Friday, September 30, 2011

The Fed Cannot Force Investors to Shift to a Different Risk-Return Profile.

Operation Twist may reduce not increase economic growth

This posting expands on concepts introduced in “Speak Softly But Carry a Big Stick, Dr. Bernanke” and “Operation Twist, Or Is It the Logic That’s Twisted?” However, it is self-contained as a discussion of the application of Modern Portfolio Theory to the issue of Operation Twist. It is a response to the WALL STREET JOURNAL, September 30, 2011 article entitled: “Fed's Twist May Prompt Bigger Turn.” The article is well worth reading if one doesn’t understand how bond investors manage average duration. However, it overlooks how people manage overall portfolio risk.

Macroeconomics needs to thoroughly incorporate the thinking behind the shift from adaptive expectation to rational expectation. The rational response to the twisting of the yield curve is to barbell one’s portfolio. The average duration can be retained by managing the cash to long bond balance. It is the only hope for those who want to maintain a given risk / return profile. This was mentioned on the blog in “Speak Softly But Carry a Big Stick, Dr. Bernanke.”

The effect on the economy surfaces through holding cash reserves rather than productive capital investment. Liquidity trap is what economists call it when people hoard their cash. Operation twist contributes to the very problem a central bank can’t easily solve (i.e., a liquidity trap).

Monday, September 26, 2011

Who Killed Stimulus as a Policy Option?

Wasn’t me. Was it you?

Obama has been out pitching his “stimulus” plan after leaking most of it earlier. It’s kind of hard to believe his rhetoric while paying any attention to how his solutions are playing out in Greece.

That comment comes from someone thoroughly schooled in Keynesian theory. Keynes had a lot to say, but some of it proved wrong. Even when right, it’s dangerous to ignore the limitations, and as the last few postings pointed out, economics didn’t stop with Keynes.

One doesn’t need to be an economist to know who is destroying fiscal policy as a tool. Just review what has been done. Consider the direct results of the Obama programs. Some seem to be effective subsidies for specific industries like auto bailouts (cash for clunkers and cram down on bond holders). Others like housing programs didn’t do much. But, stimulus has to create jobs, preferably permanent jobs. Obama’s first stimulus failed at that by any definition including his own. It’s possible to argue that the failure was then: this is now. That, however, is an experiment we can’t afford. By some estimates, his first stimulus bill cost $280,000 per job even using the administration's inflated estimates of jobs "created or saved." That is over five times the median pay. Using more realistic estimates of job creation, the picture is worse.

As was pointed out in the postings on stimulus back in September of 2010, there is plenty of room for quibbling over what to include in stimulus (in particular see: “Stimulus more or less? A failure not being acknowledged. PART 3”). That posting includes the statement:

“Interesting thing is that reassigning individual measures shifts some items from a financial measure in TARP into the stimulus category and vies-a-versa. (Retain that idea because it will explain why The Hedged Economist uses a larger number when discussing stimulus …).”

Thus, while a range of estimates of the cost per job is appropriate, it should not be surprising that The Hedged Economist’s estimate is at the high end of the range. That alone wouldn’t be enough to discredit stimulus. The problem is those darn rational consumers. The public has completely out thought the Keynesians. Increase the stimulus and the public saves more in order to pay the inevitable higher taxes. Furthermore, drive down interest rates and they’ll just hold cash.

Liquidity trap is what economists call it when people hoard their cash. In the discussion of stimulus back in September 2010, this blog argued the multiplier wouldn’t be linear. Well, it seems the wizards in charge may have succeeded in producing a negative aggregate multiplier, a result that should be darn near impossible.

Rational expectations may be the cause, but understanding opportunity costs is the solution. It may be too much to ask, but sooner or later politicians and Keynesian economist will have to acknowledge microeconomics. There is a distinct possibility people might know what to do with their own money. They may borrow too much during good times, save too much during hard times, and waste some by someone else’s definition, but for goodness sake, they don’t destroy it the way our policies have.

Sunday, September 25, 2011

A Disclosure: The Hedged Economist Does NOT Get Advanced Copies.

Nor was I tipped off of the S&P downgrade

From the posting on Friday, September 23, 2011 entitled “Possible and Advisable Aren’t the Same When Borrowing.” The relevant quote is:

“The problem with their logic [of many defenses offered for stimulus] is that back in the 1970’s and 80’s economist had to modify their thinking (and if they wanted to have a chance of getting realistic results from their models, also change their models). Economists know it as a shift from adaptive expectations to rational expectations. Basically, they had to recognize the reality that people are, in aggregate, NOT stupid. Unfortunately residents of a certain city can always find some pretend economist who will ignore developments in economics since the 1980’s and defend the “greater fool” thinking many policy recommendations require.”

Little did I know that on September 24, 2011 the WALL STREET JOURNAL would run an interview with Robert E. Lucas Jr. He is often cited as the father of the rational expectations in economics. The interview is entitled “Chicago Economics on Trial.” The column on the interview is well worth reading, but a few quotes illustrate the reason for the disclosure.

“Rational expectations is the idea that people look ahead and use their smarts to try to anticipate conditions in the future.”
“The solution, which seems obvious, is to assume that people use the information at hand to judge how tomorrow might be similar or different from today. But let's be precise, not falling into the gap between ‘word processor people’ and ‘spreadsheet people,’ as Mr. Lucas puts it. Nothing is assumed: Data are interrogated to see how changes in tax rates and other variables actually influence decisions to work, save and invest.”

With a tip of the hat to rational expectations, let me repeat my words of caution from “Operation Twist, Or Is It the Logic That’s Twisted?” The caution is “The Fed needs to think about investor reactions, not economic theory.” The market dive after the announcement shouldn’t have surprised them.

Friday, September 23, 2011

Possible and Advisable Aren’t the Same When Borrowing.

That’s an argument that one can’t win.

“Possible verses advisable” is an important issue that far too many people choose to overlook. It was stated fairly succinctly in a posting on this blog on Monday, July 4, 2011: “Yes, one can rationally say ‘take your credit and shove it’.” (See: “Whose Future Is It?” for context.) The reasons why one can’t convince people are many. The postings that follow “Whose Future Is It?” summarized the discussion (fireworks) that resulted. They illustrate one reason it’s hard to change attitudes about borrowing. As soon as one recognizes that all borrowing involves two willing parties, one has to give up the blame game. That’s no fun.

The second reason is less amusing, but it’s very sad. Once one realizes that often refusing a credit offer makes sense, one has to accept responsibility for one’s action. Taking responsibility for one’s actions is also no fun. All sorts of issues have to be addressed. Some people carry it to the extreme: they actually start thinking one should consider whether one can pay back the loan. It’s sad, but there’s a darn good chance that whoever lent the money will want to be paid back. Thinking about paying back a loan takes all the fun out of borrowing: it’s a real “bummer.”

Humbug is not the reason for bringing up paying back loans, and as discussed in “Truth In Lending” and “Borrowing For Investment,” borrowing is often a very good idea. By contrast, putting off thinking about all aspects of a loan is never a good idea. However, many people confuse not having to pay back a loan until later with not having to think about paying it back until later. Once one includes repaying in one’s thinking about borrowing, the problem shifts from how much one can borrow to what can be done with the borrowed money that justifies the cost.

There does seem to be one group that thinks it has found a solution. They congregate in Washington, DC. Need I name names? Witness the new and improved “stimulus” (a.k.a. jobs program) discussion. Washington seems to think they can say, “We’ll borrow on your behalf, but you’re so stupid you can’t figure out you’ll have to pay it back.” Thus, they think they’ll get another chance to squander money on their pet projects. The problem with their logic is that back in the 1970’s and 80’s economist had to modify their thinking (and if they wanted to have a chance of getting realistic results from their models, also change their models). Economists know it as a shift from adaptive expectations to rational expectations. Basically, they had to recognize the reality that people are, in aggregate, NOT stupid. Unfortunately residents of a certain city can always find some pretend economist who will ignore developments in economics since the 1980’s and defend the “greater fool” thinking many policy recommendations require.

Every once in a while a Washington killjoy surfaces. Then one finds reports like these quotes from the September 8th, “Heard on the Street” column in the WALL STREET JOURNAL:
“The threshold for increased government borrowing and spending should be whether it adds to the productive potential of the economy. It is through improved competitiveness that the apparent paradox of an expansionary fiscal contraction is resolved, not, as commonly assumed, via confidence alone. New investments should be judged on whether returns are likely to exceed the cost of capital rather than simply the current low cost of borrowing, a measure that takes no account of risk and is therefore likely to lead to substantial long-term wealth destruction.”
“But no government should be under any illusion that boosting borrowing and spending can provide anything more than a short-term stimulus, and it comes with big risks.”
“Some argue that the low bond yields in some countries show markets are comfortable with debt profiles and are effectively an invitation to borrow more. This is a dangerous delusion that risks a repeat of the mistakes of the boom, when households, businesses and investors were lured by cheap rates into unaffordable mortgages, highly leveraged private-equity buyouts and crazy structured investment vehicles.”

As was pointed out in “Borrowing For Investment,” the cost of borrowing is not the interest cost. The cost is always and everywhere the opportunity cost. When the proper criteria are applied almost all stimulus programs fail to pass muster. They are shown to be the boondoggle that they are.

Monday, September 19, 2011

European markets and Credit Default Swaps (CDSs)

Do they say anything?

A recent email discussion worth posting follows. It’s presented in reverse chronological order.

The Hedged Economist wrote:
Bringing CDSs onto exchanges makes sense if the margin requirements are set reasonably. It shifts all the counterparty risk onto one counterparty (i.e., the exchange). If margin requirements are set reasonably, that's considered a positive. If not, it's a disaster.

The transparency issue is not “cut and dry.” If one buys a CDS privately (i.e., off the market), one knows who is offering the CDS. On an exchange, the counterparty is the exchange. One doesn't know who offered the CDS. It could be any seller or even the market maker.

The reference to Basil III is indirectly very relevant. The issue is capital: how much capital should each type of transaction require. Put differently, the issue isn't CDSs or where they are traded; the issue is leverage. You may have confidence regulators will get it right, but history suggests capital requirements tend to be pro cyclical. This is a topic discussed on The Hedged Economist back in March of 2010 “Regulatory capital and who’s got the money?” It’s hard to figure anything to add to this excerpt: “Increased capital is ultimately the solution. But, timing changes is probably more important than the level. What we know about reserves is that people lower them in good times and raise them in bad times. We also know this aggravates the cycle. Well, surprise, surprise, governments are people; they do the same thing. Unfortunately, the government has a long history of changing capital requirements in the wrong direction over the business cycle. It’s the fallacy of composition writ large. Individual banks are safer with higher reserves, but if every bank raises more capital, oops, no credit even for productive endeavors.”

Banning CDSs wouldn’t accomplish much since it’s possible to construct a synthetic CDS. It’s less efficient than a CDS at gaining a like exposure. Further, saying they are not an efficient hedge and that their information content is questionable is very different from saying that they create systemic risk. CDSs don’t create systemic risk: at most, they concentrate it. The systemic risk originates from the total leverage.

Your argument that CDSs create systemic risk is correct if they function the way advocates say they do. The argument used to justify CDSs is that they reduce the risk of making loans by providing a vehicle that lets the lender transfer the risk to someone who wants to take the risk. Thus, the lender is free to lend more. The argument is that by shifting the risk to people who want it, the cost of getting someone to bare the risk is reduced. That, the argument goes, allows lower lending costs and more credit creation. Since credit creation is leverage and leverage (over-leverage specifically) is the source of systemic risk, your argument is then correct.

However, the presence of leverage isn’t supply constrained. If people will borrow, someone will find a way to lend to them. It may be CDSs, securitizations (squared or cubed), syndications, a loan shark, doesn’t matter. Generally, one party is a principal (usually the borrower) and one is an agent (generally the lender). By trying to regulate the agent (or the vehicle they use), regulators fail, usually for the very reason regulators focus on lenders. The regulators won’t directly tell people who buy credit that it’s a mistake. In the European case, numerous efforts were made to constrain public sector borrowing starting from the basic efforts to form the European Union. The problem is: Who can tell sovereign entities what to do?

That leaves a very perplexing problem. CDSs create asymmetric risk. The only justification for banning them might be that humans don’t do asymmetric risk well. But, the answer to the question: “Who would ban them?” certainly isn’t governments. They’re worse at asymmetric risk than markets as illustrated by “accidental” wars, revolutions, etc. Current economic distress pales by comparison to civil wars, WWI (often referred to as the accidental war), and more than a few revolutions.

There is a very effective way to eliminate the risks created by the asymmetry inherent in CDSs: don’t play; neither long nor short, directly or indirectly. Following that maxim, this may be the most The Hedged Economist will ever write about CDSs. Certainly, you won’t find them discussed as if they were investments.

Right now, most central banks are flirting with systemic risk by betting they can manage the asymmetric risks they are creating. Here’s hoping they’re right. But, unlike CDSs, central banks’ bets aren’t ones an individual can avoid.

Response to the entrepreneur from a person who focuses on the analysis of stocks of firms in the financial industry:
I believe the Dodd Frank Bill regulates them and requires exchange or clearing house transparency.

International financial regulations abound. The Basel III requirements alone are a massive set of new international requirements.

The entrepreneur’s response:
Who would ban them? Last I checked it is a global world. Like all good things CDS are good in moderation, it’s just in large volume they don’t perform as expected.

Response to The Hedged Economist from a person who focuses on the analysis of stocks of firms in the financial industry:
So...if Credit Default Swaps are poor hedge instruments, and introduce systemic risk, they are not useful economically? We can ban them and have no economic repercussions?

The Hedged Economist wrote:

CDSs are an extremely clumsy way to hedge against default on a specific position. The prices can't incorporate the correlation between the probability of default (PD) on the position being hedged and the PD on the CDS. Consequently, they are mispriced. At a cruder level, what is clear is that most CDSs are very effective at shifting default risk from a specific issuer to systemic risk.

There is a more basic problem with CDSs that contributes to the mispricing. People don’t seem to process asymmetric return calculations very well. Either (1) they view large sums of money as worth more than equal to the total of small sums that add up to the same amount or (2) above some number they can’t calculate beyond a general view that all numbers are big.

CDSs do seem to be effective at hedging downgrade risk if and only if priced right. Generally, however, my impression is that getting the right exposure to the CDSs to hedge a position is a crap shoot.

Thus, levels of CDSs on European banks’ stocks contain less information than the change. Change relative to the sovereign CDSs are usually the most informative. In the case of European banks, because the monetary authority and sovereign are separate, the only way to interpret the change is through exchange rates. In fact, cost of a currency swap that would eliminate the currency risk would seem to be the relevant thing to monitor.

Since monetary authorities have taken it upon themselves to intervene based on CDS pricing, there doesn’t seem to be much that this economist can say other than to quote from the August 25 posting: “In economics, Goodhart’s Law states that for policy purposes one can target an economic phenomenon as measured by a particular indicator. However, when one does that, the indicator will lose the information content that would qualify it to play such a role. By targeting the indicator, the policy kills its information content. It no longer conveys the same information about the economic phenomena that one wishes to target.”

My take is that the CDSs represented a highly leveraged bet on two things: the probability of a downgrade, and the probability of central bank intervention. It proved to be a profitable trade on both accounts. Since CDSs are consistently mispriced and there is a feedback loop, a reasonable conclusion is that those willing to risk the leverage are good at manipulating the monetary authority and rating agencies. That may be a good bet, but it’s not one where an economist can add insight.

Response to the entrepreneur from a person who focuses on the analysis of stocks of firms in the financial industry

That's my point, who's writing CDS swaps on sovereign credits and international money center banks and Insurance companies? Seems like a feedback loop.

The entrepreneur’s response

The market knows best. The problem with CDS on banks is counter party risk. Will your CDS pay if it is cotemporaneous with a total financial meltdown?

From: A person who focuses on the analysis of stocks of firms in the financial industry

• September 12, 2011, 1:02 PM ET (Quoting)
CDS Spreads at European and U.S. Banks Getting Scary-Wide
• By Avi Salzman
Investors are pricing a ton of risk into debt protection for European banks and sovereign debt today, as Greece teeters near default and the health of numerous banks hangs in the balance. CDS spreads reached new highs for many of the banks this morning, with investors keying in on French banks in particular. CDS spreads on Societe Generale (SCGLY) hit 450 basis points shortly before noon, up from 387 on Friday, according to data from Markit. At BNP Paribas (BNPQY), spreads jumped to 320 from 275.
Spreads on Greek sovereign debt jumped to 3,787 early this morning from 3,188 on Friday and the mid-2000′s during the crisis weeks in July.
U.S. banks were also hurting, with spreads on Bank of America (BAC) hitting 375, up from 353 on Friday and under 200 at the beginning of August (pre-Standard & Poor’s downgrade of U.S. credit rating). Citigroup (C) spreads swung to 263 from 245 on Friday. Goldman Sachs’ (GS) spread hit 272, up from 252.

Thursday, September 8, 2011

Operation Twist, Or Is It the Logic That’s Twisted?

One can’t force risk taking

Bill Gross wrote an opinion piece in the FINANCIAL TIMES entitled “‘Helicopter Ben’ Risks Destroying Credit Creation.” In it, he discussed the risks inherent in an “operation twist.” Bloomberg summarized the conclusion: “If the Fed seeks to drive down longer-maturity yields, as some are anticipating, then the central bank may ‘destroy leverage and credit creation in the process’.” Basically, Bill Gross argues that a “barbell” approach is a logical response by investors. That should sound familiar to readers of the Hedged Economist. The last posting on this blog, “Speak Softly But Carry a Big Stick, Dr. Bernanke,” pointed out that the portfolio adjustment is only part of the story.

Pursuing a barbell approach is probably important among money managers, but for individual investors, the major impact of an operation twist will be that it introduces more uncertainty. The uncertainty is real. Many individuals sense that we’re approaching a situation described in that posting: “Under that scenario, the net result would be an optimum portfolio composed of just the safe, liquid asset. In the common vernacular, the market participants conclude that not losing is a higher return than any potential positive return. Heard that lately? If not, get the beans out of your ears.” Operation twist contributes to the very problem a central bank can’t easily solve (i.e., a liquidity trap).

The Fed needs to think about investor reactions, not economic theory. Granted, in a backhanded way, economic theory explains the phenomena, but few students of economics think in terms of what actions or conditions invalidate a conclusion. Yet, as pointed out “…the adjustment process necessitates a period where covariances will break down. Why people assume that the covariance matrix is stable escapes this observer. Stability of the covariance matrix seems like a particularly silly assumption when policies that will destabilize it are the current rage.” Operation twist weakens, or perhaps undermines, the assumptions one has to make in order for it to be justified.

The Fed has other less risky options.