Carl from Chicago

Business executive interested in history, economics, taxation and energy policy.

Who’s Buying This Crap

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As the European debt crisis continues, the insatiable need to raise NEW debt drives the PIIGS (Portugal, Ireland, Italy, Greece and Spain) back to the bond markets to raise more capital. This is the direct result of running structural budget deficits for long years of times (i.e. spending more than you earn).

Traditionally, the “spread” between what Germany pays (the soundest Euro country) and what the weakest country pays have been limited by the fact that the weaker countries had the implicit backing of the stronger countries, similar to the manner in which Fannie Mae and Freddie Mac were able to borrow just above the US Treasury rate for equivalent maturities since it is assumed that the US government would bail out these quasi-public companies if it all ever went wrong (it has, to the tune of >$400B). Now, however, the gap is very large as cited here:

But after hitting euro lifetime highs of 7.3 percent in the secondary market last Friday, the yield on Portugal’s benchmark 10-year bond has come down to just below 7 percent at Tuesday’s settlement, with traders citing ECB purchases.

These countries are basically insolvent when they have to pay 7% on new debt, which is what a (rational) private buyer would demand as a risk premium to take on the newest, riskiest paper.

But it isn’t going to be that high. Why? Because governments are going to step up and buy these bonds. Japan is now planning on buying 20% of Ireland’s next bond issue, according to this article. I can only imagine how well this is going to go down for Japan’s politicians when Europe begins circling the drain; it is a nice show of solidarity but Japan has their own debt crisis without inter-twining it with Europe’s.

This is similar to when Chase bank, under Bill Daley (the brother of Chicago’s mayor), decided to buy up an Illinois bond issue that might have otherwise demanded stiff premiums to attract (rational) private buyers. When the rational buyers leave, it is time for governments and politically-connected entities to step in, I guess. Until it all falls apart.

Cross posted at Trust Funds For Kids

Municipal Bonds

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In general the investing thought process on risk is:
– US government debt lowest risk (and CD’s)
– then municipal debt, which rarely defaults (often the “nominal” interest rate offered is lower than the Federal rate because it is tax exempt, for the most part, but the “effective” rate is higher)
– then stocks

All things being equal, you’d expect to have a low interest rate on US government obligations (now short-term it is effectively zero or less than 1% unless you go out a couple of years), a modest rate on municipal debt, and then the return on stock prices is a component of the rise in prices (generally expected to be about 10% over time by most commentators) plus dividends (and the growth in dividends).

What people are starting to notice, however, is that municipal debt “earns” that higher return than the Federal instruments by being riskier. The New York Times (which has an excellent business section) had an article titled “Gauging Those Tremors in Municipal Bonds” on January 9, 2011:

(the) benchmark muni index lost 4 percent in the fourth quarter, nearly a year’s worth of income yield for an intermediate-term, high-grade tax-exempt bond fund.

Meredith Whitney recently raised her profile in the media by going on “60 minutes” and describing how we are going to have a “Day of Reckoning” for state budgets. Side note – gotta love Wikipedia – I would have never known that Meredith is married to a former pro wrestler.

I would say that, in general, the nation was taken aback by the fall in home prices and now people have a grim understanding of how the housing market really works. An acquaintance of mine recently said he couldn’t re-finance his home because he didn’t have enough equity in it; and he purchased it in 2002, far from the frothy 2007 at market highs. In the 90’s and up to the mid 2000’s the average person also believed that the stock market could give them 10% returns over time; we have spent the last decade or so essentially flat. Anyone retiring soon or looking at their statement also has seen that the common wisdom isn’t paying the bills.

So I would say that the public will likely awaken sooner to the issues with municipal debt sooner than they did to these other asset class issues. It is strange to say that there is an asset class “bubble” but in some sense there is with municipal bonds because they are able to sell them with such a small risk premium (only a bit above the Federal risk free rate) while they, in fact, have been storing up a great deal of risk.

While the “professional” indicators are seeing red (CDS rates by state), there are new “measures” being tossed about by commentators attached to the status quo (pretty much everyone in government and the muni-issuing community) showing statistics such as “debt to GDP” with the states around 5% while the Federal government is > 70%. The difference is that the crisis at the state level is laid bare; you can’t go to California now and say that there isn’t a debt crisis or in Illinois either; the state of Illinois is not paying bills nor have they made contributions to the states’ massively underfunded pension plans – and the only place they can go to are the state tax payers who emphatically are not excited about putting more money into such obviously un-restructured institutions.

If you have money in municipal bond funds you are subject to many other items driving change than the credit worthiness of the main issuers; you have benefited from the Fed’s policy of dropping interest rates to nearly zero and the Federal governments’ cash infusions into the states as part of the stimulus package. Both of these tides are likely to recede at some point, as well.

In the vast universe of municipal bonds there are huge differences in credit-worthiness and if you select individual bonds and hold them to maturity you won’t face the same issues that the bond funds face, above. However, the fact is that municipal bonds are traditionally priced as if the likelihood of default is remote and over the next few years we will see if, in fact, that is true. If you are holding municipal bond funds, especially those with concentration in risky states (pretty much any state run by a “blue” party right now), you are in effect betting that these defaults are remote and that no risk premium is warranted.

Good luck.

Cross posted at Trust Funds for Kids

Infrastructure and the meaning of “Investment”

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In the field of accounting traditionally assets were “hard” assets, like land, cash on hand, factories, and other similar items. You could “touch” an asset, and you saved up capital in advance and then “invested” it into projects that would expand your capacity to do business or do it cheaper than your competitor (improvements). This “traditional” view of assets came under attack in the 2nd half of the 20th century, as accountants pointed out that brands had value (the classic example – the “Golden Arches” at McDonald’s). As the economy moved more towards services, the public accounting firms also noted that people did not have value in this model; the famous line was “all my assets go out the door each night”.

The traditional view of government was that they 1) built things like roads, bridges, schools, and jails 2) provided critical services like police, fire and military protection. In this manner citizens could see with their own eyes the value of the taxes that they were paying to the government; with it came roads, schools, and essential services.

Analogous to what occurred with accounting practitioners, those lobbying for higher taxes, which mainly go to transfer payments to favored constituencies, re-defined what an “investment” means. An investment used to be something tangible, like a highway extension or a new school; but now it is an investment in people, meaning that you as a citizen are in effect paying for a transfer payment to someone else.

It is astounding to see the degree to which the “traditional” view of government investment has been crowded out by the new view of investment being a transfer payment to someone else. In the City of Chicago we see the rotting, rusting hulk of the “L” tracks over our head every day, with holes in the streets and bridges and the only things that are new are the buildings erected with private funds that comprise our skyline.

Meanwhile in China they are building ENTIRE CITIES the size and scale of Chicago FROM SCRATCH. Now that is the traditional view of investment; power plants, roads, bridges, and all manner of hard assets to boot. It is amazing to think of what they are constructing there vs. the pathetic state of our infrastructure in the United States. And yet our government spends much more, but we direct it into transfer payments to other citizens or for retired government employees, rather than those “old school” ideas of traditional investments.

This rhetorical sleight of hand has gotten out of control; we need to re-label transfer payments as transfer payments and investments to be those things that actually serve the population for the future. This is not to say that all money spent on education and health care isn’t an investment; it IS when those individuals gain significant and useful skills that they can utilize for the economy. But overall, the building of even a highway or power plant is now beyond the pale even with government spending far higher than the historical norm; transfer payments have been re-defined as investment. Just look at those rusting “L” tracks to prove it.

Cross posted at LITGM

Tribune Images and The Media’s Relationship with the Military

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If you are in Chicago and get an opportunity to walk along Michigan Avenue you should pay attention to the Chicago Tribune headquarters. In the outside of the building they have stones embedded from historic locations worldwide. In the interior lobby they have statements engraved in the foyer.

The Chicago Tribune building was built between World War One and World War Two. They have the motto of the First Infantry division, made famous in the first world war

No Mission Too Difficult, No Sacrifice Too Great

The history of the division can be found here at Wikipedia. In brief, they were part of the US forces that blunted the German offensive in 1918 when the other Allies (French, British) were crumbling, leading the victory at Cantigny and moving on to other costly battles through the remainder of 1918 until the armistice. During WW1 this division and their bravery and sacrifice were portrayed well by the media, indicated by the fact that this motto was carved on the wall and generally the public would not view this as an obscure fact.

The second quote would be obscure today even to most individuals reasonably acquainted with military history. As a teenager I read Blair’s “Silent Victory” which was an account of the US submarine offensive against Japan in WW2 so I recognized it.

Take her down

Was the command made by the captain, Howard Gilmore, of a US submarine on a mission when his sub was severely damaged by a Japanese gunboat. The captain was wounded and still on the bridge; this order was essentially his death sentence because he was not going to be able to get into the sub in time to avert the Japanese ship. Gilmore received the highest US military honor, the Congressional Medal of Honor, for his bravery.

At its time the newspaper and radio were powerful forces for communication, as well as movies which took the place of television today as a visual medium. The US forces were portrayed well in combat and the media helped to promote the true heroism displayed by our soldiers.

It is interesting to think, today, if anyone can name any divisions’ motto or cite specific acts of bravery by individual US soldiers. While people go to great pains to say that they support the war, the media does not work the war into everyday stories as far as heroism, and Hollywood is even worse, focusing on the hunt for weapons of mass destruction rather than the day-to-day heroism of our soldiers on the front line. It isn’t a co-incidence that most of the movies about Iraq (are there any about Afghanistan, except for the excellent Restrepo?) have been flops (with the exception of the Hurt Locker) but we know no one in Hollywood is learning.

Cross posted at LITGM

It Is All Market Timing

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When I first started in investing one of the cardinal rules (for the general public) was “don’t try to time the market”. From a practical perspective this meant that you were supposed to continue putting money in the market whether it went up or down and then hold for the long term.

Everyone knew that the market does move in cycles, such as the giant bust at the time of the great depression in the 20’s and the 30’s when stocks crashed, wiping out many investors. Another classic example is the Japanese stock market which peaked in 1989 at around 39,000 before falling to a low of 7000 in 2009, over 80% below its high (today it is around 10,000). Even the most cursory review of the chart shows that if you sold at the peak and / or bought at the trough (this hasn’t worked yet in Japan because the market hasn’t moved back up yet) you’d make a tremendous amount of money; but the popular wisdom is that it was “too hard” for an individual investor to determine when to enter and exit the market so don’t try at all.

To some extent “re-balancing” is a form of market timing, because as stocks rise in value if you practice the model you are supposed to sell off some stocks and buy bonds (or whatever else is in your portfolio, could be commodities or real estate) which accomplishes much of what market timing is supposed to do. Re-balancing is more complex because it involves multiple asset classes which each have their own valuations but you could say that re-balancing is at least a “cousin” of market timing.

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