than what could be earned with the money and the interest that will have to be paid. Second, while the price could go up, generally the opposite happens. Envision buying an Ianything or a computer and leaving it in the box for a year or two. It isn’t going to fetch a higher price a year or two later. Ah, you say: technology is different. Is it? Try it with a car, a washing machine, any durable. In some rare instance it may work out, but seldom. There’s a business secret behind model changes and upgrade cycles in durables. Manufactures know they can’t reduce costs fast enough to compete with the declining value of last year’s product. So, they discontinue production and try very hard to make last year’s product obsolete.

So, durable or not, borrowing for consumption seldom is good financial management. Note the sentence says seldom; it doesn’t say “never.” If the loan amortizes much more rapidly than the durable, there is a small chance the borrowing might squeak by. But, such situations are rare enough to be ignored. (The Hedged Economist can’t think of an example other than a mortgage).

It makes more sense to save for durable purchases than to search for such a rare situation. The opportunity costs associated with the search make never borrow for consumption a good financial management principal.

Wednesday, July 20, 2011

The Many Roads To Broke.

Unlike Rome, not all roads lead to broke, but a lot do.

Personally, being broke doesn’t seem appealing. That’s why it seems strange that so many people aspire to it as discussed in a previous posting entitled “The Only Truth About Finance.” However, there’s more than just ignoring the fact that “If you always spend all the money you get on consumption, you will always be broke.” Logicians have a fancy word for it, but in simple terms, the reverse isn’t true. Even if you don’t always spend all the money you get, you can end up broke. One way was mentioned as a corollary: Just spend all you have one time and you get to broke.

There are, however, numerous other paths. Bad investments are one, thus the extensive discussion of investing in previous postings. The path most relevant currently is borrowing. Mismanaging credit can offset prudent attention to the only truth in finance. When one thinks about borrowing, it is essential to remember this quote from “Whose Future Is It:” “The borrower is betting his or her future. The lender is just betting someone else’s money.” So, let’s look at betting one’s future. In the posting entitled, “On Investing Part 14 (contd.): Some old fashion beliefs had a sophisticated basis,” it was addressed as it relates to the most common form of real estate investment, but there is more nonsense said about borrowing than just about any topic.

We’ll come back to the myths; for now let’s focus on broke as it relates to borrowing. Borrowing by itself can lead to broke. That’s very true of consumption loans. But, even with consumer loans, borrowing alone doesn’t make the broke permanent. There’s certainly greater risk with consumer loan than loans used to finance investments. So, consumer loans will be the topic of the next posting.

What’s particularly risky about borrowing is that previous experience where borrowing worked out, isn’t good guidance as to whether it will work out the next time. Each success influences the borrower’s perception of the cost and risk. Thus, success reduces, or biases, the assessment that led to success. That’s true without reference to repetitiveness (i.e., how often loans are taken out). It’s true without reference to scale (i.e., how much is borrowed or how much leverage results from the loan). Those can be viewed as results of the bias; they are symptoms, not the cause.

In fact, on a mass scale, previous success actually gives off the wrong signal. If the logic above is as correct as behavioral research indicates, then mass success creates a leverage bubble. The risk associated with each individual’s borrowing is increased because everyone is successfully borrowing. That’s true even without the demonstration effect (i.e., everyone is doing it, so it must be OK) on each individual’s assessment. Further, those results don’t even take into account the analogous lender responses.

Borrowing can take one beyond just ignoring the only truth in finance and actually, in a sense, stand it on its head. It is the only way to actually spend more than what you make. So, it isn’t too surprising that borrowing is a major road to broke. It is worth remembering the three Ds of estate sales (death, divorce and debt).

Tuesday, July 19, 2011

A Clearer View Of The Fireworks

And The Reader Said, "Say what?"

My comments in the last posting raised the need for some clarifications. By interspersing my comments in a more conversational mood, it may be clearer.

Parts of what you have written seem way over my head, only partly because of not reading some of your citations. I am jealous of your well-roundedness.
It probably isn’t over your head. It’s more my limitation -- English as a first language and all that. As you know, I do much better talking.

The citations have a simple explanation. Often you ask good questions that force one to think about the basis of an opinion. The citations are an explanation of where an opinion is coming from. Besides, one could say: “In the 1950s the Fed was trying to end the wartime practice of buying bonds across the spectrum. The Fed wanted to let the market determine the yield curve. It took a few unsuccessful tries and was very controversial.” However, that hardly conveys the complexity of the decision, the roles of players, or the ideological / theoretical arguments involved. The citation is one way to say,” I’m not projecting today backward; it did happen,” and “there’s more than I am covering.”

The reference to earlier Fed history is just a reminder that the notion that monetary policy can be effective just by influencing the price of credit (interest rates) is historically recent. Before 1930 the thinking was it should channel flows (volumes) as well as costs (interest rates). The “round-up-some-banks” reference just illustrates that just targeting prices has failed repeatedly. So, the “bailouts” aren’t unprecedented. What was new was how it was done: through direct Fed loans to non-banks. Traditionally, that was a Treasury role, for better or worse. That’s the subtler issue.

The entire issue of the Fed’s role probably could have been skipped except that it is going to explain why the Fed is going to lose any semblance of independence. Since I favor a relatively independent Fed, I consider that important.

If the Gov’t steps up in a bailout situation, why worry about whether they are pricing the risk appropriately?
Short answer is that’s what economists do. We worry about allocating resources properly. I confess; I’m addicted. Also, remember the issue was raised in connection with the accounting, not the economics; but as explained below, it’s relevant to the economics in a different form.

To me, it sounds like the old cliché of…arranging the deck chairs on the Titanic. I view the recent Gov’t action since 2008 (and during the 1930s) as a powerful entity attempting to steer the economy back toward equilibrium. The price need not be planned with sharpened pencils. The intended “ends” will be justified by most “means,” except by those who believe they were snookered by the “big boy” who stole his opportunity to capitalize on a bad situation.
Agreed! The consequences of a financial panic are always to be avoided. Like you say, the social accounting makes that clear. Bankruptcies, etc. aren’t pretty.

There is a limit on the “arranging the deck chairs on the Titanic” analogy that is particularly relevant to economists; it’s those pesky opportunity costs. That was my criticism of the Blinder / Zandi analysis of the “stimulus,” the topic of all my postings in September 2009 starting with “Stimulus more or less? A failure not being acknowledged. PART 1.”

[It is] kind of like John Paulson and Goldman’s “Fabulous Fab” (in some respects only).
We all have our part in creating bubbles. Think of all of the factors that contributed. Even the innocuous refi contributed, regardless of whether it was “cash out.” Many people refinanced to get a lower the rate and shorten the maturity. Also, the mortgage players, CITI, BofA, etc. are consistently in the most active list, and CITI and BofA were widely held by individuals, mutual funds and pensions as were Fannie and Freddie and their bonds. A lot of people participated by defaulting the management of their assets to others.

It also seems many people were later on the same side of the trade as Paulson et al without thinking about it. Those who paid off their mortgage in anticipation of retiring, or for any reason, eliminated the long side of the mortgage trade (at a personal level). Amortizing a mortgage is the same process in slow motion. For many conservative investors eliminating a long position is as close as they will come to shorting. More direct examples will surface with time, but the most obvious example is the number of people who cut bank stock exposure. The volume and price behavior of the stocks certainly indicates it wasn’t an isolated few who made that trade.

The Paulson trade was discussed in previous postings on The Hedged Economist in April and May of 2010 starting with, “Sometimes Wall Street provides more entertainment than Hollywood: PART 1 the winners.” The focus throughout was on what an individual investor could learn, and then use. That seems more productive than trying to assess how much blame should be apportioned to each player. To illustrate from personal experience, one of the analysts hired by Paulson had been retired from Fannie and a mortgage insurer (as in encouraged to leave, forced out, or just so discouraged he left). At one, his mistake was pointing out that the organization was taking on too much risk, and at the other, pointing out that reserve provisions were inadequate. How much blame should he get?

I guess I’m just a believer in “racing back to equilibrium…and then re-regulating” rather than letting things run their course. If smart boys took advantage of bad policy, I don’t hold harmless the smart boys. They really aren’t different than smart thieves.
When one says “to equilibrium,” remember Keynes’ point: There are multiple points where the economy is in equilibrium, some of which aren’t very pretty. But, I know what you mean, and it would be hard to disagree.

As to regulation, it seems a stretch to argue regulators are free from some guilt for the mess we are in. They are as likely to make errors as anyone less. In fact, again from personal experience, they were making exactly the same mistakes in many cases. There isn’t a more obvious and currently relevant example than bank capital requirements. Regulators have a long history of lowering them during expansion and bubbles, and raising them during contractions and crashes. So, regulations are hardly a total solution.

Crimes should be punished, but being right and profiting from it shouldn’t be a crime. If it is, we all need to get stupid. That’s certainly not what you’re advocating.

Your last thought… “if more people focused on their own self-interest as in “how to make oneself robust against the inevitable fact of uncertainty,” the asymmetric risk associated with consumer loans would not loom so large” …was a little hard for me to understand what you meant.

I thought about whether to say, "The borrower is betting his or her future. The lender is just betting someone else’s money," again. Or, closing with:

Any loan can involve agent issues. All consumer loans involve one agent (the lender) and one principal (the borrower). In that environment, it seems to me the quickest solution is through the principal -- as in educate the public.

Sorry for the awkward wording.

At the risk of mis-understanding, I would like to give you another thought…
Did you ever see the TV commercial for (I believe) Charles Schwab where the guy, someone who looks like he is successful/smart/wealthy/etc., complains that his broker “can’t figure out how much money he needs to retire.”… “…a vineyard? Give me a break!” I look at that commercial and wonder, if that guy hasn’t a clue, who the hell is supposed to? I know, I know. It was the point of the marketing effort….EVERYBODY NEEDS SCHWAB!

I get a kick out of that commercial too, especially since it describes my situation. (It is a Schwab commercial by the way). It may be that the guy is looking for certainty where there isn’t any. If one plays with the retirement planners (actually simulators) at Schwab, Fidelity, T Rowe Price, and the various free unaffiliated websites on financial education, it’s still a crap shoot. A close look at Monte Carlo methods shows lots of assumptions to question.

But my point is, massive numbers of people just don’t do what they are supposed to do. The reasons are many…lack of education, brain power, desire, time, some are too trusting, and some just don’t care.
There are lots of reasons for sure. What seems curious is the number who ignore the implication of the only universal truth in finance: If you always spend all the money you get on consumption, you will always be broke. A corollary of the axiom is that if you spend everything you have, you will achieve broke. Close behind that is the number who aspire to broke as in: “I want to spend as much as I can,” or “I want to get as many things and experiences as I can.” (See “The Only Truth About Finance,” for more on my take on the issue).

The point of this and the previous comments is that given the magnitude of the challenge we each face, it seems more productive to focus on what we can do, rather than what others did wrong. That’s not to imply a pass for those who commit crimes. We pay people to take care of that. It seems like better resource allocation given those pesky opportunity costs -- especially given that, as you say, massive numbers of people just don’t do what they are supposed to do.

There will always be Bernie Madoff types. Do we blame the successful, wealthy he stole from? Do we blame the system that enabled him to pull it off? Do we even think we will ever put in place solutions that can even stop it from happening again? Shouldn’t a country that claims it is the best in the world stand up to “dis-equilibrium-izers”? (Is that term patented yet? )

Churchill’s comment that “Democracy is the worst form of Government unless you compare it to all others,” seems relevant. We can be good, maybe the best, without being prefect. That’s just an observation, not an excuse for not striving to be better.

The questions about who to blame are one of the reasons I try not to play the blame game. As I said in a recent posting entitled, “It’s My Party, And I’ll Cry If I Want To,” bubble and crashes are mass phenomena. It’s probably impossible to find the blameless.

The overarching point of the discussion of blame is that the time can be better spent focusing on those things one controls. With that, the next posting will return to that theme.

Monday, July 18, 2011

More Fireworks.

Serious questions

While the previous posting, “It’s My Party, And I’ll Cry If I Want To,” focused on blame, economist being a serious lot (or at least they try to be), the focus now goes beyond blame. Blame is still there; it’s just accompanied by a lot of analysis.


The email included this article from FORTUNE, “Surprise! The Big Bad Bailout is Paying Off” By Allan Sloan, senior editor-at-large July 8, 2011 with this note: This article is from the July 25, 2011 issue of Fortune; additional reporting by Tory Newmyer. Since the article is available, the posting doesn’t quote it. The article is worth reading.


Thought you’d like to see this.
Don’t let the accounting get in the way of the economics.
I’ll certainly agree that the “bailout” is apparently producing more in-flow than out-flow, that the “bailout” was necessary to avert The Great Depression II, and avoiding the GD II “saved” a lot of money.

But many unanswered questions remain. First, why aren’t the masterminds that brought us to the economic abyss doing the Perp Walk? Second, the supposed financial Maginot Line embodied in the Dodd-Frank bill to prevent all this from happening again is being scuttled by politicians being bought by lobbyists. Third, the “Too Big to Fail” banks are now even bigger. And fourth, the $42 billion on the government’s new income statement is a pittance compared with the $14.0 trillion on its new balance sheet.

This is no different than a bank “restructuring” a loan to an underwater homeowner. The bank keeps the original loan on its books, enlarges the loan even more, and buys toxic assets from the homeowner. The bank’s balance sheet is now much bigger and much more risky. The homeowner, in the meantime, pays a little more in each installment when compared with the additional loan balance. And viola – the bank says “Yippee … we’re now making money!!”

Accounting is one thing; Economics is another. The sad truth is the true cost of our financial idiocy is actual output being way below potential output. These costs show up as unemployment, foreclosures, curtailed public services, bankruptcies, lower home values, ruined lives, and suicides. These economic costs are not counted in the accounting … and that’s why the “bailout” looks less costly than it really is.

Interesting article. Thanks.

Back in about 1872 Bagehot made a statement to the affect that during a financial panic a central bank should lend freely against good collateral at usurious rates and it would always make money. The Hedged Economist never doubted the loans in total would make money. [See the October 2, 2010 posting, “TARP: A success not being acknowledged.” The Hedged Economist thought the issue was important enough to justify leaving the posting up into November]

If The Hedged Economist had lots of money or could print it, it would have been glad to make some of the loans. But in a liquidity crisis, no one has money. There were specific loans that The Hedged Economist figured were write-offs from the start. That's politics. No big thing.

This blog’s TARP posting didn't try to figure a subsidy value of the loan guarantees. With few exceptions, The Hedged Economist doesn't like government loan guarantees as a policy. They move a liability of unknown size to the treasury. The preferred approach is the cut and dry of either making the loan or not. But, loan guarantees can make sense in a panic.

Three things about discussions of the bailout are of concern:

First, it's frightening to think that a substantial portion of the public still thinks a loan is a bailout. You'd think the deleveraging we're going through would teach the public otherwise.

Second, the number of people who think lenders are, or should be, doing the borrower a favor is fascinating and frightening.

Third, so many people are letting the search for who to blame distract them from solving the problem that it should worry anyone who wants to see the slowdown end. The focus on blame seems to originate from a sense of injustice about the disparity in the risk exposure inherent in loans. "The borrower is betting his or her future. The lender is just betting someone else’s money." But, blame doesn’t solve problems.

Any loan can involve agent issues. All consumer loans involve one agent (the lender) and one principal (the borrower). In that environment, it seems to me the quickest solution is through the principal -- as in educate the public. We’re trying to regulate the agent. It won’t work. Doesn’t matter who is to blame. The incentives for lenders and borrowers to find loopholes are too great.

All valid points.

On a slightly different slant, I want your opinion on this: If the Govt. helps out a “GM” or “AIG” and takes partial ownership, gets them turned around and sells their shares off at a profit, how is it any different than a Kirk Kerkorian-type leveraged buy-out?

Ignore the fact that Govt. prints the money and “KK” rounds up the leveraging. Assume that the Govt. profit allows the newly printed money to fully be destroyed.


First note that the assumption, print the money then retire it, screws up the accounting. Since one can’t calculate the cost of the capital, one never knows whether the turnaround made money. In TARP it is possible to argue the Government loans are a subsidized source of capital, but since interest was charged and there were comparable loans being made (Buffet’s loan to Goldman, for example), it is possible to make an estimate. However, it’s impossible to determine the exact subsidy value without estimating the value of the implied infinite liquidity associated with direct bailouts.

Even the Government includes a cost of capital, although they tend to use Government borrowing costs. They’re clearly too low for the risk involved. So, granted the cost of capital issue exists for all of the Government “bailouts,” it seems like less of an issue when liquidity is the focus than when it’s actually a quickie bankruptcy like the auto bailout. With AIG, The Hedged Economist has repeatedly admonished to follow the money flows. I’m sure the Government will claim a profit, but it may be the same fiction as they apply to the debt (where unfunded liabilities are ignored).

Given that caveat about the assumption, making your assumptions isn’t that big a stretch. Then the first big difference is inherent in all direct government interventions. Government is the only organization that has the ability to use force. The auto industry bailouts illustrate the difference. KK couldn’t force the unions or bondholders to accept his terms although he certainly tried. The bank loans, however, weren’t free of force. Setting aside terms, the big difference was that banks weren’t given the choice of whether to accept the loans. A discussion of why would be a good topic for a book. So, let’s just set why aside and note the use of force.

In many respects, it’s wise to view the Government in the same light as KK. They both act in their own self-interest. One difference between direct intervention and the private sector action answers your question earlier about why the big banks got bigger. Big Government needs big banks to collect big sums of deposits, the only real source of capital, in order to finance big deficits. However, as explained below, in that respect KK is different from banks.

Currently, I’m reading Allan H. Meltzer’s HISTORY OF THE FEDERAL RESERVE, Volume 2. It’s amazingly relevant. The discussion of the Fed / Treasury accord of the early 1950s seems relevant to the “bailouts” and “quantitative easing” debates; it is amazing it doesn’t get more play. The discussion of the debate around the “bills only” shift in the fifties illustrates the difficulty of disassociating monetary policy from more direct market intervention. For most of its history, the Fed has tried to use intermediaries (banks) to accomplish similar objectives.

In fact, going back farther in history, even during the Great Depression, the Treasury was the vehicle for direct capital allocation (e.g., reconstruction authorities even when they were called “banks,” FDIC, Fannie, etc.). The Fed just took on the role of financing the Treasury. With AIG and QE2, the Fed intervened directly. That may not matter to some, but it sure changes the role of the Fed.

Another Economist pointed out that the Fed has a long history of “rounding up banks” when it wanted to allocate capital to a specific organization. Long Term Capital Management is an example we’re all familiar with. During this crisis, Bear Stern via JP Morgan and, probably, Countrywide and Merrill Lynch via BofA are examples. Interestingly, pre 1930s the Fed’s thinking was monetary policy should focus on credit in the private sector rather than in Treasuries.

The difference between direct intervention and the round-up-some-banks approach is subtle; mainly it is the absence of the intermediary. The Fed isn’t elected; technically it is a creation of, but not a part of, Government. The Hedged Economist take is that by directly intervening, the Fed has sacrificed any coherent defense of its independence. So, the method matters. The Fed may have punched a tar baby that it will be stuck with forever.

As commented, in “It’s My Party, And I’ll Cry If I Want To,” if more people focused on their own self-interest as in “how to make oneself robust against the inevitable fact of uncertainty,” the asymmetric risk associated with consumer loans would not loom so large. Then, they might not feel that blame is worth the effort. More importantly, The Hedged Economist could focus on personal financial management without the drop in readers.

Saturday, July 16, 2011

It’s My Party, And I’ll Cry If I Want To

It’s sad

An interesting observation is: one can track traffic on a website. The Hedged Economist website gets more traffic when it’s about policy, especially blame, than when it’s about how to make oneself robust against the inevitable fact of uncertainty. That’s sad. Policy and uncertainty aren’t under one’s own control. Theoretically, each of us should have some control over our own behavior. That was the thinking behind “Whose Future Is It?” and the reason for the multiple postings On Investing. For most people, the biggest influence on their future is their own behavior.

Yet, policy does peak people’s interest, and the blame game is fun. It’s a win-win-win game since bubbles and crashes are mass phenomena where almost everyone is to blame. It’s mass participation (either as players, cheerleaders, or fans) that defines a bubble or a crash. So, everybody gets to blame someone, and they’re all correct.

It’s unfortunate that people seem to forget the management saying: “Don’t fix the blame; fix the problem.” They divert valuable resources from the search for solutions to the search for whom to blame. (They ignore those pesky opportunity costs economists are so fond of). With that in mind, The Hedged Economist put most of the post, “Whose Future Is It?” in a comment on the website referenced in the posting. That elicited an interesting response. The response is reproduced below.

“Why reproduce it?” you ask. Well, bingo, we’ve got a winner. It presents an accurate description of how consumer loans are done complete with editorial reaction.

KNOW10, JULY 4TH, 2011 AT 4:07 PM

@The Hedged Economist: “It seems more constructive to focus on the fact that transactions take two willing parties”
In the housing bubble, it seems more constructive to focus on the middleman. At root, there are two transactions involved: (1) The initial loan and (2) the selling off of the loan. Only one party is involved in both transactions, and it’s the party with the least risk because they take their profit up front in fees at (1) and offload the risk as soon as they can at (2). That middleman is the loan originator. As the Opinion Piece implied, we should focus on “Loan Origination Fraud.”

@The Hedged Economist: “It is not lender’s responsibility to ‘determine who is creditworthy’”
Yes it is. That’s why we have companies like TransUnion, Experian and Equifax — to try to quantify risk to the lender. It is the borrower’s responsibility to present their situation honestly, and it is the lender’s responsibility to make a profitable loan, or make no loan at all, given their best estimate of the risk involved.

But if there is a middle man who can bleed fees off the transaction with little risk — encouraging borrowers to borrow beyond their means (by putting off costs and downplaying long-term risks to the borrower of exotic loan instruments,) and who then can offload the debt to investors by hiding that same risk (perhaps through complex collateralized debt-based derivatives) — well, that smells like “loan origination fraud” to me.
In the end, many of the unwise investors got something of a bailout. Most of the unwise borrowers are pretty much on their own. And the loan originators — well, they took their profits up front, so they’re sitting pretty. That’s where I place the lion’s share of the blame.


Regarding your first point, all that is accurate, but my point is that borrowers can put a stop to it when it’s not in their interest to borrow. There is no reason a person has to take every loan offered. Further, it makes no sense to be surprised to discover that organizations don’t lend because the loan is in the borrower’s interest. They lend because it is in their interest. A borrower shouldn’t rely on lender to act in his or her interest as a borrower.

I would be, and have been, quick to point out there are “agent” problems throughout. The only place where they don’t exist is at the borrower level when the borrower retains the obligation to pay.

Regarding your second point, we could get into a lengthy discussion of credit rating agencies and what they do, but that would be a distraction. Your final paragraph makes a point I’ve stated differently: “The borrower is betting his or her future. The lender is just betting someone else’s money.”

In the case of Greece, which was what Barry was addressing, there are agent problems on both sides of the transaction.


Again, bingo, we’ve got a winner. An opinion piece from the WALL STREET JOURNAL “Government-Sponsored Meltdown,” presents an accurate description of some more people to blame. Copyright restrictions preclude my including the piece, but this quote should present the flavor. The book and the entire opinion piece present the details.

“With the publication of "Reckless Endangerment," a new book about the causes of the crisis, this story is beginning to unravel. The authors, Gretchen Morgenson, a business reporter and commentator for the NEW YORK TIMES, and Josh Rosner, a financial analyst, make clear that it was Fannie Mae and the government housing policies it supported, pursued and exploited that brought the financial system to a halt in 2008.”

Whenever blame is the focus, the discussion gets indeterminate. People tend to look for one cause to blame, but our economy is far too big and complex for any one party, even government, to have other than a marginal impact. So, my reaction to this piece from the WALL STREET JOURNAL is the same as my reaction to the blame-the-lender-or-the-originator argument.


Unfortunately, the email has long since been deleted. But, again, bingo, we have a winner. The exchange occurred back in 2009. Basically, the idea that borrowers could be the key to avoiding liquidity bubbles was greeted with an immediate assumption that the borrowers were being blamed. That brought forth a tirade about greedy bankers, loose monetary policy, greedy bankers, federal deficits, greedy bankers, Fannie / Freddie, deregulation, greedy bankers, media touts, rating agencies, global capital markets, greedy bankers, hedge funds, politicians, voters, securitization, and, did I mention, bankers. All guilty as charged.

The idea that any participant in a bubble could stop the madness, as they say, just didn’t compute. It seems foolish to accept the “government / Wall Street view that the populous is an ignorant vessel that can only just accept whatever is poured in it.” But, some people go beyond passive vessels and firmly believe consumers should borrow any money offered. It doesn’t seem to occur to them that the populous has to be the source of capital. If the populous should never say no to borrowing, where is the capital supposed to come from? Granted, if consumers should always borrow, they are off the hook, but bubbles can’t occur because there’s no capital. No capital sounds a lot like broke.

Since a bubble did occur, and lenders are paid to lend, borrowers seem like a good candidate for stopping the madness. Why consumers rather than other participants? Well, many of the other participants are paid to play, cheerlead, or be a fan. The consumer, on the other hand, is betting his or her future. They’ve got skin in the game, as politicians like to say, and no matter how one slices and dices it, everyone else is playing with other people’s money. It matters only marginally whether it’s investors, depositors, stock owners, or taxpayers who foot the bill; it’s other people’s money.

The July 4th posting closed with “Now watch the fireworks.” Next posting will be more fireworks. Blame is so much fun. It’s better than fireworks.

Sunday, July 10, 2011

The Only Truth About Finance.

It really is the only universal truth, but that didn’t seem as catchy.

One can learn a lot about finance simply by looking at what is true by definition. Ultimately, definitions provide the only true axioms in finance. Everything else is behavioral. So, what axiom is universal, always and everywhere true? Surprisingly, it’s a truth that’s often overlooked. If you always spend all the money you get on consumption, you will always be broke. A corollary of the axiom is that if you spend everything you have, you will achieve broke.

If you’re broke, it isn’t that you earn (are given, win, etc.) too little, and it isn’t that you spend too much. Those are just excuses for ignoring the only axiom in finance. Being broke may be justified, and there shouldn’t be any stigma attached to it. Most people are broke at one time or another in their life. The Hedged Economist was very broke at one time, but I had one asset many people refuse to accept. I accepted the truth of the axiom.

However, many people view being broke as an objective, as in: “I want to spend as much as I can,” or “I want to get as many things and experiences as I can,” or the most insane variation, “I want to spend it all before I die.” Egad, don’t they realize that once they’re dead, they won’t regret not spending it all? Really now! Being broke may be a legitimate goal while living, but to aspire to it as a corpse seems a bit weird. It’s equally silly to aspire to consuming all you can, and then to complain about being broke. Not being broke inherently involves consuming less than you could consume.

If one dislikes “broke” enough, two other behaviors that economists often view as axioms become a little less absolute. They are: (1) wants, desires, needs, or whatever you call them, are unlimited, and (2) resources / incomes are limited. The implication is that one can never have everything one wants / needs. In the long run, that implication is probably true, but it ignores a number of important considerations.

First, the adjustment to changes in either resources (income) or tastes (wants) is not instantaneous. There can be temporary periods at what economists call "local satiation points" where one exists in a state of contentment. The “never have everything one wants” implication gets particularly awkward since research seems to indicate that contentment isn’t related to levels of resources. In fact, without reference to resources, it isn’t related to wants. Furthermore, other than in the short run, contentment doesn’t seem to be related to changes in either.

Second, “wants” has to be so broadly defined that the statement loses any operational implication. People save so “wants” has to include anticipated future wants. People may want leisure. That’s one explanation economists use to explain why at higher wages people may work less (the backward bending labor supply curve when it occurs at a society level). People may want security, and security can be achieved in many ways, some of which are only marginally related to resources.

Most importantly, people confuse the statement “one can never have everything one wants” with the statement “you can never have enough.” The two statements have very different implications. Confusing the two statements can be the difference between being content and being unhappy.

So, let’s stick to one universal truth.

Monday, July 4, 2011

Whose Future Is It?

It’s Independence Day; happy 4th of July

Barry Ritholtz of Fusion IQ wrote an interesting piece entitled, “First, Blame the Lenders.” It discusses the Greek mess, but this quote is worth discussion in-and-of-itself:

“Which brings us back to the lenders. What is their role, if not to exercise expert judgment? If they cannot independently determine who is credit worthy and who is not, then why do they even exist at all? We might as well leave piles of money around and ask borrowers to self-regulate their appropriate credit limits.”
“…it is the lender’s job to assign credit, to determine who has the ability to service the debt and who is a bad risk. Indeed, lenders have legal and fiduciary duties to their shareholders, capital sources and regulators….[borrowers] have no such obligations.”

Interesting perspective. It seems more constructive to focus on the fact that transactions take two willing parties. I don’t share the government / Wall Street view that the populous is an ignorant vessel that can only just accept whatever is poured in it. If you are a borrower, it doesn’t seem wise to assume that it is the lender’s responsibility to act in your interest. The lender’s “legal and fiduciary duties” are no more important than one’s obligation to manage one’s own affairs. Yes, one can rationally say “take your credit and shove it.”

It is not lender’s responsibility to “determine who is credit worthy.” That’s the epitome of conceit if they think they determine it. They can’t even guess it. Each individual determines their own creditworthiness by their behavior. Perhaps more focus on education about credit and less on blame would be advisable. It would definitely be of greater benefit to the public.

If one looks at this from a macro perspective, one comes away with a very different view. Credit is originated when someone doesn’t consume (spend) all the income (goods and services) one produces. Who does that? It isn’t the government, businesses, or banks. The consumer sector is the only sector that historically produces more than it earns (i.e., saves). Consumers failing to save can only be offset by borrowing from foreigners (i.e., trade deficits) or brief periods of government surplus (i.e., government debt reduction). Neither can be sustained indefinitely.

From this perspective, one is very likely to conclude that it is more important for consumers to manage their use of credit than it is for bankers and other lenders to manage consumers. With that in mind, this will be the first of a few posting on leverage, an issue ducked in previous postings.

From a personal perspective, whose future is it? Every consumer knows the answer. The borrower is betting his or her future. The lender is just betting someone else’s money.

Now watch the fireworks.