1) The Federal Reserve and the People’s Bank of China
For different reasons, these two central banks kept interest rates too low, touching off a boom in risk assets in the USA. The Fed kept interest rates too low for too long 2001-2004. The Fed explicitly wanted to juice the economy via the housing sector after the dot-com bust, and the withdrawal of liquidity post-Y2K. Also, the slow, predictable way that they tightened rates did little to end speculation, because long rates did not rise, and in some cases even fell.
The Chinese Central Bank had a different agenda. It wanted to keep the Yuan cheap to continue growing via exporting to the US. In order to do that, it needed to buy US assets, typically US Treasuries, which balanced the books – trading US bonds for Chinese goods – and kept longer US interest rates lower.
Both of these supported the:
2) Housing Bubble
This is the place where there are many culprits. You needed lower mortgage underwriting standards. This happened through many routes:
US policy pushing home ownership at all costs, including tax-deductibility of mortgage interest.
GSEs guaranteeing increasingly marginal loans, and buying lower-rated tranches of subprime RMBS. They ran on such a thin capital base that it was astounding. Don‘t forget the FHLBs as well.
Appraisers went along with the game, as did regulators, which could have stopped the banks from lowering credit standards. Part of the fault for the regulatory mess was due to the Bush Administration downplaying financial regulation.
Financial guarantors insured mortgage paper without having good models to understand the real risk.
People were stupid enough to borrow too much, assuming that somehow they would be able to handle it. As with most bubbles, there were stupid writers pushing the idea that investing in housing was “free money.”
3) Bank Asset-liability management [ALM] for large commercial and investment banks was deeply flawed. It resulted in liquid liabilities funding illiquid assets. The difference in liquidity was twofold: duration and credit. As for duration, the assets purchased were longer than the bank’s funding structures. Some of that was hidden in repo transactions, where long assets were financed overnight, and it was counted as a short-term asset, rather than a short-term loan collateralized by a long-term asset.
Also, portfolio margining was another weak spot, because as derivative positions moved against the banks, some banks did not have enough free assets to cover the demands for security on the loans extended.
As for credit, many of the assets were not easily saleable, because of the degree of research needed to understand them. They may have possessed investment grade credit ratings, but that was not enough; it was impossible to tell if they were “money good.” Would the principal and interest eventually be paid in full?
The regulatory standards let the banks take too much credit risk, and ignored the possibility that short-term lending, like repos and portfolio margining could lead to a “run on the bank.”
4) Accounting standards were not adequate to show the risks of repo lending, securitizations, or derivatives. Auditors signed off on statements that they did not understand.
That’s all, I wanted to keep this simple. I do want to say that Money Market Funds were not a major cause of the crisis. The reaction to the failure of Reserve Primary was overdone. Because of how short the loans in money market funds are, the losses from money market funds as a whole would have been less than two cents on the dollar, and probably a lot smaller.
Also, bailing out the banks sent the wrong message, which will lead to more risk later. No bailouts were needed. Deposits were protected, and there is no reason to protect bank stock or bondholders. As it was, the bailouts were the worst possible, protecting the assets of the rich, while not protecting the poor, who still needed to pay on their loans. Better that the bailouts should have gone to reduce the principal of loans of those less-well-off, rather than protect the rich. It is no surprise that we have the politics we have today as a result. Fairness is more important than aggregate prosperity.
PS — the worst of all worlds is where the government regulates and gives you the illusion of protecting you when it does not protect you much at all. That tricks people into taking risks that they should not take, and leaves individuals to hold the bag when bad economic and regulatory policies fail.
added the information about changes to the uptick rule (which did not reflect anything post-2006),
corrected a small math error,
made the example more realistic as to how margin works in this situation,
added almost all of the section on risks
totally rewrote the section on picking shorts (if you dare to do it), and,
added the famous comment by Daniel Drew.
I have shorted stock in my life at the hedge fund I worked at, hedging in arbitrage situations, and very rarely to speculate. Shorting is a form of speculation shorts don’t create economic value. They do us a service by pruning places that pretend to have value and don’t really have it.
In general, I don’t recommend shorting unless you have a fundamentally strong insight about a company that is not generally shared. That happens with me occasionally in insurance where I have spoken negatively about:
The various companies of the Karfunkels
The mortgage and financial guaranty insurers
Oh, and the GSEs… though they weren’t regulated as insurers… not that it would have mattered.
But I rarely get those insights, and I hate to short, because timing is crucial, and the upside is capped, where the downside is theoretically unlimited. It is really a hard area to get right.
Last note, I didn’t say it in the article, and I haven’t said it in a while, remember that being short is not the opposite of being long — it is the opposite of being leveraged long. If you just hold stocks, bonds, and cash, no one can ever force you out of your trade. The moment you borrow money to buy assets, or sell short, under bad conditions the margin desk can force you to liquidate positions — and it could be at the worst possible moment. Virtually every market bottom and top has some level of forced liquidations going on of investors that took on too much risk.
So be careful, and in general don’t short stock. If you want more here, also read The Zero Short. Fun!
I published another article at The Balance: Considering Event-Driven Investing. This is one place where writing in the third person leaves a lot out. I’ve done a lot with some types of event-driven investing.
Speculating on hurricanes — I did that successfully at the hedge fund 2004, 2005 and 2006. 2006 because I thought the risk of another strong hurricane year was overplayed. 2004 and 2005 because I had a good idea of who was underreporting claims after disasters. That was the only time in my life that I went from long a company to short without stopping, and I covered on the day the CEO resigned, and caught the bottom tick.
Index arbitrage — did a neutral trade where we shorted one company out of the Russell 2000, and bought another one in. Made no money on the trade. We had a good fundamental justification for the trade, but it just goes to show you that this isn’t as easy as it looks.
I buy a decent number of spinoffs. Most succeeded as investments for me.
Now, all that said, most areas where there are simple arbitrages typically boil down to a simple credit risk: will the deal get completed? Will the company not take an action that changes its capital structure in a way that hurts me?
Since these are relatively simple trades, the returns are relatively low like that on a short-term junk bond — at present, like the yield on T-bills plus 2-3%. It’s not very compelling given the risks involved. Most of the mutual funds that do that type of arbitrage have not done so well.
Thus, aside from spinoffs, at present, I don’t do that much with event-driven investing. Many of the forms of it are too crowded, and I prefer simplicity in investing.
This was rejected at the founding of Social Security because of the socializing of America’s private companies as a result. Also, given that politicians would never make decision immediately after a crisis, there would be the tendency to buy in when expensive, and becoming the ultimate dumb money of the market. Assets subject to the whims of politicians rarely get managed well — they are the worst at greed and fear.
Note: this is the last “Best of Aleph Blog” post for a while. My policy was don’t decide on what’s best for a year. As it is, given that my posting rate has slowed, these posts may come even more rarely, because there won’t be enough in some three month windows to justify a post.
Because of underfunding, there will be more cuts. Depend on that happening for the worst funds, and at least run through the risk analysis of what you would do if your pension benefit were cut by 20% for a municipal plan, or to the PBGC limit for a corporate plan. Why? Because it could happen.
This is an underrated report from the US Government, but even it is forced to downplay how the situation is for Social Security and Medicare. Things aren’t getting better, and time is running short. The next time I write about this is when the 2018 report comes out. Until then remember my more recent piece .
This is timely. Are US firms too short-term in their orientation? No. To be more controversial, if companies in the rest of the world imitate the US, they will be better off. They don’t push the present hard enough, and the great long-term returns don’t materialize as a result.
Fertility doesn’t turn on a dime. When women conclude that the rewards of society (money, power, approval of peers) go to those with fewer children, that’s a tough cultural idea to overcome. I would conclude that it will take a lot longer than a single five-year plan to turn around birthrates in China… if they can be turned around at all. All across Asia, marriages happen at lesser rates, happen later, and produce fewer children. China is one of the more notable examples.
A lot of people got skinned by the bankruptcy of Horsehead Holdings, which was unfair to stockholders, but sadly, legal. That said, those that owned the company missed several significant points regarding risk control, and that is why they lost.
On a rare time that I agree with Paul McCulley — we both think the Fed in general should not invert the yield curve. Also, how the Fed could be genuinely independent, unlike their “independence” that they talk of presently.
“What municipalities lose businesses and people? Those that treat them like milk cows. Take a look at the states, counties and cities that have lost vitality, and will find that is one of the two factors in play, the other being a concentrated industry mix in where the dominant industry is in decline.
The more a municipality tries to milk its businesses and people, the more the businesses begin to hit their flinch point, and look for greener pastures. With the loss of businesses and people, they may try to raise taxes to compensate, leading to a self-reinforcing cycle that eventually leads to insolvency.”
“Money does not flow into or out of assets. When a stock trade happens, shares flow from one account to another, and money flows the opposite direction, with the brokers raking off a tiny amount of cash in the process. Prices of assets change based on the relative desire of buyers and sellers to buy or sell shares near the existing prior price level. In a nutshell, that is how secondary markets work.”
For about two months, I wondered when I would write this. Now I know… I’m writing it now. To all my readers, I am letting you know that Aleph Blog is not ending, but it is changing. I accepted a writing assignment with The Balance. I am going to write 4-5 articles for them per month, and correct some old articles as well. I will publish links to them here. Like Aleph Blog, The Balance is free, so you don’t have to do anything more than click on the article link here to read it.
Why did I do this? I felt I was getting stale in my writing. I was a little bored; that’s why I wasn’t writing so much. I had completed all of my main goals for the blog in 2014, and slowly lost the will to keep cranking it out.
The deal with The Balance is like theStreet.com in that I get compensated. It is not like theStreet.com in three ways.
I write primarily in the third person, like a journalist.
They don’t want any stock picks.
They assign me topics to write on, and I pitch ideas to them, which they must approve before I write.
I like it. It forces me to learn new things and write in a new way outside of my comfort zone. It is a challenge.
I will still write some pieces natively for Aleph Blog, but most of what you will see here will be lead-ins to my articles at The Balance. I will personalize them here, and say things that I can’t say there, because here I don’t have to be neutral.
Let me simply say here that I am not crazy about Private Activity Bonds [PABs], and municipal bonds generally. If you have a long enough time horizon to buy and hold a muni bond 20-30 years, then you may as well own stocks. Aside from that, these aren’t municipalities paying on the PABs — these are private corporations. It is a “heads they win, tails you lose” situation in many cases. The credit risk level is higher than an equivalently rated muni. So, buyer beware, and stick to investments that are simple, because complexity favors the financial structurer, not the buyer of the note that is a part of the financial structure.
But maybe I am wrong. If you think I missed something, let me know in the comments.
In general, I think there is no value in preparing for the “total disaster” scenario if you live in the developed world. No one wants to poison their own prosperity, and so the rich and powerful hold back from being too rapacious.
The sun will rise tomorrow, Lord helping us… so diversify and take moderate risks most of time.
My modified “Fed Model” as a measure of the equity premium inherent in the well-known Dividend Discount Model applied to the market as a whole. Then I break the equity premium apart into three concepts that are simpler to understand.
On another type of charlatans, the political sorts. Two of the few things I had to say prior to the elections in 2016 — the first one about how the problems were bigger than the government could solve, yet the politicians would still promise solutions. The second was in the same vein, but at greater length.
Last set of charlatans, the ones at the Fed. Using money finance has always led to bad results. Much as I think the Fed talks about monetary policy lags, and then acts like they don’t believe that, that is a small error compared to helicopter money. (This one got me a 15-minute interview on an English-speaking financial radio in Seoul, Korea.)
Two real long-term problems that our world will have to face. High private and governmental debt around the world, which may lead to some weak nations defaulting on dollar-denominated debt. “Weak parts of the Eurozone and Japan are possibilities, along with a number of emerging markets.” Pensions are another issue, and most of the news globally is depressing. So much for not having children and not saving.
Though I always consider illiquidity to be a risk factor, for the economy as a whole, liquidity is overrated. Public policy should not be geared to making all/more assets tradable. Things that are genuinely illiquid should remain so, lest you have financial crises like the recent housing bubble, where too much money was lent against illiquid assets.
Actual asset performance is more important than liquidity. Analyze your investment selections carefully.
The first two articles on The Economic Philosopher’s stock valuation model that I have written. As an update, the market is currently priced for a 3.8%/year return over the next ten years, not adjusted for inflation. This is the best model available on future returns, bar none.
“My advice to you tonight is simple. Be skeptical of complex approaches that worked well in the past and are portrayed as new ideas for making money in the markets. These ideas quickly outgrow the carrying capacity of the markets, and choke on their own success.”