Sunday, January 25, 2009

Will the Paradox of Thrift Pound Pensions?

Sunday mornings are reserved for political news shows. I start off with ABC's This Week, then I move around to CNN and other shows depending on the topic being discussed.

The big topic these days is President Obama's aid plan and how it will stimulate the U.S. economy:
President Barack Obama met with his economic advisers Saturday after he asked Americans to support his economic package as a way to better schools, lower electricity bills and health coverage for millions who lose insurance.

The two-hour session in the Roosevelt Room focused the proposed $825 billion economic stimulus package that Congress is considering. The group also discussed the upcoming federal budget, Obama's first chance to shape the country's spending amid a recession that lost 2.6 million jobs last year, the most in a single year since World War II.

"Our economy could fall $1 trillion short of its full capacity, which translates into more than $12,000 in lost income for a family of four. And we could lose a generation of potential, as more young Americans are forced to forgo college dreams or the chance to train for the jobs of the future," Obama said in a five-minute address released Saturday morning by radio and the Internet.

"In short, if we do not act boldly and swiftly, a bad situation could become dramatically worse."

It was the latest appeal from the new president for a massive spending bill designed to inject almost $1 trillion into the economy and fulfill campaign pledges. Obama spent much of last week wooing reluctant legislators -- many from his own Democratic Party -- and weighing whether there's a need for a second economic package, which aides refused to rule out.

That sequel would be designed to assuage Democratic lawmakers who fret that too little of the money is going toward public works projects that would employ their constituents. Others aides are trying to work with Republican leaders to sustain the current bill's bipartisan flavor; the president planned to visit to Capitol Hill on Tuesday to meet privately with GOP lawmakers.

House Republican leader John Boehner of Ohio said his party would continue to push for immediate tax cuts -- "not slow-moving government spending programs" -- in the weekly GOP address.

"We let families, entrepreneurs, small businesses and the self-employed keep more of what they earn to encourage investment and create millions of new private-sector jobs," he said.

Republicans also proposed a tax credit for home purchases, an end of taxation of unemployment benefits and tax incentives for small businesses to invest in new equipment and hire new employees. Boehner was scheduled to make the case for the GOP plan on Sunday morning talk shows; Vice President Joe Biden and Obama economic adviser Larry Summers also planned interviews that morning.

"We cannot borrow and spend our way back to prosperity," Boehner said.

Both parties, though, agree something has to be done.

Manufacturing is at a 28-year low and even Obama's economists say unemployment could top 10 percent before the recession ends. One in 10 homeowners is at risk of foreclosure and the dollar continues its slide in value. On Friday, 1st Centennial Bank of Redlands, Calif., became the third U.S. bank to fail this year.

That harsh reality has dominated Obama's first days in office.

In addition to the president's speech, Obama aides released a report Saturday that outlined exactly what people could expect if Congress supported his proposed economic legislation.

Many of the ideas, such as shifting to electronic medical records and investing in preventive health care, were familiar from Obama's two-year campaign for the presidency. Other parts added specifics.

Obama's recovery package aims to:

--Double within three years the amount of energy that could be produced from renewable resources. That is an ambitious goal, given the 30 years it took to reach current levels. Advisers say that could power 6 million households.

--Upgrade 10,000 schools and improve learning for about 5 million students.

--Save $2 billion a year by making federal buildings energy efficient.

--Triple the number of undergraduate and graduate fellowships in science.

--Tighten security at 90 major ports.

The plan would spend at least 75 percent of the total cost -- or more than $600 billion -- within the first 18 months, either through bricks-and-shovels projects favored by Democrats or tax cuts that Republicans have pushed.

There is heavy emphasis on public works projects, which have lagged as state budgets contracted.

Governors have lobbied Obama to help them patch holes in their budgets, drained by sinking tax revenues and increased need for public assistance such as Medicaid and children's health insurance. Obama's plan would increase the federal portion of those programs so no state would have to cut any of the 20 million children whose eligibility is now at risk.

As far as the stimulus plan, some economists remain skeptical, while others think we need to proceed full steam ahead with transparency and accountability (I happen to agree with Joseph Stiglitz and Martin Feldstein). I would also recommend you read Robert Skidelsky's article in the Globe and Mail, The unreality of the 'real' business cycle.

The roundtable discussion on ABC's This Week discussed the stimulus plan in detail. George Stephanopoulos invited George Will, Cokie Roberts, Sam Donaldson, Carly Fiorina and Paul Krugman to discuss the stimulus plan. Click here to watch the roundtable discussions.

I honed into what Mr. Krugman and Ms. Fiorina were saying. On the economic crisis, Krugman said that "everybody's forecast calls for an extended slump in the economy...we are not looking for something called a V-shaped recession...we are looking at an L-shaped recovery, which is hardly a recovery at all".

Referring to Christina Romer's paper, Krugman said what Romer found was that "monetary policy works better than fiscal policy but the problem is that we don't have monetary policy because interests rates are close to zero."

For her part, Ms. Fiorina said that the "structure of the economy is very different today" because two thirds of the economy is driven by consumers and small business, which are not receiving credit. She also mentioned that what troubles her about the stimulus package is that we have a credit crisis, consumers and small businesses are not receiving credit and we have a home foreclosure rate that is rising. We have to solve those problems."

Krugman said that the difference between this recession and the one in the early eighties was that "interest rates were high in the early eighties". Moreover, he added that "in the early eighties we had a recession which was induced because the Fed raised interest rates and squeezed housing..and when the Fed brought rates back down, housing came springing back because it was squeezed by those high interest rates.... we are nothing like that now...we are in a situation where none of the things that worked 25 years ago have any prospect of working."

On the financial crisis, Krugman said that the "ultimate problem - the core of it - is that we have a borderline insolvent financial system.We have huge amounts of dubious assets. If you take a narrow definition - stuff that highly that is high likely to go belly-up - it's $1.4 trillion of dubious assets. If you take a broad definition, which includes stuff like auto loans and commercial real estate which is looking worse by the minute, you get up to $5 trillion of dubious assets."

Krugman roiled against the "toxic waste metaphor", saying that these assets do not infect other assets. "Banks are holding a bunch of stuff that may not be worth much and what people want to know is the bank solvent or not." "Until the banks have enough solid assets" they will not lend.

Fiorina disagreed with House Speaker Nancy Pelosi that American taxpayers should get equity in these institutions, preferring that a more important principle is that "conditions be attached" to lend the money into the economy. Krugman pounced on that saying that is like the government "running the bank without owning it".

Fiorina added that "business has a role in restoring confidence in the capitalist system. I think boards ought to put CEOs up for shareholder vote. I think CEOs and boards who come to ask for American taxpayer money should tender their resignations because they've clearly made some poor decisions. I think there are things businesses ought to be stepping forward and doing without the press of political pressure. "She questioned whether the stimulus package will address the core problem, namely that credit is not flowing in the economy.

Krugman ended by stating "this is the kind of the economy in which privately sensible decisions lead to publicly bad outcomes - the paradox of thrift and the paradox of deleveraging. There a whole set of things where if everybody decides to save more, the economy declines, everybody ends up poorer and they end up saving less. This the type of economy where you don't want people to act sensibly."

Krugman is very smart but I was surprised that he dismissed the effects of monetary policy without mentioning that both the Fed and the Bank of England are busy with "quantitative easing"- radical measures to combat deflation and unblock frozen credit markets - by promising to start buying billions of dollars of corporate bonds and other assets. These moves are intended to pump cash into the banking system and restart the flow of credit in the economy.

A long time ago, I predicted the U.S. housing crisis, financial deleveraging, the bursting the the alternative investment bubble, deflation and a world of zero interest rates, rising unemployment and social unrest.

Importantly, I knew interest rates were heading to zero all around the world and they would stay there until the risks of deflation have completely subsided, which is likely to be a very long time (possibly several years).

I was amazed this past week when I read the Bank of Canada's latest Monetary Policy Report where the Bank projected Canadian GDP to decline by 1.2% in 2009 and to rebound by
3.8% in 2010:

Economic activity in Canada is projected to decline through mid-2009 as a result of these global developments. Canadian exports are already falling sharply in response to the downturn in external demand, especially from the United States. Reductions in real income associated with the reversal in commodity prices, together with steep declines in confidence and reductions in household net worth, are leading to a decline in final domestic demand.

The Canadian economy is expected to recover in the second half of 2009 and to grow above potential in 2010, as policy actions begin to take hold, both in Canada and globally.

Support will also be provided from the past depreciation of the Canadian dollar. On an average annual basis, real GDP is projected to decline by 1.2 per cent in 2009 and to rebound by 3.8 per cent in 2010.
There is this firm belief among many investors that aggressive policy actions will work and that the markets and the global economy will rebound in 2010, no later than 2011.

I don't know about you, but as the IMF gets ready to significantly adjust downward its forecast for world growth for 2009, I am starting to get worried here. Let me be specific: what if all these measures just don't work? What if the banks keep using bailout funds to bolster their balance sheets without lending more and consumers use any tax cuts to pay off their debts because they are scared to death about losing their jobs knowing they are carrying a huge debt load?

Worse still, what if all those home owners in the U.S. and now in the U.K. falling into negative equity decide to walk away from their mortgages because they figure it isn't worth paying off an asset that is worth far less than their mortgages? At that point, banks will have to deal with an extra burden on their balance sheets (Read the Ninja's comment on how U.K. banks were just three hours from collapse).

And how long will foreigners keep buying up U.S. Treasuries? Answer: as long as they have to because their economies are getting weaker by the day and no matter what people tell you, decoupling is a myth. In this environment, Chinese excess savings will keep flowing into U.S. Treasuries, propping up the U.S. dollar.

[All of you who are praying for the end of Pax Americana better be careful for what you wish for because at this rate it will not take long before social unrest and global violence hits our shores.]

What this means is that even though they are at historic lows, bond yields are heading lower. There is no bond bubble that is going to burst anytime soon. As one bond trader succinctly put it to me last week: "Do you know anyone that has lived through aggressive quantitative easing? Who in their right mind will short bonds knowing the Fed can come in at any time to buy bonds?"

Great point. We are living in uncharterred territory and anyone who thinks they will make a killing shorting bonds will likely get their heads handed to them. Even the smartest hedge fund managers don't stand a chance against the biggest hedge fund in the world - the Federal Reserve.

And what about the stock market? Given the weights of financials, I am not very optimistic on the overall market. However, I did mention the sectors I am watching as we muddle through in my Outlook 2009.

But as I have repeatedly mentioned, it will take time to see returns in stocks and deflation/deleveraging will continue to weigh down stocks. Importantly, if debt deflation develops, you are better off forgetting about stocks altogether and stick your money in long-term bonds, even if they are yielding next to nothing.

I will end this discussion with a few thoughts from Walter Zweifler of Zweifler Financial Research. Walter contacted me about his firm's new initiative to value credit default swaps (CDS) based on transactions history as well as discounted cash flows.

A short analysis by the Stanford Progressive on the $45 trillion CDS market reveals the following:
Speculation on CDS is made worse because the CDS market is an over-the counter (OTC) market. This means that there is very little transparency to the market, and it also means that issuers of CDS are making a large amount of money in fees.

In turn there is not truly a market operating in the case of CDS, as there is no transparent environment for market forces have an effect. This means that in many CDS, the premium leg is probably not the optimal market price for the contract. The irresponsible use of CDS for speculation can put an individual or company millions of dollars in debt, even when it appears they have limited liabilities.

The overuse of CDS was one of the main contributing factors to the near collapse of AIG. The main cause was that defaults caused AIG to have to pay 18 billion dollars in default leg. As there was no “foreseen” reason to keep large amounts of capital around in case of defaults, the company was unable to meet its contractual demand without government aid. It has been mentioned by AIG executives and analysts that the Financial Services unit of AIG was the most recklessly run and it was the main seller of CDS in the company.

Credit Default Swaps are not inherently evil but have been used by some executives as risky bets or a free source of income without thinking of the possible consequences. Both these positions have failed miserably during the current financial crises and have forced the government to hand out loans along with starting the process of regulating CDS. The government is currently in the process of creating an exchange for CDS, to help rid them of their OTC flaws along with using regulation to help cure unsupervised irresponsibility.

Hopefully, along with regulation, the lessons of the past few months will be pressure enough to cure unsupervised irresponsibility.

As hedge funds, regulators, policy makers and even pension funds struggle to unravel the knot of credit default swaps, I think Mr. Zweifler is on the right track with this new initiative and he has tapped into the expertise of traders and academics to help price these instruments as accurately as possible.

Walter specifically asked me to post this:

Credit Default Swaps are at the center of many institutional portfolios in distress. A reliance on CDS transaction history is a favored valuation technique. Until now “Current Value Reporting” under FAS 157 and other pronouncements relied on discounted cash flow models.

Zweifler Financial Research ( has developed a CDS prototype report which draws on several transaction price publishers and CDS trading desks.

This prototype explains the valuation issues faced in exactly matching trades to a particular CDS at a specific valuation date. Zweifler Financial wants to talk to others who share their enthusiasm for this improved CDS valuation approach.

For the moment I am reluctant to offer a detailed road map. The existence of trading markets and the S&P CDS index are known to the seasoned professionals with an interest in CDS.

I am hoping that responses from this modest insert will emerge based on the objectivity of our reports and the reliability of transaction bases used in arriving at Fair Market Values.

If you can offer a convenient way for me to contact the following target audiences – through your website or elsewhere, it would be greatly appreciated:

1. CPA firms offering compliance with FAS 157 “Current Value” mandates

2. Pension and retirement fund portfolio managers

3. Institutional investors in CDS positions through hedge funds

4. State and Federal treasury departments requiring current value opinions in bulk

5. Law firms focused on hedge / venture fund consolidations and recapitalizations

6. Investment advisors

7. Investment bankers and private wealth advisors

8. Charities and planned giving organizations affected by Madoff or who fear similar problems with their existing accounts.
I want to make it clear that I have no ties whatsoever to Mr. Zweifler or his firm, nor will I profit in any way, shape or form from any revenues this plug may generate his firm.

I just think the CDS mess is huge and initiatives such as these that bring transparency and more accurate pricing should be promoted but as always, you need to do your own due diligence.

As far as the stock market and stimulus plan, Walter shared these thoughts with me:

Most sophisticated academics compare the current markets to the 1980s in Japan, not the 1930s in the USA. Most institutional investors are betting on a support for the DJ at 8000 and the S & P 500 at the current level. Initially the projections were for an economic bottom in this coming summer – That is being moved back to later in the 3rd quarter or later.

The issue to be analyzed in investment strategic terms are – if the markets are similar to the pattern since 1950 then you should stay in equities and ride it out – albeit having taken a sizeable bath. This strategy relies on the Ibbotson & Sanquefeld 1926 – 2007 data, which showed a gain over the long term.

If we are into a “Depression” not a Recession then the shift to principal preservation makes more sense. To adopt such a policy allows for two potential returns – 1) buying zero coupon taxable municipals when the yield curve steepens and 2) then replacing equity positions at a much lower level – closer to 6500 to 7000 on the DJ.

I hope this entry has given you lots of food for thought. We are clearly not out of the woods yet and I know that far too many pension funds hoping for some form of V-shaped recovery will be sorely disappointed in 2009.

They'd better get used to a long L-shaped recovery as the paradox of thrift/deleveraging continues to wreak havoc on all asset classes, including those beloved alternative investments.

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