Archive for category Finance
Discount That Optimism
Posted by Joshua Sharf in Colorado Politics, Finance, PERA on July 28th, 2010
On Sunday night’s Backbone Business, we discussed the problems with (mostly) public pensions. PERA, Colorado’s Public Employee Retirement Administration, is not exempt from these issues.
The biggest issue with public pensions is that, for some reason, they’re allowed to game the number that describes how much money they need to have in hand in order to cover future expenses.
We should always discount future cash flows according to the required rate of return of the project. In this case, the project, a government guarantee, should be discounted at the same rate as comparable government bonds. Corporate pensions, a company guarantee, discount at a rate equivalent to a basket of highly-rated corporate bonds, since that closely matches their obligation.
The economic reason for this is that a lower interest rate is associated with lower risk. If you discount at a lower rate, it implies a higher level of safety, and therefore, creates an obligation to have more money on hand to cover those expenses. Since the level of risk associated with a state pension is the same as the level of risk associated with a government bond, they should be discounted at the same rate. Otherwise you have equivalent risks paying different returns which creates all sorts of arbitrage opportunities.
The problem is that government pensions are allowed to discount at the expected rate of return of their investments, in effect presenting a risky investment as though it were a sound one, and therefore underfunding the plan.
Currently, PERA takes full advantage of this loophole, and discounts its obligations at 8%, the expected return on its investments. Needless to say, despite whatever reforms were passed in the last session, it’s not enough, and the taxpayers are going to be left holding the bag.
Eventually, we are going to have to transition to a defined contribution plan, and with the unfunded obligation growing rather than shrinking, the sooner we make that decision, the less painful it will be.
Financial “Reform”
Posted by Joshua Sharf in Business, Finance on June 25th, 2010
According to the Wall Street Journal:
…Banks [will be allowed] to trade interest-rate swaps, certain credit derivatives and others—in other words the kind of standard safeguards a bank would take to hedge its own risk.
Banks, however, would have to set up separately capitalized affiliates to trade derivatives in areas lawmakers perceived as riskier, including metals, energy swaps, and agriculture commodities, among other things.
At one level, this makes sense. Banks can use the markets to hedge risk, but would set up separately capitalized companies to speculate. But that isn’t what the article says, and it’s not clear that’s what legislators have in mind. And it shows they still don’t understand the problem.
Classifying tradeable derivates on the basis of how lawmakers perceive their risk is like classifying road repairs based on how lawmakers perceive the sturdiness of the bridge. Al Franken probably drove back and forth across the I-35 bridge all the time, never guessing that it was unsound, and I can guarantee you he knows even less about what constitutes a “risky” derivative.
I still think the proper distinction here is between hedged and unhedged risk. If the bank is sitting in the middle between two sets of counter-parties, it’s at considerably less risk than if it’s speculating on a directional move, or if it could get killed by a large directional move.
The other derivative legislation largely mirrors what Eric Janszen talked about on the Bubble show:
Would for the first time extend comprehensive regulation to the over-the-counter derivatives market, including the trading of the products and the companies that sell them. Would require many routine derivatives to be traded on exchanges and routed through clearinghouses. Customized swaps could still be traded over-the-counter, but they would have to be reported to central repositories so regulators could get a broader picture of what’s going on in the market. Would impose new capital, margin, reporting, record-keeping and business conduct rules on firms that deal in derivatives.
This is a big change, and pardon me if I doubt the ability of regulators to actually understand what’s going on in the market in any way that lets them steer clear of crisis. But on the whole, more transparency is better. I am given to understand, however, that the exchanges, which are nominally supposed to adopt the underwriting risk of the contracts, would themselves be backstopped by the government. So much for ending “too big to fail.”
Cross-posted on Backbone Business.
UPDATE: Additional thoughts here.
German Shorts
Posted by Joshua Sharf in Business, Finance on May 18th, 2010
No, not liederhosen.
The German government has announced that it will ban short-selling of 10 major financial institutions, government debt, and CDSs on government debt. It roughly parallels our three-week ban on short-selling about 800 financials in the fall of 2008, and is likely to be about as effective, pretty much like all short-selling bans throughout history.
It’s already had the effect of appearing more like panic than prudence, driving the Euro down over a penny against the Dollar today, since the announcement, and probably increasing short interest today in all three areas it seeks to shore up.
Short-sellers, as apparently has to be endlessly repeated, provide liquidity and more information to the market than the long side alone can provide. The fact that this action will have to go to the options market for satisfaction is likely to increase transaction costs. It may reduce naked short-selling, but it will also similarly increase transaction costs for those who are merely hedging, as well.
Similarly, it’s like to decrease the liquidity for Euro-zone government debt, raising interest rates; probably not the effect that the Germans are looking for here. And remember, being short the CDS means being the counter-party for someone who’s looking to parcel out some of the risk, which takes even more liquidity off the table.
Good move, Germany.
Inflation and Gold
Posted by Joshua Sharf in Economics, Finance on April 18th, 2010
Gold fanatics are of the opinion that the gold markets are predicting a massive run-up in inflation. Their policy responses run from abandoning the Fed, to establishing competing currencies, to establishing gold as legal tender for debts, and are not mutually exclusive. The problem is, the debt markets tell another story.
Since 2003, the US Treasury has offered 10-year TIPS, Treasury Inflation-Protected Securities, bills whose coupons is linked to inflation. At a fairly simplistic level, but an internally consistent one, you can subtract the TIPS rate from the nominal 10-year Treasury rate to see how the markets are pricing 10-year inflation:
As you can see, from mid 2003 until late 2008, the market pretty consistently priced inflation at about 2.5%, and that’s about where it was most of the time. Then, in late 2008, the world came to and end, and with the 2nd Great Contraction, the TIPS rate jumped up to the nominal rate, indicating that inflation was the least of anyone’s concern. The last 16 months have seen a gradual return to historical averages for inflation. But even as nominal rates have risen, the TIPS rates have kept pace, and the current implied inflation, 2.33% is at or slightly below historical averages.
Compare this to gold over the last few decades. Here’s just over 40 years’ worth of gold price info: the current price, the CPI-adjusted price, and the CPI (1982=100):
So much for gold as an infallible inflation hedge. From 1983, prices march inexorably upwards, but I’ll wait until 2010 for the real price of gold to come back. The quadrupling of gold’s real price from 1970 to 1975 doesn’t seem justified by the CPI, and while there’s a definite bump in the CPI in 1980, again, it doesn’t seem to justify gold’s move from $200 to $800. Then, even as there’s another little bump in 1990, gold prices continue down.
Gold is a commodity, with its own price dynamic. Fear can drive up the price, and people move to safety. But gold can also be its own bubble, with inflation being the justification rather than the cause. Like any other commodity, there’s supply and demand. Gold bugs tend to focus on demand. But…
This is the world production of gold according to the USGS. Now, we’ve seen declines in the production of gold before, so perhaps this isn’t “Peak Gold.” In the early 1970s, coinciding with the run-up in prices from ’72-’75. After 1980, production picks up in response to the bubble, and continues to rise until 1990 or so. And then, from 1996 until 2010, production and price are almost inverse to each other.
If this is Peak Gold, if new veins aren’t as productive, and worldwide production will continue to fall, then that goes a long way towards explaining the recent run-up.
This doesn’t mean that inflation won’t happen, or that all’s right with the world. The massive pile-up in federal debt is the sort of thing monetary catastrophe is made of. And once a loss of confidence occurs, it usually happens more swiftly than imagined, even by most who expect it. The credit markets can, and do, miss signals. Perhaps they’re pricing in a higher likelihood of either default or punitive tax rates to make up for the unbearable entitlements we’ve loaded onto ourselves. Or perhaps, more ominously, they’re just not looking beyond the next couple of years, and since we can’t predict when the bottom falls out, there’s no point in trying.
But gold bugs can’t pick and choose signals, and right now, the credit markets just aren’t signaling, “Weimar 1923.” A comprehensive theory has to encompass all the data. The simplest answer is that the run-up in gold isn’t very much about inflation, but about simple supply and demand, with supply falling as much as demand picking up.
PERA Nears A Deal – UPDATED
Posted by Joshua Sharf in Budget, Colorado Politics, Finance, PERA on January 8th, 2010
The Denver Post is reporting that negotiators are nearing a deal on PERA, the generous defined-benefit plan that most state workers have benefited from over the years:
The major changes to the Public Employees’ Retirement Association include increasing employee and employer contributions by 2 percent and reducing cost-of-living increases for current retirees from 3.5 percent this year, capping them at 2 percent….
Several issues remain to be resolved, most revolving around age of retirement and years of service needed to get full benefits, but both men said those issues could be resolved by the time lawmakers convene for their 120-day session next week….
So let’s assume that accounting for the government worked the same as accounting for a private pension. In fact, in this case, there’s no good reason why it shouldn’t. Basically, the plan has assets and obligations, but both of those change over time. So the inputs to the model are 1) Actuarial Assessments, and 2) Interest Rate Assessments.
Actuarial assessments include things like Years of Service, Age of Retirement, Years of Benefits, Salary Increases (due to seniority), Benefit Increases (due to age). Interest rate assessments include benefit inflation, health care inflation, discount rate, and return on plan assets.
The things that can be adjusted generally fall into Actuarial Assessments, and that’s where the article focuses. Retirement age and years of service all fall into this category. What’s critical is the stuff that’s left out. We have no idea what the plan’s assumed rate of inflation, discount rate, rate of benefit inflation or health care inflation are, or what the assumed return on investment is. We don’t know what they’ve assumed them to be in the past. If those numbers are unrealistic, or even aggressive, we’ll likely find ourselves right back in the same place a few years from now.
Consider a simple scenario, where the plan assumes a constant 8% real return on plan assets. Historically, this might be reasonable. But if the bulk of the return is in the out years, the plan will have depleted its assets before those returns can catch up, and will run out of money. (Cool graphs on this topic here.) If you could forecast how returns would change over time, you’d have a more accurate model, but the fact is, as we’ve seen time and again, it’s impossible to make those sorts of predicts 5 years out, never mind 25 years out. Which means that the solvency of any defined-benefit plan is mostly guesswork. Promises of long-term solvency are simply mirages.
Maintaining a defined-benefit for incoming and even current employees is not realistic (promises made to those already retired must be honored). The only fair way to move forward is to transition to a defined-contribution plan, which has only assets, and by definitions, no liabilities. Unfortunately, the political will for this move doesn’t seem to exist.
UPDATE: According to the actuarial projections accompanying PERA’s legislative recommendations, they are indeed projecting a constant 8.0% return for the next 30 years. This strikes me as aggressive. But they key point to remember is that these returns are never constant, and that the shape of that returns curve strongly affects the ending balance. There is simply no way for even the best prognosticators to get that right, and worse, no acknowledgment in the docs that it even matters.
Venture Capital, Take Note
Posted by Joshua Sharf in Economics, Finance, Health Care on September 22nd, 2009
In the generally miserable venture capital environment of that last few quarters, one bright spot has been the health sciences market. It’s one of the area where Colorado can compete effectively, and an area where America is well ahead of the rest of the world. It produces actual long-term savings and real quality-of-life and lifespan improvements.
And the Senate – presumably with the agreement of Colorado’s Bennet and Udall – is getting ready to kill it.
First, the numbers. VC itself has, not surprisingly, gone cliff-diving along with the rest of investment capital recently. After the dot-com craziness, total VC investment seemed to return to a normal growth curve this century before crashing in the recent downturn:
The one exception to this has been Life Sciences. While well behind last year’s pace, VC in life sciences has recovered fairly well in Q2, to the average over the last 5 years, and close to 2005 levels:
Note the steep drop-off in Healthcare Services VC after 2000. I’m not certain why that’s so, but it’d be interesting to find out. Also note that medical device investment has grown not only in dollars, but also as a percentage of total LS investment.
While the National Venture Capital Association doesn’t provide crosstabs between regions and sectors, it’s reasonable to assume that at least some of Colorado’s growth from 3.0% of venture capital dollars in 2008 to 4.3% in 2009 is a result of our strong biotech sector.
Now, the Senate is proposing what is, in effect, a national excise tax on medical device sales, to help pay for the health care takeover. (Hat tip: TigerHawk) Exactly where do they think the large companies come from? Exactly where do they think the large companies get their devices to re-sell? They don’t free-ride on this technology, they buy it once the ideas have been developed by smaller, ie, venture firms.
Brilliant idea, gentlemen.
More Community Reinvestment
Posted by Joshua Sharf in Finance on September 18th, 2009
As though forcing banks to loan to bad risks had worked before:
The Obama administration’s chief steward over small-business policy visited Colorado on Thursday, in part to deliver a message that the state’s banks need to do more to extend emergency stimulus aid to struggling businesses.
In remarks to The Denver Post before a speech to the U.S. Hispanic Chamber of Commerce, Small Business Administration head Karen Mills said her staff has ramped up efforts here to promote America’s Recovery Capital loans. Banks make the $35,000 loans while the SBA guarantees them at 100 percent.
Mills met with Gov. Bill Ritter, who is trying to promote the program, and Don Childears, head of the Colorado Bankers Association, who has criticized ARC lending as unprofitable for banks unless they take on large volumes.
Of course, it’s not the banks who are on the hook here. It’s you. I’m sure that not all of these businesses are bad risks. Most probably aren’t. But enough probably are to poison the whole pool if banks are expected to loan en masse, and the government doesn’t exactly have a sterling record in distinguishing between the two
We’re not in the business of promoting panic here, but it’s not as though the banking and mortgage systems have exactly been put on sound footing. The Congress – notably that savant Carl Levin – is encouraging the FDIC to borrow from the Treasury (who will borrow from the Fed, who will either print the money or borrow it from the Chinese or take it from the banks in question, anyway), at the same time that the FHA is tightening lending standards after discovering that the subprime business may be riskier than we thought. Horse, meet barn door.
What Do Freddie & Fannie Have that Sallie Doesn’t?
Posted by Joshua Sharf in ACORN, Finance, National Politics on September 18th, 2009
The same thing that a public option in health insurance would have: the ability to run off the competition.
Yesterday, you may have heard, the House voted to cut off funding for Acorn, with all of the opposition coming from 75 Democrats. Typically, the minority – the Republicans, for the moment – will try to tack something truly poisonous to the majority on a bill that the majority – for the moment, the Democrats – just can’t refuse.
In this case, it was the final gasp knee on the ventilator tube of the independent student loan market. The story combines the worst elements of the government part of the mortgage mess with the scariest elements of the proposed insurance mess. Way back, bankers and independent lenders didn’t see students as such good credit risks. (They still don’t, which is why they tend to loan to them at 18% interest on credit cards.) So the government decided to step in and offer subsidized loans for education. Over time, the banks who made the federal money available were subject to more and more restrictions, until they became, to all intents and purposes, a utility of the federal government when it came to student loans. So much so that they could be portrayed – sadly, with some justification – as rent-seekers offering no value added:
“This bill will end the billions upon billions of dollars in unwarranted subsidies that we hand out to banks and financial institutions, and will use that money to guarantee access to low-cost loans,” Obama said in a statement.
The unwarranted subsidies to bad credit risks and liberal universities naturally go unmentioned, those being virtuous in nature.
Now, in a student-loan version of the Community Reinvestment Act, the government will spread that virtue around:
The Obama administration would use anticipated savings from the measure to increase grants for low-income students, boost funding for minority student groups, provide money for school construction, with a small portion left over to pay down the deficit.
The news has driven Sallie Mae’s credit rating down to a BBB-, and its stock price down accordingly. This is exactly the path that a public option in health insurance would take. The public (heh) has roundly rejected that idea as pretty terrible. It was terrible with mortgages (85% of which are now backed by the government), it would be terrible in health insurance. Why is it any better with student loan debt, which is also some of the worst debt in the world to owe?
I understand the Republicans’ desire to get the Democrats to vote on ACORN. With any bills likely to be bottled up in committee forever, a floor amendment to one of the few bills the Democrats were permitted amendment to was the logical path to take. Ironically, it may also focus attention on just how bad a bill that is.