Dollars and Jens
Saturday, February 28, 2009
Buffett's letter
I'd like to highlight the following item from the letter, which is not unrelated to the segment my brother noted:
Clayton’s lending operation, though not damaged by the performance of its borrowers, is nevertheless threatened by an element of the credit crisis. Funders that have access to any sort of government guarantee — banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella — have money costs that are minimal. Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.

This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire.

Though Berkshire’s credit is pristine — we are one of only seven AAA corporations in the country — our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.

Today’s extreme conditions may soon end. At worst, we believe we will find at least a partial solution that will allow us to continue much of Clayton’s lending. Clayton’s earnings, however, will surely suffer if we are forced to compete for long against government-favored lenders.

Systemic Risk
From Warren Buffett's new letter to shareholders (PDF):
Derivatives contracts, in contrast, often go unsettled for years, or even decades, with counterparties building up huge claims against each other. "Paper" assets and liabilities – often hard to quantify – become important parts of financial statements though these items will not be validated for many years. Additionally, a frightening web of mutual dependence develops among huge financial institutions. Receivables and payables by the billions become concentrated in the hands of a few large dealers who are apt to be highly-leveraged in other ways as well. Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease: It's not just whom you sleep with, but also whom they are sleeping with.

Sleeping around, to continue our metaphor, can actually be useful for large derivatives dealers because it assures them government aid if trouble hits. In other words, only companies having problems that can infect the entire neighborhood – I won't mention names – are certain to become a concern of the state (an outcome, I'm sad to say, that is proper). From this irritating reality comes The First Law of Corporate Survival for ambitious CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply won't do; it's mindboggling screw-ups that are required.
A related problem is that government rescue operations give preference to those who take on systemic risks. If you took a risk that would cost you a lot of money in scenarios in which nobody else gets hurt, you'd have to eat that loss. But if everybody else is lending money to people who can't pay it back and you jump on the bandwagon, your problem carries a lot more political weight when the subprime mortgages hit the fan.

We'd be better off if our stupidities were uncorrelated, but correlated stupidity comes with better political insurance.


Friday, February 27, 2009
III 06IV 06I 07II 07III 07IV 07I 08II 08III 08IV 08
Gross domestic product.
Nondurable goods.
Durable goods.
Change in private inventories-.11-1.41-
Fixed investment-.81-1.27-.57.47-.15-.97-.86-.25-.79-3.26
Net exports of goods and services-.121.33-1.201.662.03.94.772.931.05-.46
Government spending.

The increase in inventories accumulation that was holding up the first estimate of Q4 GDP was pretty much revised away, net exports were downgraded, and some shockingly weak goods consumption was revised to shockingly weaker. 1982Q1 saw growth at a -6.4% rate, which isn't remotely outside the realm of possibility when this is revised again next month.

(A note on the inventories number: keep in mind that inventory accumulation is counted as investment and therefore part of GDP, so that the contribution of inventories to GDP growth is the second time derivative of real inventory accumulation. The slightly positive contribution in Q4 represents a draw-down (or write-down?) of inventories, but at a slower rate than in Q3.)

Update: Casy Mulligan says that the price deflator for investment rose at a 3.6% annual rate, which I've not checked but agree seems a bit odd. If nominal investment were as reported and the deflator were less aggressive, of course, real investment would not be quite so bad, but it would be hard to make it actually look good, or even mediocre.

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S&P 500 dividends
The S&P 500 overall is expected to issue nearly 25% lower dividend payments in 2009 than in 2008. "Expected" by whom isn't clear to me; I would guess this is assuming flat regular dividends from the most recently-announced payments.


Wednesday, February 25, 2009
"risk free" default probabilities
Say, has anyone noticed that 30-year swap spreads have gone negative? (I'm sure the traders have.)

Google is my friend; this was much crazier in November, and the FT was apparently on top of it in October:
On Thursday, the 30-year swap spread turned negative after briefly flirting with such levels earlier this month. This implies investors are somehow reckoning that they are more likely to be paid back by a private counterparty than by the government.

"Negative swap spreads have been considered by many to be a mathematical impossibility, just like negative probabilities or negative interest rates," said Fidelio Tata, head of interest rate derivatives strategy at RBS Greenwich Capital Markets.
Yeah, just like negative interest rates.

We're now approaching the anniversary of the demise of Bear Stearns. It's been a good year for economic cryptozoology.

mortgage cramdowns
This article about "cramdowns" of mortgages doesn't go into a lot of depth about them, but I want to use it as an excuse to explain why I support them, and to clarify some issues around them.

The main reason I support allowing cramdowns of mortgages is that they're allowed for other kinds of secured debt, and in a way that makes sense. Corporate bankruptcy is simpler — perhaps because not quite as emotionally fraught as personal bankruptcy — and while I believe and hope most of what I'm about to say (except where noted) is true of personal bankruptcy, it's more reliably true of corporate bankruptcy, but hopefully at least provides some guidance.

If a creditor has a security interest in an asset, the creditor has first dibs on seizing and selling that asset to get its money back. If the asset sells for less than the creditor was owed, the creditor is still owed the difference, but now on the same basis as (other) unsecured creditors. Bankruptcy to a large extent looks to nonbankruptcy debtor-creditor law — that's how a lot of the state exempt property statutes come into the process, for example — and it generally preserves this feature in bankruptcy, where the secured creditor isn't allowed to seize the asset, but will retain the security interest. If, however, the value of the asset is less than the size of the debt, the portion of the loan that exceeds the value of the asset on which the security is held is effectively an unsecured debt, and it gets separated off and treated as such. Thus if I lend you $100,000 in exchange for a security interest in a can of tuna, that is effectively an unsecured loan, and remains such in bankruptcy, where I can retain the $1 secured loan and the security interest in the can of tuna, but face the same prospects for collecting the rest as any other creditor who lent you $99,999 unsecured.

Chapter 13, though, makes exceptions to this rule, limiting the alteration of secured debt incurred less than a year before bankruptcy, with a longer period for car loans, but a complete ban on forced alteration of mortgage terms. It might make some sense to treat loans incurred shortly before bankruptcy differently from those incurred earlier — indeed, there are a number of ways in which bankruptcy can reach back and change things after-the-fact to, among other things, dissuade bankruptcy fraud. It makes less sense to me that some of these secured interests are treated so differently from others based on uninteresting characteristics of the property securing them.

(Under current law, if your home loan is forcing you to bankruptcy, be sure to walk away from the house before filing. Even if you're in a state where the lender can get a deficiency judgment for the portion of the debt that the sale of the house doesn't cover, that's unsecured debt. Forcing you to do this, rather than allowing a cramdown, doesn't benefit the bank in any way, though, of course, the fact that many people might not do it probably does.)

There is some concern that this will cause mortgage rates to go up. It should, indeed, do that, to some extent, particularly on high loan-to-value loans, particularly to poor credits. At the moment, I have trouble seeing that as a persuasive argument against it, though I don't expect it to be a large effect anyway. In an attempt to avoid this, though, there is some indication that the bill will only allow cram-downs of mortgages made before a certain date, which is one of those things I try to store up for comparison in case I come across something else I think is the stupidest idea I've ever heard. Henderson is right about the time-consistency problem, and insofar as what this does is create uncertainty about future law, you're likely to reap something of the worst of both possible sets of law. I would oppose this as worse than nothing.

The other point I want to make — which, granted, is more true in Chapter 11 than 13, but is also to large extent true in Chapter 13 — is that the primary beneficiary of a law that harms a creditor in bankruptcy is not the debtor, but the other creditors. In Chapter 11 the shareholders and likely junior debtholders are wiped out regardless, and what you have is a contest for a pie that is, in some sense, fixed, or at least constrained; in Chapter 13, when the court determines how much money you can afford to put to paying off your old debts, if some of that money is then dedicated to the mortgage-holder, that much less is available for other creditors. Insofar as this is true, interest rates on other kinds of consumer debt would be expected to drop as a result of this provision. To the extent that people are unable to meet their mortgage payments when all other debt is eliminated, the provision might make Chapter 13 workable for some people for whom it would otherwise not be, but to a large extent this is less a bailout of irresponsible homeowners at the expense of irresponsible mortgage lenders and more a bailout of unsecured lenders to irresponsible homeowners at the expense of irresponsible mortgage lenders. Which may or may not make you feel better.


GDP release and my schedule
I like to post my summary view of the GDP report fairly promptly when it comes out, but this Friday — when, as it would happen, we're expecting a big revision — I'm going to be at a conference. I may take my computer, in which case if I have wireless internet, I may post something Friday morning, but it's likely not to show up until Friday evening.

For what it's worth.

Wednesday, February 18, 2009
bank solvency, mark-to-market, and capital requirements
All the cool kids are linking to John Hempton's extended discourse on bank solvency. A point a number of people, including me but most notably Arnold Kling, is that
The whole point of regulatory capital is to ensure buffers in case of a really bad downturn. When the really bad downturn happens the buffers will be (naturally) be used. It’s perfectly normal (and in my view acceptable) to have inadequate regulatory midway through a nasty downturn.
I think that's better said than it has been said before.

His third definition of solvency is what I was trying to give in my last blog post of this title, and I'd like to see it apply during the crisis, at least to the extent that a bank shouldn't be forcibly shut down unless there's a reasonable likelihood — not necessarily high, but at least 25% or so — that it fails that test. It's hard to measure, though, which is why it's not a good measure for use for regulatory purposes in ordinary times. (The 25% rule wouldn't be bad under normal times; I guess what I mean to say is that the primary bank adequacy measures should be more easily measured, and banks should be put on notice to raise capital on that basis rather than a less-precise standpoint that a private investor would be expected to take.) It also applies, even more strongly, to GE, which I recently saw lumped in with banks because of its financial services involvement; GE has very little tangible equity, and is more highly leveraged on that basis than any of the financials. GE, however, has many operating divisions that are clearly worth more alive than dead; the "tangible" in "tangible equity" imagines that you're forced to sell off not just divisions, but dead capital. If GE is a bank, it is one that would be much better able to sell off operating parts for more than the value of their assets, to a much greater degree than is the case for "other" banks.

This definition of solvency requires that assets be fairly valued. One of the things Hempton notes is that the value of a cash stream depends on your cost of funds, and the market value of an asset may be lower than its value to a bank if the participants in the market have a higher cost of funds than the bank does. There's some value to this point, but it would nice, in his hypothetical, if a bank could at least be asked to mark down from 90 cents to 75 cents. A bank that can't do this and remain solvent under the operating value definition of solvency is playing with creditors' money.*

It's worth noting that Hempton talks repeatedly of the solvency of "the system", as though it were a single, large corporation potentially on the brink of failure. Given all the talk about "nationalizing banks", I rather think that's what the FDIC and various banking regulators do all the time, and I very much hope there's no plan to nationalize all of the banks — at which point I'm not sure what the discussion is about. (Sweden, in the nineties, really only nationalized one bank, though that one was 25% of Sweden's banking — larger than Citigroup and Bank of America combined. I don't think we need a more socialist solution than Sweden.)

Also — I mention this mostly because I linked to the post from four months ago — I'm no longer confident that Citigroup and perhaps even Bank of America are solvent, even under this definition.

*In re TARP as originally billed and now as Geithner seems to plan, note that a bank unwilling to mark down its assets below n% of par value is not going to be willing to sell its assets for less than n% of par value, as that would amount to the same thing. The government has lower cost of funds than hedge funds do, and a public-private pool might be able profitably to pay closer to the 75 cents in the aforementioned example than the market for these assets is currently supporting, but if you're hoping to mop up bad assets that way, you're either going to have to make the banks willing to do it, or you're going to have to shut down the ones that won't. A good solvency measure is thus required for the Troubled Asset plan to work.


Monday, February 16, 2009
Credit Crisis in Europe
Interesting tidbit:
In Poland, 60pc of mortgages are in Swiss francs.
Western European financiers are getting hit not only with bad American debt that they've taken on, but also bad Eastern European debt.

Friday, February 13, 2009
P/E ratios
Another story on negative earnings for the S&P 500.

Wednesday, February 11, 2009
mark to market and financial regulation
Lloyd Blankfein in the FT:
Last, and perhaps most important, financial institutions did not account for asset values accurately enough. I have heard some argue that fair value accounting – which assigns current values to financial assets and liabilities – is one of the main factors exacerbating the credit crisis. I see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures.
I think a lot of banks are being squeezed by accounting regulations that require that they mark some things to market while they are forbidden to mark other things to market; if you make a loan and buy a CDS to protect the loan, you are better hedged from an economic standpoint, but not an accounting standpoint. The accounting standpoint becomes a little bit more real when you're subject to capital requirements, and that's another problem area here; some financial firms might well be able to recover given enough time, but the regulatory system — for some good reasons — won't give them that time if they acknowledge reality in their statements. Blankfein comes from a trading background, and he (like I) has a mark-to-market view. If everything is marked to market, I think that's a good idea, but some things are hard to mark to market, and doing so in a reasonable way requires discipline.
The percentage of the discretionary bonus awarded in equity should increase significantly as an employee’s total compensation increases. An individual’s performance should be evaluated over time so as to avoid excessive risk-taking. To ensure this, all equity awards need to be subject to future delivery and/or deferred exercise. Senior executive officers should be required to retain most of the equity they receive at least until they retire, while equity delivery schedules should continue to apply after the individual has left the firm.


Capital, credit and underwriting standards should be subject to more “dynamic regulation”. Regulators should consider the regulatory inputs and outputs needed to ensure a regime that is nimble and strong enough to identify and appropriately constrain market excesses, particularly in a sustained period of economic growth. Just as the Federal Reserve adjusts interest rates up to curb economic frenzy, various benchmarks and ratios could be appropriately calibrated. To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk.


After the shocks of recent months and the associated economic pain, there is a natural and appropriate desire for wholesale reform of our regulatory regime. We should resist a response, however, that is solely designed around protecting us from the 100-year storm. Taking risk completely out of the system will be at the cost of economic growth. Similarly, if we abandon, as opposed to regulate, market mechanisms created decades ago, such as securitisation and derivatives, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.

Wednesday, February 04, 2009
P/E ratios
The P/E ratio of the S&P 500, based just on annualizing earnings from the fourth quarter, is looking like about -30 or so.

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