Businomics Blog

America The Beautiful: Ray Charles

The most beautiful music of the day (HT to Mark Perry at Carpe Diem)

Financial Stress Moderating, At Least By Some Measures

The measures of financial stress based on short-term markets are looking much better, though bond-market related measures are slow to improve.  The most popular measure of stress is the TED spread, which is the difference between interest rates on inter-bank loans (LIBOR) and Treasury Bills.

We're getting so close to normal that some complacency--but that would be a mistake.  The low TED-spread probably reflects central bank and government guarantees of bank borrowing.

Another measure of stress in short-term markets is the interest rate spread between the safest commercial paper and somewhat riskier paper, which is the difference between A2P2-rated paper and AA-rated paper.

There may be some implicit guarantee helping the spread, but not as much as in the case of bank debt.  This is very good news.

Bond market stress measures continue to improve, but have not yet come down to normal levels.  BAA bonds are investment grade (if you believe the ratings agencies), and we can compare their yields to 10-year Treasury Bonds.

My final measure of stress is the spread of junk bond interest rates over the 10-year Treasury

Economists at the Kansas City Federal Reserve Bank have recently developed a more comprehensive index of financial stress that incorporates 11 components.  The developers of the index, Craig S. Hakkio and William R. Keeton, have written up their results in a good article, which though somewhat lengthy provides a good primer for those who want to learn more.  They don't seem to be posting their data online yet, but the charts in their article suggest a relatively small drop in financial stress since the October 2008 peak.

401k Investment Education

In my spare time I've been working on a start-up business in investment education, initially focusing on helping employees learn about their 401k plans.  Our new website is now up and running: www.abcInvesting.com.  (Some features are not yet operational.)  Take a look and let me know what you think.  There's lots of free information, plus a book available for sale.  We'll soon be offering subscription services that will make investment decisions easy.

A portion of our business is directed at businesses trying to save money.  Here's our value proposition:

If you are a corporate executive who has to cut the employee match, call us now.  We can provide all of the retention benefits of a match, at a much lower cost.

Credit Default Swaps: Self Regulating?

One common proposal for the new financial regime is regulation of credit default swaps.  A CDS is like life insurance on a bond.  (Here's my simple explanation, and my view of what went wrong with CDSs.)  A good example of a call for regulation is an article by my friend Bert Ely, generally a supporter of market forces.  He proposes that CDSs should only be bought by parties with an "insurable interest."  The analogy is to life insurance.  If you and I are not related, you are not allowed to buy life insurance on my life.

I'm about to tell you how the CDS problem is becoming a non-problem, but first let me quibble about the life insurance parallel.  There's a reason that you cannot buy insurance on my life: it would give you a big financial interest in bumping me off.  That would be bad for the insurance company, and bad for my health.

I don't see the problem with respect to corporate bonds.  I buy a CDS that will pay me if Chrysler goes bust.  I guess that gives me an incentive not to buy a Dodge, but I honestly wouldn't know how to go about killing the corporation.  (The owners, though, were able to do it.)  So there doesn't seem to be the risk involved here that there is with respect to life insurance.

So how does the CDS market learn to behave?  The same way we humans learn most lessons: by getting hurt.  The Wall Street Journal has an interesting account of a CDS deal that taught a number of traders an interesting lesson.  Here's the gist of it:

There were some debt securities backed by subprime loans.  The principal (after some losses and prepayments) amounted to $27 million.  The volume of credit default swaps written against the securities was $130 million.  Obviously, most of the folks buying the CDS on this security did not have an insurable interest, they were simply speculating that the bonds would default.

One investment firm, Amherst Holdings of Austin, was writing many CDSs on the securities.  They probably had sold CDSs that in aggregate far exceeded the $27 million of bonds outstanding.  They were paid a high price, often 80 to 90 cents on the dollar.  That is, the investor who wanted to speculate that these bonds would not be paid off made an upfront payment of 80 cents, in the hope of receiving one dollar later.  Take these numbers and multiply by millions, of course.

Then Amherst did a very clever trade:  they bought the underlying mortgage bonds at full value, 100 cents on the dollar, a price that was tremendously higher than a fair market price.  Why would they overpay?  So that the bonds would not go into default.  All of the CDS money, the 80 or 90 cents times millions of dollars, that Amherst received for writing the swaps?  Amherst kept that money.  They lost money on the bond purchase, but more than made up for it by pocketing the CDS payments.

I love a clever trade that is entirely legal and honest.  The folks on the other side of the trade are crying foul, but I don't see the basis for their complaint.

Why is this trade good for financial markets, and good for the economy?  It reins in the use of CDS by those without insurable interest.  If a CDS had been bought by a bondholder, he would have shrugged.  He doesn't care whether the bond pays off or whether the CDS pays off--he's in the same position either way.  It is only those who were simply gambling that got hurt.  Now they have a reason to be cautious.  And their caution comes without a government regulation preventing the instruments from being used.

Why not simply outlaw them?  CDSs have a role.  They make financial markets deeper, and more liquid.  It may be easier for a bond-holder to reduce his risk by buying a CDS than selling the bond.  Or he may not want to eliminate his risk entirely, just reduce it a little.  The CDS offers flexibility.  Why allow unrelated parties to be involved?  It deepens the market.  More transactions, more volume, and generally more accurate pricing.

The bigger principle, as I explained recently, is that many of our past financial mistakes will not be made again.  Re-read what happened to AIG in my earlier post.  Ask yourself how many companies are doing the AIG think now.  I think we've learned that lesson.

New Financial Regulations: Trying to Fix Self-Correcting Problems

In the midst of the banking crisis, the Obama administration is considering sweeping financial regulations.  But before fixing problems with a sledgehammer, let’s assess which of these problems have fixed themselves.  It turns out that many of the private sector errors that helped trigger the financial crisis are not going to be repeated; at least not for many years.  These mistakes are only part of the problem, of course, but the new financial regulations focus on them, yet most of the private sector errors have already self-corrected.

The greatest private sector error was over-optimism in the housing market, which led first-time homebuyers to purchase larger homes than they needed or could afford.  It led people with marginal credit to strive to qualify for a home mortgage. It led individual investors to buy homes either to flip or to rent out.  It led institutional securities investors to believe that mortgage pools were as good as gold, and it led ratings agencies to put AAA labels on bundles of sub-prime mortgages.  However, we do not need new regulations to solve this problem, for now everyone knows that real estate prices can go down.  That memory will last many, many years.

The second private sector problem was a willingness by institutional investors to buy securities they did not understand.  The collateralized mortgage obligations and collateralized debt obligations became terribly complex.  A full understanding requires computer simulations that would dim the lights of a major city.  Investors simply accepted the results of the ratings agencies.  Investor appetite for these securities helped to fuel the lax mortgage lending practices, but what’s happening today?  Securitization has come to a standstill (aside from federally guaranteed issues), not because of regulation but because investors are now scared of anything they do not understand.  When the market for asset-backed securities returns, it will return only for plain vanilla transactions, deals simple enough that anybody can easily understand them.  No one will buy complex pools of sub-prime mortgages for many years to come.

The third private sector mistake was the high leverage of investment banks and hedge funds.  Companies that had historically operated with 10 to 1 debt-to-equity ballooned up to 30 to 1 or higher.  Although the large investment banks have all become bank holding companies to qualify for federal money, even unregulated companies would be more conservative now.  Everyone has seen what happened to Bear Stearns, Merrill Lynch, and Lehman Brothers.  Moreover, the leverage they attained required a willing lender.  In the current environment, no one will lend money to an investment bank or hedge fund that has too much debt already.

Private sector individuals and businesses are not immune from mistakes, but they adjust their behavior to avoid further losses.  In contrast, public sector errors tend to continue.  Fannie Mae and Freddie Mac continue to have government backing with a misguided mission.  The Community Reinvestment Act continues to encourage banks to make high risk loans to people with poor credit.  The tax code continues to encourage excessive leverage, including to homeowners.  Congress and the President should focus their attention to an area in which they can do some good: public policy.  They need not concede that only the private sector made mistakes.  They need only acknowledge that the private sector errors are self-correcting.

Consumer Spending: Savings Will Soon Drive Increased Spending

I've been saying that consumer spending would soon increase.  It has not happened yet, but consumers are now in position to get going.  The key concept is that consumers have not been income constrained, as a group.  In the aggregate, they are simply scared.  They have the income to spend more, but they choose not to.  Here's the month-by-month changes in disposable income and spending since last September (when the economy really started to tank):

Late last year, incomes were down sharply (the orange columns) but spending was only down a little.  So far this year, there have been significant income gains, but without spending gains.  So it is absolutely wrong to say that people have cut back on their spending because they don't have the money to spend.  Certainly some people are in that condition, but not the aggregate mass of consumers.

As a result, the savings rate has risen sharply:

My look at long-run history (see this post) leads me to think that consumers will get back to savings of 8 to 10 percent of disposable income.  Here are two ways to get there: continue recent patterns of saving all income gains for another four or five months, then spend the bulk of the income gains.  That would add a good push to consumer spending, and thus the economy.

The second approach, which I think is more likely, is for the savings rate to come down a bit from the latest spike, like down to three or four percent.  Then consumers would gradually ramp it up to the 8 to 10 percent range.  If this happens, then spending growth will outpace income growth for a few months.  This seems to be how past long-term changes in savings have occurred.  This scenario is very positive for the economy in the next six months.

Home Prices and Consumer Spending

Some friends have been debating the role of housing prices in consumer spending, stimulated by two recent articles in the Wall Street Journal's Real Time Economics blog.  First, Charles Calomiris, Stanley Longhofer and William Miles wrote that effect of housing wealth on consumption is about zero.  Then, Atif Mian and Amir Sufi of the University of Chicago offered a differing view.

I am very cautious before throwing out conclusions that have been tested in multiple ways over many years.  The wealth effect on consumption has been studied since the 1930s, with fairly consistent findings of low elasticity (one to three percent is common).  I quickly scanned some macro-econometric books on my shelf (Michael Evans, Macroeconomic Activity, 1969; Otto Eckstein, The DRI Model of the U.S. Economy, 1983, and Ray Fair, Estimating How the Macroeconomy Works,  2004).  All these guys, very familiar with past research and deeply hands-on in their own model development, have negligible to low wealth elasticities in their models.  Their work also spans several decades.

We must differentiate an actual wealth elasticity from the method of funding consumption.  A person who chose to increase consumer spending and who was acting in accordance with a mainstream consumption function might well have used home equity financing so heavily that it looked like it was housing wealth that enabled consumption.  That's because  mortgage finance was a cheaper (especially net of taxes) way to fund car purchases than car loans. Also cheaper to use an HEQ or cash-out refi to buy furniture or take a vacation than run a high balance on credit cards.   In addition, many consumers consciously leveraged up their balance sheets: lots of mortgage debt to fund investments, not just consumption.

Mian and Sufi's most interesting conclusion is:

"... the effect of house prices on homeowner borrowing is isolated to homeowners with low credit scores and high credit card utilization rates."

It surprising that they find such a large macro effect from this one segment of consumers.  If they are right, here's the interpretation I'd give:  normally housing wealth has a negligible effect on consumption.  Then for a few years it had an unusually positive effect, as it allowed otherwise credit-constrained families to spend more.  But now that's over and we're back to normal  The transition back to normal is tough, but we will resume the old fashioned consumption function.  However, the Calomiris et al research disputes this view.  It's quite possible that their analysis, which covers a large swath of post World War II economic history, misses the Mian and Sufi effect because it wasn't just housing prices that stimulated consumer spending, but the combination of rising housing prices and readily available sub-prime debt.

In any event, I think we're headed back to a normal relationship now.  Consumer spending will move independently of housing price changes in the future.

How to Trust Your Investment Advisor

With the current news about Ponzi schemes and crooked investment managers, people are asking me how they can avoid being Bernie Madoff'ed.  I've been in the investment management business (but no more), and I've read the stories, and I think I can offer some good tips.

As you have no doubt figured out already, personal references don't count for much.  The crooks have already charmed your friends.  References may protect you from the fly-by-night flim flam men, but you are not protected from the roots-in-the-community schemers.

One protection is to use a stock broker from a respected firm.  The brokerage has its own fraud controls in place, and it has deep pockets if your broker does defraud you.  It's sometimes hard to get to those deep pockets, but the worst cases usually don't occur through stock brokers.

A sure fire protection is to do your own trading.  You can pay a financial planner or investment advisor a fee, but then do the trades yourself in your own discount brokerage account, or directly through mutual fund companies.  You'll get the benefit of professional advice, and excellent protection against scams.  However, you have to have the discipline to actually carry out the trades your advisor recommends.  If you let things pile up, this is not a good approach.  One thing a professional investment advisor does for you is to actually get the trades done.

The best protection against Ponzi schemes run by investment managers is a respected third-party custodian.  Here's how that works.  Say you have selected an investment manager.  He will have you open an account at a brokerage firm such as Schwab or Fidelity.  You'll sign papers giving him a limited power of attorney.  He'll be able to trade stocks and bonds, but he will not have the authority to take money out of the account.  Every month you'll receive a statement from the brokerage--directly from the brokerage, not through the investment manager--listing your assets.  You have 100 shares of Apple, 200 shares of Boeing, etc.

When opening the account, you'll typically fill out the brokerage's new account forms, which will be supplied to you by your investment manager.  He may even fill them out for you, to make the process easier.  However, I recommend that you call the brokerage company yourself and ask two specific questions.  1)  Who has authority to withdraw cash? and 2) Who has authority to change the address to which statements are mailed?

The first question is pretty obvious; only you, not your investment advisor, should have the authority to withdraw cash (or stocks or bonds).  The second question is equally important.  There have been scams in which the investment advisor listed his own address to receive the client's statements.  Then he prepared phony statements that looked just like the brokerage statements, but which misrepresented the client's positions.  So make sure that only you can change the address that the brokerage mails statements to.

There are two challenges to this system.  First, the investment manager may want to invest in a private deal, something that cannot be bought or sold through the brokerage.  This is a high risk issue.  It's not necessarily wrong for the manager to propose that you invest in a private placement, but it exposes you to a ton of risk, not only investment risk but fraud risk.  What is that private placement worth?  You'll have to trust your advisor.  Was your advisor paid a kickback to get you to invest in the private placement?  That's not a hypothetical concern; we had just such a case in my town.  The investment advisor ended up going to jail, but that didn't help the investors much, aside from some psychological satisfaction.  When your investment advisor puts you into listed stocks and bonds that you can get quotes on from any brokerage or Internet site, your fraud risk is dramatically lower than if you are investing in private deals.

The second challenge to third party custody is the hedge fund structure.  In a hedge fund, your money is commingled with other clients' funds in what you might think of as a small mutual fund.  But hedge funds lack the reporting requirements of mutual funds.  As a result, your fraud risk is high.  It might be worth it, but there's definitely risk.

Finally, don't let the risk of fraud keep you from making a decision.  Your financial success depends on you getting invested.  Sitting in cash while you try to make a decision is a disastrous strategy.  If you are really, really afraid, consider using three different advisors.  However, unless you have a lot of money, you'll pay more for three different advisors than if you gave all the business to just one.

Job Goal: Doing What You Love, or Loving What You Do?

I heard a presentation by Jean Chatzky about her new book, The Difference. It sounds like a good book on personal finance, but one item in particular caught my ear.  She said that instead of focusing on doing what you love, you could focus on loving what you do.

I've known plenty of displaced executives who bought the "do what you love" story and applied for jobs at the sports apparel company in my town.  That company was inundated with resumes from talented people with great business skills who also loved sports.  As a result, the company picked the cream of the crop, at relatively low salaries. If you're willing to work cheap because you may get a glimpse of Tiger Woods walking past your cubicle, go for it.  Or, try to go for  it.  The competition for the job will be brutal.

The other approach is to love what you do.  Last week I spoke to a group of accounts payable managers.  Now, I've asked plenty of children what they want to be  when they grow up, and not a single one has every said, "An accounts payable manager."  Heck, I haven't even heard anyone say "Accounts receivable manager."  Yet these people like their work.  At the cocktail reception, they were having exciting conversations about the latest trends in AP systems.  I have to believe that they get paid better for working in mundane occupations, at mundane corporations, than the people who do glamour work for glamour companies.

How do these people get excited about a mundane job?  Jean says, "Fake it until you make it."  Meaning, pretend that it's interesting and exciting, act like its a job you love, and you'll come to love  it. I would say, consider it a challenge.  How can I do this better?  Can I reduce the time it takes me to perform a task?  Can I reduce my error rate?  Can I coach another employee to be better at the job?  Can I provide even better service?  Can I help my boss succeed?  In most jobs, there are challenges all around, for the person who takes notice.

So don't focus on what you think you like now.  You can love any job.  Go for the decidedly unglamourous.  You may be the only one to apply for the job at the sewage treatment plant.  Believe me, I've known a sewage treatment professional, and when I asked about his work, he babbled on for 20 minutes with the look of a man who loved his job.

Economic Effects of Climate Change

I don't pretend to be an expert on the subject, but there is a good summary of this topic by Richard S. J. Tol in the Journal of Economic Perspectives (available only to members of the American Economics Association).  Here are my notes:

What is the economic impact of climate change?  Estimates range from zero percent to -4.8 percent of world gross domestic product.  This cumulative impact is roughly the magnitude of annual economic growth, so it's as if we skipped a year of growth and never made up for it. (sounds kind of like a recession).  [my comment: this is a genuine loss, but it does not justify Al Gore's statement, "This is not a political issue so much as a moral issue."  Maybe it's just a nuts and bolts economic issue.]

Recent estimates of the economic impact of climate change have been smaller than earlier estimates, probably because they have been better at estimating adaptation.  (Example without adaptation: calculate change in production per acre of apples and oranges.  Example with adaptation: calculate how farmers will change the number of acres they plant of each crop, and apply that to the new output/acre estimates.)

Regional variation of economic impact is very large.  One example of an estimate (from Maddison) has a total impact on the world of -0.1 percent of GDP, but South America loses 14.6 percent, while Western Europe gains 2.5 percent.

The social cost of carbon may be around $50 per ton under (what I consider) reasonable assumptions.  The European Union's carbon permits are traded at $78/ton, meaning that they are forcing too much restriction of carbon.

Uncertainty of the economic estimates is large.  However, none of the reasonable estimates for the planet as a whole is nearly as high as I expected to see, given the current state of hysteria.

What do you do when the economic costs are uncertain?  Tol says to err on the side of stricter environmental controls.  I think he's wrong there.  Think of us as having two possible assets in which we can invest.  The returns from traditional capital spending (factories, roads, computers, education) are fairly well understood.  The returns from environmental capital spending (carbon reduction or mitigation) are highly uncertain.  Every finance professor will tell you that when the returns are comparable, you should invest less in the risky (environmental) asset and more in the safe (traditional) asset.

Economy Still Declining Despite Talk of Green Shoots

The economy is still headed down.  The best monthly look at the economy's current state involves the four coincident indicators.  These tend to move up and down as the overall economy moves up or down.  Consequently, the folks who determine business cycle beginnings and ends look carefully at these four indicators.  Here's the picture:

I think that we're near a turning point, but that's a forecast, not an analysis of the most recent data.

June 2009 Economics Newsletter Published

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Groundswell: Social Networks for Business, but With a Broad Value to Business Leaders

Groundswell: Winning in a World Transformed by Social Technologies is an unusual thing: a great business book.

First, it contains valuable insights that are not obvious.

Second, it has information for all parts of the business world: sales and marketing, production, finance, R&D.

Third, it give realistic advice rather than encouraging everyone to do more and more in the authors' pet areas.

The book is about social media, which is obviously of interest to modern marketers.  The authors also explain how the new tools can be used for internal collaboration and productivity improvement.  They see these new tools as just that: tools.  They don't tell every executive to Twitter and blog, but they do explain the strengths and appropriate uses of all the new techniques.

One of my popular speeches is about "The 20-Teens," what business leaders should be doing today to get ready for the next decade.  I've been talking about using LinkedIn and Wikis.  Now I'll add Groundswell as a highly recommended resource for more information.