Businomics Blog

Pension Crisis: Institutional Investor Quotes Your Favorite Economist

Institutional Investor has an excellent article about the pension crisis, made all the more excellent by usage of an article I wrote for the National Center for Policy Analysis.  I commented on how ERISA (the employee benefits law) changed the playing field between defined benefit plans (traditional pensions) and defined contribution plans (such as 401k's):

After ERISA the move away from corporate fixed pensions became a rout. “Virtually no new defined benefit plans have been created in the last ten years,” wrote economist William Conerly in a 2005 study for the National Center for Policy Analysis, a conservative think tank. “Once the Cadillacs of retirement plans, they are now the Edsels of employee benefits.” [emphasis added]

My paper is available at NCPA's website.

Three Questions about Financial Reform

Who are the Evil Bankers?

Make the banks pay!  Regulate the banks!  Don’t let the banks mess up again! Common sentiments miss a critical question: which banks are you talking about?  Consider the large Wall Street institutions, including the current Goldman Sachs and the late Lehman Brothers, as well as the former Bear Stearns, Merrill Lynch and JPMorgan.  These firms are very different from your local community bank with one office, or even 100 offices.  Their business model was different, their regulations were different, their regulators were different.  Any discussion of  “banking” should clarify whether we’re talking about investment banking or commercial banking.

Which banks should pay?  There’s a desire to punish the miscreants, which seems reasonable.  But the worst of the commercial banks have already gone under—further punishment is impossible.  So if more punishment is to be meted out, it will go to those institutions that did not make such egregious mistakes, but which had to compete with banks making big mistakes.  Some of these survivors were making mistakes on a small scale, but others were trying to avoid the mistakes while still competing with companies lifted up by the housing mania.  Penalizing them would, in many cases, amount to punishing the innocent for the crimes of the guilty.

How Will Innovation Proceed?

The 30-year fixed rate mortgage, which we think of as plain vanilla, was wildly innovative back in the 1930s.  Before that time, home-buyers typically paid 50 percent down on a house and got a five-year interest-only loan.  They refinanced their mortgage at the end of the five-year term, if they could.  In the Great Depression, banks needed liquidity and refused to roll over the mortgages into new loans, but the borrowers had trouble finding other loans, so the borrowers defaulted.  Bank failures resulted.

When thinking about regulating residential mortgages, we should ask how innovation can occur.  Are we locking ourselves into 20 percent down payment, 30-year fixed rate loans?  Is 20 percent always the threshold between prudent and imprudent?  Should the threshold be lower in a stable real estate market, but higher in a booming market?  Or perhaps the other way around?  The market system answers these questions through experimentation by profit-seeking lenders.  It may appear that the experiment created some pretty bad monsters, but one has to be quite the pessimist to assume that there would be little value to innovation in the future.

Will the Government Continue to Promote Risky Schemes?

It seems that the private financial services sector needs regulation, but think about the major thrust of financial regulation before the crisis: making mortgages more available to people with poor credit.  Fannie Mae and Freddie Mac were both established to increase mortgage lending, but proved to be hugely risky.  Their liabilities are about $5 trillion. (I’ve seen a $6 trillion figure, but what’s a trillion dollars among friends?)

Look forward a few years and ask what policy would help get a Congressman re-elected: acting to promote financial safety, or acting to make mortgages available to more people?  Quis custodiet ipsos custodes?

A History of Interest Rates

If interest rates matter to you, and you have an inquiring mind, pick up a copy of Sydney Homer's A History of Interest Rates.  (The latest editions were co-authored with Richard Sylla and include more recent developments, but I treasure my first edition autographed copy.)

Here's the opening paragraph:

In historic times credit preceded the coining of money by over two thousand years.  Coinage is dated from the first millennium B.C., but old Sumerian documents, circa 3000 B.C., reveal a systematic use of credit based on loans of grain by volume and loans of metal by weight.  Often these loans carried interest.

Global Economic Forecast for 2010: Optimism Rising

The IMF released its April 2010 World Economic Outlook, and it's good reading, as always.  I don't always agree with their Outlook commentaries, and I certainly disagree with many of their policies, but their numerical forecast is a good indication of where the mainstream economic outlook lies.  I noted that their most recent forecast for 2010 is much more optimistic than a few months back.  That led me to tally up the forecasts for 2010 that they made over the past two years.

In April 2009, the depths of the recession, IMF was pretty gloomy about the world's economic outlook.  The latest revision pushed the forecast up over an entire percentage point over last fall's major report, and they now expect this year to come in at 4.2 percent growth, inflation-adjusted, for the whole world.

In the best book about business and economics, I strongly recommend using consensus forecasts for business planning.  The IMF isn't actually a consensus (an average of professional forecasts), but it's pretty representative.  I also believe that the forecast revision has additional information.  That is, a consensus forecast of three percent, up from a prior forecast of two percent, is more bullish than a consensus forecast of three percent, down from four percent.  So this upward revision in the IMF forecast is good news in and of itself.

Problems over?  Not at all.  Getting better?  Yes indeed.

Housing Not An Indicator of Overall Economic Health

Today's Wall Street Journal suggests that the housing industry will provide a measure of the strength of the post-stimulus economy.  I think that view totally ignores the fundamental issue of the housing market: oversupply.  The government today released data on housing inventory, and the news is still grim.

We have too many housing units.  Population growth would normally solve this problem, but the recession has triggered a lower ratio of households to people.  In other words, we're living together more often.  Couples are delaying divorce, or else staying in the same house after divorce (which must put a real chill on dating after divorce).  Adult children are coming back home.  In addition to these factors, a number of immigrant workers have returned to their home countries, preferring to be unemployed at home rather than unemployed in the United States.

With the housing oversupply, there isn't much reason to build.  Oh, there are certain neighborhoods where certain types of housing at certain price points are still in demand.  New construction is not falling to absolute zero.  But there is no hope for a healthy housing market until the oversupply goes away.

What will lead to the end of housing oversupply?  First, job growth will get those kids out of their parents' homes.  Second, general population growth will help, including some foreign workers returning to this country.  But don't look at your 2010 calendar to find the date that the oversupply will be worked off--you need a calendar that runs into 2011 at least.

Federal Debt Crisis in the United States?

Does the federal government’s huge debt burden threaten an American debt crisis?  This is the second post in a series of three about the damage that might be done by our federal budget deficit and accumulated debt.  The previous one covered the risk of inflation.  The next will address tax hikes.  Today I’m talking about a debt crisis.

The plan is to explain

1.  The classic debt crisis pattern, and possible outcomes
2.  Early warning signs of an impending debt crisis
3.  Likelihood of an American debt crisis
4.  Practical tips for those worried about a debt crisis

Debt Crisis Pattern

The debt crisis pattern can apply to a country, a corporation, or an individual, but we’ll talk about it in terms of countries.  A country runs a large deficit year after year.  In addition to new borrowing each year, the country must refinance old debt coming due.  The country’s creditors start to get nervous about the country’s ability (or willingness) to repay the debt.  They demand higher interest rates, and may offer to buy debt only if it is denominated in some other currency.

Recall from our last post that a country can use inflation to reduce the real (inflation adjusted) value of its debt.  Creditors know that.  They know that inflation typically pulls down the value of a country’s currency on foreign exchange markets.  So if, for example, global investors were nervous about Mexico’s debt, they might refuse to buy peso-denominated bonds.  However, they might take dollar-denominated Mexican debt.  In that way investors are protected against Mexican inflation, though not against Mexican default.

There are three possible resolutions of a debt crisis. 

First, the country may pay higher interest rates on its debt, then show fiscal responsibility by cutting its deficit, and thus win credibility with global investors. 

Second, a bailout package may be assembled by other countries (perhaps with participation from the International Monetary Fund or another multi-national organization).  The other countries will typically require an austerity package of fiscal policy changes, designed to bring the country’s budget back into balance. 

Third, a country may not be able to resolve the worries of global creditors.  It either repudiates its debt, or simply announces a deferred payment plan.  The creditors cannot foreclose on an entire country, but they will decline to lend any new money to the country.  Thus, the country has to run either a balanced budget, or a deficit small enough that it can be financed by its own citizens.

The common element is that external creditors impose fiscal discipline on a country, either directly or indirectly.

Early Warning Signs of a Debt Crisis

There are two signs that you are entering a crisis:

1.   The interest rate the country has to pay rises

2.   Lenders are not interested in bonds denominated in your own currency.

With that in mind, let’s take a look at interest rates on U.S. Treasury Bonds.

Well, hard to see an impending debt crisis.  Here are the results from the Treasury’s last auction:

This 10-year note had a yield of about 3.9 percent.  Total bids on the notes were $80 billion, of which $23 billion were accepted.  This is an auction, so there were some bidders who did not bid a low enough interest rate to win.  Those bids totaled $57 billion.  It looks to me like there was adequate interest among lenders.  And these were denominated in dollars.

Going forward, those who are worried about a debt crisis will have a challenge interpreting interest rates.  Think of three components to the Treasury’s long-term bond rates:
The global risk-free interest rate.  This used to be measured by the U.S. Treasury bond, but that proves problematic if we are worried about America’s credit quality.  The key concept here is that the global business cycle will push the global risk-free rate up or down, as demand for credit from all users increases or decreases.

Expected U.S. inflation.  Lenders want to be compensated for any loss of purchasing power due to inflation.

The U.S. risk premium.  This is the spread that lenders demand over the risk-free rate to compensate for the risk of default.

A good early warning system (which I have not set up numerically) would monitor several factors.  Start with the interest rates and inflation expectations in major low-risk countries.  You can use the IMF’s database to identify advanced economies with positive “fiscal balance” and low current inflation rates.  Taking a quick scan, I see Denmark, Finland, South Korea, New Zealand, Sweden and Switzerland seem to fit the bill.  The Treasury Bonds of these countries will roughly measure the global risk-free rate.  Then add in U.S. inflation by looking at the difference in interest rates between regular Treasury Bonds and inflation-adjusted bonds.  Right now that spread is about 2.3 percent.  Any increase in U.S. bond yields above changes in global risk free rate and U.S. expected inflation may be due to risk of a debt crisis.

Likelihood of a United States Debt Crisis

I don’t think an American debt crisis is very likely.  Call me Pollyanna, but I’m struck by how we reversed a large deficit in the 1980s and actually ran a surplus in the Clinton years.  How did that happen?  Back in that old time, some Republicans still believed in fiscal responsibility.  More importantly, control of the government was divided between Democrats and Republicans, unlike the W. Bush years or the Obama years (so far).  The differences of opinion led to gridlock, which many people thought was bad back then.  Oh, how we long for some gridlock today.  The final issue that helped restrain spending was President Clinton’s scandals.  The nation was focused on what happened to that blue dress.  On top of the fiscal responsibility was a thriving economy, which boost tax revenues.

Looking forward, our formula for working out of the current deficit pattern would be to have the Republicans regain control of one house of Congress (but not both houses of Congress plus the White House).  The economy fully recovers.  I’m not ready to forecast surpluses to come, but I can envision the deficits coming down to reasonable magnitudes.

How big is our deficit relative to the supply of funds available to support it?  The deficit is (in round numbers) $1.5 trillion.  Total world savings is about $25 trillion, so our deficit is a good chunk, but a manageable chunk, of the funds that investors put to work every year.

That’s the annual deficit.  What about the accumulated debt?  Right now it’s about $8 trillion, to which we need to add about $5 trillion of off-balance sheet liabilities of Fannie Mae and Freddie Mac and other Government Sponsored Enterprises, for a total of $13 trillion.  (We won’t add in the unfunded liabilities of Social Security and Medicare, which are pretty scare 20 years out, when the baby boomers have retired and are big health care consumers).

The $13 trillion in official debt is getting close to our $14 trillion gross domestic product, but be careful.  The debt is often put in terms of GDP, but it’s dangerous to compare a stock variable to a flow variable.  Instead, here are some interesting stock variables:  net worth of the U.S. household sector is about $54 trillion.  Net worth of our business sector is about $18 billion.  (The federal government itself does not have a balance sheet!  The government does not tally up all of its land, buildings, ships, etc.)

In summary, I am not worried about a United States debt crisis.  Don’t take my lack of fear as an endorsement of our fiscal policy of recent years, however.  I would have voted against the President’s stimulus proposal.  In fact, had I been in Congress, my voting record would have made Ron Paul look like a socialist.  (Which is one reason I’ll never be there.)  But one does not have to believe that calamity is just around the corner.

Investment Tips for Those Worried About a Debt Crisis

I know that some of you are still not convinced, so here are some investment tips for those still worried.

The simplest way to invest in anticipation of a debt crisis is to avoid U.S. dollar-denominated assets.  Buy foreign stocks, bonds and real estate.  Those countries with fewest ties to America will be least affected.

One can use the futures market to short United States Treasury Bonds.  Here’s a rough rule of thumb: the 10-year Treasury bond has a “modified duration” of about eight years, which indicates that for every percentage point change in interest rates, the value of the bond will decline by eight percentage points.  Right now Greece’s bonds are yielding about five percentage point more than German bonds.  If you think that the U.S. will have a credit risk at least that large, then there’s a 40 percent gain waiting for you on the short side of the transaction.

Next Up: Taxes

So I’m not too worried about inflation, nor about a debt crisis.  I am, however, worried about the impact of the higher taxes that are likely to come.  I’ll address that in the next blog post of this series.

Goldman Sachs, Synthetic CDOs, and ... Fraud?

The Goldman Sachs fraud charges certainly make the company look sleazy, but one key fact seems not to be discussed too much:  the securities involved were synthetic CDOs, and I think that makes a big difference.  The plan for this article is

1.    Explain what a CDO is
2.    Explain what is different about a synthetic CDO
3.    Explain how that matters for the fraud allegation

What is a CDO?

CDO stands for collateralized debt obligation.  The CDO is a separate legal entity, like a little corporation.  It borrows money.  That debt is backed by collateral.  The collateral is purchased with the money that was borrowed.  Although most any kind of asset can be purchased, the most common assets were mortgage backed securities.  So the CDO had these mortgage backed securities as assets, and the money it originally borrowed as liabilities.  If the MBS paid off as scheduled, the CDO would be able to honor its debts.  However, if the MBS did not pay off, then the CDO would go bankrupt, and the folks who lent to the entity would lose their money.

(By the way, here’s what a mortgage backed security is, for those who want to brush up on basic finance concepts.  Think of a mortgage as a collection of payment coupons.  A thirty year mortgage consists of 360 coupons (30 years times 12 payments per year).  Take 1000 mortgages and throw all the coupons (that would be 360,000) into a bowl.  Then sort the coupons by date.  Now gather up all the coupons for payments in the first 3 months and offer this collection of coupons for sale.  That is a mortgage-backed security.  Investors can choose whether they want near-term money, like the first three months of payments, or late money, like the last 10 years of payments.  Along the way various rules can be set up to deal with early payments and defaults.  The resulting collections of coupons, with their associated rules for what happens in different scenarios, are mortgage-backed securities.)

What is a Synthetic CDO?

A synthetic CDO has all the profit and loss potential of a CDO, but without the mess that comes from actually having assets and debts.  The people who buy a CDO know that their income depends on the underlying mortgage holders making their payments on time.  They will lose money if the homeowners with mortgages cannot make their payments.  So a synthetic CDO simply consists of contracts between the two sets of parties, one set wanting to bet that the CDO pays off as scheduled, the other set betting that the underlying mortgages will fail.  There are no real assets in a synthetic CDO.  Instead, it consists of Credit Default Swaps (CDS).  A CDS is simply a bet on whether a real CDO with a certain pool of MBS as assets would fail or not.  (It’s actually a bit more complicated, with the amount of payment from one party to the other depending on the portion of the MBS that pay off or fail.)

In a regular CDO, the “long” side of the transaction consists of the investors buying the CDO, who ultimately are funding the mortgages.  The “short” side are the borrowers—homeowners across the country.  In a synthetic CDO, the long side are speculators betting that the mortgages pay off; the short side are other speculators betting that the mortgages do not pay off.

Why the Synthetic CDO Matters in the Goldman Sachs Case

The synthetic CDO makes a difference, I think.  The people who took the long side of the trade knew they were getting a synthetic CDO.  That is, they knew that the other side of the transaction consisted not of homeowners with mortgages, but rather other sophisticated parties.  Those sophisticated parties would only take the short side of the trade if they thought mortgages would not be paid off.  In a synthetic CDO, the issuer (Goldman) has to work with both sides of the transaction, both the longs and the shorts.  There is no expectation that the underlying assets are real mortgages.  In fact, my underlying expectation would have been that the underlying assets make a good horse race; that they could go either way, and thus we’d have a difference of opinion.  If the underlying MBSs were all derived from pristine good-as-gold mortgages, then who would take the short side in a synthetic CDO?

It seems to me that Goldman’s failure to talk about Paulson is a trivial issue.  The long side of the transaction had to know that there was a short side.  If the longs wanted to know who was taking the short side, they could have asked, as a condition of buying the long side.  However, I might be persuaded that Goldman was in the wrong if it proves true that in one of their representations they said the MBS were selected by one party (ACA) when in fact they were selected by a different party (Paulson).  However, whether this would have been material to the longs in the deal is hard to say, and I confess that I’m skeptical.

One last comment on the fraud allegation:  if this is the best case that the SEC has, then it doesn’t have very much.

Business implications:  if you enter into a transaction to buy, assume that the other party thinks he will be better off selling.  If you enter into a transaction to sell, assume that the other party thinks he will be better off buying.  If a salesman tells you this is a great buy, assume that his statement has zero information content.  If you don’t understand it, don’t buy it.

Disclosure: I own stock in Goldman Sachs.

Federal Budget Deficit: How Big a Problem?

Many of my friends are losing sleep over our federal budget deficit and accumulating debt burden.  The level of discourse is usually simple:  "We're going bankrupt!"  In a short series of posts I want to look at the possible problems caused by our large debt burden, covering inflation, debt crisis, and high tax rates.  This post is about the potential for higher inflation due to the deficit and debt.

Back in the 1970s I taught my students that if I asked on exam whether deficits caused inflation, a "B" answer would be, "Yes, they always have."  However, an "A" answer would be, "They always have in the past, but they don't need to cause inflation.  They are only inflationary if the central bank accommodates the deficit by pumping up the money supply."

The 1980s proved that a country can have high deficits and falling inflation, if the central bank will limit money supply growth.  Why did the Fed limit money supply growth?  I think the key issue was a change in attitude among professional economists.  We abandoned the old Phillips Curve idea, that inflation could only be reduced by accepting high unemployment, for a new idea: that an economy paid a temporary price in the form of unemployment for a permanent gain against inflation.  Furthermore, economies with low inflation tended to be more stable, and also had higher long-term growth rates.  (For more detail, read the best book about economics and business, pp. 96-100.)

The crucial question is whether the folks at the Fed will stick with the anti-inflation doctrine or whether they will help the Treasury by inflating the currency.  Inflation helps the Treasury by lowering the real (inflation-adjusted) amount of the debt.  This is typically done in countries where the central bank is controlled by the government.  Our Federal Reserve, in contrast, has substantial independence.\

Is the Fed's recent behavior proof one way or the other?  They have radically increased the monetary base, which is also called high-powered money.  This is the raw material out of which regular money is made.  However, the linkage between the monetary base and the money supply is looser than historic norms.  Think of a car with a slipping clutch.  The motor is revving up, but the axle is moving slowly.  One fear is that the clutch will suddenly take hold, and then we're off on a wild ride.

Recently the Fed has flattened out the level of the money supply:

Even though the money supply has been flat in recent months, the Fed is slowing the growth rate of its monetary stimulus.

The Fed has communicated that it will one day have to actually tighten to prevent inflation.  If they do it at the right time, they can prevent inflationary pressures.  I'll concede that they have to do it just right, in terms of both timing and magnitude.  However, I think it very unlikely that they will go on willy-nilly letting inflation accelerate as high as ten percent.  Five percent I could see, as a result of error on the Fed's part, but not much higher.

What if I have not convinced you?  Then think inflation hedges.  Gold is the classic, but it might be worth reviewing what would have happened had you bought an inflation hedge back in 1980--just as the Fed was shifting to an anti-inflation stance.  In January 1980 gold sold for $675 per ounce.  If you had bought back then, you wouldn't have broken even until April 2007.  Even with the recent run-up in gold, you still would not have kept up with inflation since 1980.

However, I'd buy gold if I thought we were headed into a long bout of inflation.  Mining companies are also a good inflation hedge, as is real estate.  I'd also own more foreign stocks if I were worried about inflation (and I have a large portion of my investments in foreign stocks now).

What are the business planning implications of higher inflation?  First, do not lock yourself into fixed prices for your products.  However, try to lock in supplies at fixed prices.  (Just keep in mind that if a long-term contract ends up heavily disfavoring one party, that party will work hard to find a way to break the contract.)  Along with inflation expect more of a roller-coaster ride, with wider price fluctuations than we've had over the past 25 years.  That means more attention to hedging and contingency planning.

Will Rising Prices Choke Off Demand? A Basic Economic Lesson

I'm gnashing my teeth and wailing in disgust over newspaper headlines like this: "Oil Prices May Choke Off Recovery."  Or "Forecast of Rising Interest Rates Threatens Economic Growth."  Or even "High Lumber Prices Threaten Housing."  These headline writers flunked Econ 1.  For those of you who need a review, take a look at a basic Supply and Demand chart.  Let's say we're talking about widgets.

Initially, the price is at the level that brings Supply into equality with Demand (Original).  Find where these lines intersect and then move over to the left axis to find the price.  The quantity sold can be found by starting at the intersection of supply and demand and then moving down.

Now suppose that the demand for widgets increases.  The demand curve shifts to the right, meaning buyers want to buy more widgets at any given price.  The new equilibrium (where Supply intersects  Demand, New) is at a higher price, but also a higher quantity of widgets sold.  It doesn't make sense to worry about a higher price stifling sales when the higher price is a result of higher demand.

There's a sense in which the bad headline writers are correct.  Start with the old equilibrium (that intersection of Supply and Demand, Original).  Move horizontally to the right until you hit the Demand, New line.  That's the increase in quantity that would have occurred if the price had not risen.  From there, move up and the left along the demand curve (new) until you hit the new intersection point.  That leftward move up the demand curve is how much of the increase in demand was lowered by rising price.  But the quantity of goods bought will always be higher when demand has increased.

Let's go to the real world.  Oil prices will rise as the global economy increases.  But rising oil prices will not derail global recovery--rising oil prices are a result of rising demand.  It would be a different story if the rising oil prices were due to an exogenous factor, such as a disruption of oil production due to Middle East war.

Interest rates will rise as the economy strengthens.  Long-term rates will rise due to market forces; short-term rates will rise because the Fed pushes them up.  But in both cases, the rise will be a result of increasing demand for credit, so it will not stifle that demand.

Lumber prices are up because of some small rebound in construction.  As such, it cannot prevent a housing recovery.  (I'm not expecting much of a housing recovery, but if one comes, lumber prices will rise a little without choking off the recovery.)

Business planning implications: when you see rising prices in your sector, figure out whether they are due to rising demand, or a supply restriction.  Expect quantities to rise if demand triggered the price hike.

Recession End Still Not Official--But What's That Mean for Business?

The committee that determines the beginning and ending dates for recessions still is not talking.  Actually, they issued a press release saying that there was nothing to say.  (Note: the date on the release is probably incorrect--these guys are not real good with dates.)

Let's understand their issues.  The committee does not have a fixed decision rule, but they often look at four coincident indicators:

However, they are not simply tossing ideas around about whether the recession is over.  Instead, they ask themselves this key question:

If we begin getting very negative news on the economy tomorrow, will we say that the economy is in a new recession, or that we are in a continuation of the old recession?

They are NOT speculating on whether that bad news will actually come in.  For the purpose of dating the business cycle, they have to answer the hypothetical question.  If real income and employment had risen, as industrial production and real business sales have, then they would call new weakness a new recession.  But right now they would have a good argument, based on real income and employment, that new weakness is part of the old recession.  That tells them not to declare an end to the recession yet.

Another issue they cope with is data revisions.  All of these data are subject to revision by the government, especially real income and real business sales.  So they have to consider whether they are looking at some numbers that will be revised.

What are the business planning implications of the committee's delay in making a decision?  Don't take the news as negative, first of all.  These are academics who are in no hurry, who would rather get it right than get a decision made promptly.

What use should business leaders make of the recession's turning points?  I strongly recommend using those dates to determine an industry's vulnerability to recession, as in my case study on economic vulnerability.

For current information, though, don't give this issue too much of your time.