Archive for the ‘Nature of the Squid’ Category

Post-Squid Investing Attitude Shift

Thursday, May 13th, 2010

I’ve done my share of speculative trading, but lately I’m no longer interested in dancing with the squid. At the moment I’m focused on my bond portfolio, and I’m trying to figure out how to be a *lender*, the old fashioned way, not a “bond trader”. I’d like to buy, hold to maturity, and sleep soundly at night without having to worry if a greater fool will turn up tomorrow to relieve me of my “paper” (now there’s a nice squid doublespeak term – a bond is a loan, a debt, an obligation which forces people to toil who otherwise might not – not just “paper”).

Looking at stocks, I was enamored for a while with the “Dividend Achievers” approach, e.g. the VIG or VDAIX fund. But the underlying “Dividend Achievers” index lost about 1/3 of its components in 2008-2009… Looks like dividend achievement is a bit unstable. Also, much of that dividend achievement is done with borrowing/leverage and may not be sustainable. And there are whole market sectors that need to experience destructive re-creation. I’m tempted to look more at low-debt, smaller companies (which respect their shareholders enough to pay at least some kind of dividend), with prospects for growth.

More philosophically: I don’t want to “own” something that “owes”. In my stock portfolio, I want to own things that produce, without being burdened by the high fixed costs of debt service… In my lending portfolio (bonds and bank accounts), I want to be owed, by those who don’t need my money, who I’m confident will pay me back, because they will amortize the debt and won’t need to roll the debt over. I want to be helping others do productive things and growing their way out of debt … not trapping them in it….

Lending needs to become more constructive, not predatory. And that means not giving the debt addicts another round, even when they ask for it.

And the ownership of stocks needs to be about rebuilding the real, physical, tangible, doing-cool-things economy, not speculative paper-shuffling.

What the Federal Reserve Actually Does

Monday, March 29th, 2010

I saw some comments over on CalculatedRisk which compel me to explain how the Federal Reserve actually works in reality. It is different from the Fed’s self-generated mythology – and also from the skeptics’ mythology.

The Fed will have you believe that they “set interest rates”.  The skeptics will say no, the market sets rates, and the Fed merely follows and claims victory.

Neither is true, and yet both are true.  As usual, look not at what they say, watch what they do, and follow the money!  What does the Federal Reserve actually do?  They buy and sell debt, and they talk a lot.  But it is by means of the first activity that the Federal Reserve is able to manipulate the total amount of credit (what we now use as “money”) that is available in the economy. It does this by expanding or contracting its “balance sheet”.  For every security stored inside the Fed’s balance sheet … and paying interest to the Treasury … after the Fed takes its cut … someone else has a large amount of credit to spend on something.  The Fed creates credit “ex nihilo” – out of nothing.  A mighty power, which is why the Fed Chairman is frequently described as the most powerful man in the nation.

Those claiming that the Fed is a fictitious organization often point out that short term interest rates lead the Federal Reserve’s policy target rate. The market leads and then the Fed follows, right?  Well, the Fed does have to react when short term rates pressure the bounds of the policy target, because otherwise rates would go where the Fed doesn’t want them to go. But ask yourselves — how many folks spend thousands of hours each year trying to figure out where the Fed wants rates to go, and get there first? The market is doing the Fed’s bidding because that’s where the money is. What actually happens is that the Fed telegraphs to the market which way the rate is about to go — or the market has figured out where the Fed will be telegraphing, and has front-run them, which amounts to the same thing but yields more profit for the banksters.

Now, if the Fed can convince the market where it wants the market to go, and the market goes there, it’s a lot less work for the Fed.  And thus a lot less expensive. But there are times when the Fed has to take the market by the horns and implement massive adjustments.  This is part of what happened in 2008-2009. Sometimes the Fed dances with the market, and sometimes the Fed picks the market up bodily and shoves it into place…

But back to the standard operating procedure: the main tool is the policy press release issued at each Fed meeting, which typically reveals (in a few words) the Fed’s outlook for short-term rates. Secondary tools are the minutes released between the meetings, the “Beige Book” economic analysis, and also the public speeches which are frequently given by the various Fed members.  Each of these helps to set the market’s expectations of future policy.  Conversely, the market also communicates with the Fed, by way of current interest rate pressures (relative to the current Fed target rate) and prices in the rate futures markets.

Now, which is more powerful?  The market would always go where the Fed leads it, unless it believed the Fed were fully able to implement its targets.  On the one side, the Fed’s ability to drain credit from the market (by selling assets on its balance sheet and siphoning cash out of the system) is a potent, but not omnipotent, lever for raising interest rates.  By shrinking the supply of short-term credit, the Fed can fully offset private-sector increases in credit, and force short-term rates upwards.  This generally moves the long-term rates up as well — who wants to lend long when short rates are paying more, and less risky?  But sometimes the market is in full fraudulent bubble mode, in which case the Fed can force up short-term rates, but long-term lending supply doesn’t respond immediately, and rates fail to respond — as Greenspan’s “conundrum” showed in the 2004-2007 tightening cycle.

On the other side, by expanding the supply of short term credit, the Fed can fully offset just about any private-sector decrease in credit, and force rates downwards. And again, drops in short rates tend to result in drops in long rates, as yield-seeking borrowers are forced to make longer commitments (and thus take on more inflation risk).  This again can fail (or at least take a long time) when the market is in full panic mode, in which case the Fed can also force down long-term rates by purchasing long-term securities.  (But as Bernanke is now experiencing, even after buying up over $1 trillion in fraudulent mortgage securities and flooding the banks with enough cash to give nearly $3,000 to every man-woman-and-child legally in the country, the Fed can force short term rates to zero, and it can pull 30-year rates under 5%, but it still can’t make  creditworthy borrowers out of overindebted individuals and institutions, nor can it make others lend for 30 years in a climate bordering on hysteria over long-term fiscal/policy stability questions…)

So which is more powerful?  From 2004-2008 we saw the market bubble with low long-term rates, despite (belated) Fed efforts to raise rates.  In 2008-2009 we saw the market panic with a total credit freeze (infinite rates – no credit at any price!) in many parts of the market. But we also saw the Fed go thermonuclear and force short rates to zero and long rates to record lows.  So in the short term, the Fed is more powerful.

But in the long term, the actions of the Fed have economic and political consequences. Buying up Treasuries is seen as printing money and enabling Congressional waste.  Buying up mortgage securities is not only probably illegal (based on a tight reading of the Federal Reserve act and the legal technicality that Fannie & Freddie debt is not “full faith and credit” debt of the U.S.), but also has political consequences as people begin to realize that fraudulent lending is “crime that pays”.  Some of those political consequences lead to “Audit the Fed” movements and other political pressures, and those in turn remind us that in the end, the Federal Reserve is only as powerful as Congress allows it to be.

But remember to watch what the Fed actually does!  It’s the Temporary and Permanent Open Market Operations that matter!  And the alphabet soup of lending programs.

And finally:  A more transparent Fed would go a long way toward cleaning up the Augean Stables of American Finance, and while that would be painful for us all in the short term, in the long term, accurate and transparent national accounting is vital to restore investor confidence in security of prinicipal and reasonable rates of return, on investments one can be proud of.

Preventing the Next Crisis? Automatic Stabilizers?

Monday, January 25th, 2010

Apropos of the current fears of another market panic in 2010, and a new topic for Do Not Feed the Squid fans: “How can we arrange economic matters differently, so that we do not have another crisis, either soon, or ever?”

There was an interesting discussion of the concept of “Automatic Stabilizers” to provide countercyclical fiscal policy, but like all other policy responses I don’t think auto-spending plans or other “stabilizers” will help to prevent future financial excesses. Centuries of financial history, as retold in books such as “Manias, Panics and Crashes” by Kindleberger, tell us that crash-preventing and crash-mitigating policy constraints tend to be undone by the same economic and political forces that lead to the financial excesses. It is not enough to imagine stabilizers, they must be implemented, and they must be implemented in such a way that they remain effective without being evaded or gamed.

Perhaps the best stabilizer is a system which doesn’t tend to excess in the first place, so that the resulting crashes are not so severe. The Founding Fathers, within the constraints of the 1700s, were not unwise in this regard – Article 1 of the U.S. Constitution actually has the simplest of all financial stabilizers, demanding that only gold and silver coin may be used as tender for debts (Section 10), authorizing only Congress to borrow money on the credit of the United States (Section 8), empowering only Congress to coin money (Section 8), and that “No money shall be drawn from the treasury, but in consequence of appropriations made by law” (Section 9). Congress has managed to mismanage this. Why should they be expected not to muck up any other “automatic stabilizers”? (An interesting side note — the rest of the Constitution does not even mention money.)

Now, the 1800s had plenty of financial ups and downs, and politicians (seeking always to take credit for trying to make things better?) have muddled with the system, so that despite the constitution gold and silver coin are no longer money, Congress has delegated a lot of financial responsibility, and savers seeking to invest must deal with a lot more “political risk”… Meanwhile, financial crises still occur, and they are certainly more complex now, but are they any less severe?

This sort of thinking led me to the following rant, which I want to post here for posterity:

We HAD automatic stabilizers! But the problem with “automatic stabilizers” is that, in a credit mania, the political process leads to the dismantling of the stabilizers. How many defensive mechanisms were put in place after the Great Depression, and then dismantled in the 1990s and early 2000s, again? We had banks that could be “failed out” via the FDIC. We had Glass-Steagall separating speculation from honest lending. We had lenders who had to own the risks of their own lending, not pawn them off via “securitization” (what an oxymoron! no one was made secure!). We had a whole alphabet soup of regulatory agencies.

We HAD automatic stabilizers. But we threw them away! The regulators allowed both commercial and investment banks to hide toxic debts “off balance sheet” (as though, in reality, there could even be such a thing?). We let the banks leverage up well beyond historically prudent levels, ignoring centuries of financial history and thinking “it’s different in our time” (I.D.I.O.T. thinking). These failures were systemic and widespread and they did not come out of nowhere for no reason. They occurred because a long reign of prosperity had led to complacent outlooks. They occurred because an overly complex system was built up to hide the sausage, and the new system permitted trillions of dollars in hidden fraud (Galbraith’s “Bezzle”). They occurred because the people asking for the bending of the rules were making gobs of money, and the people who had the authority to say no, in far too many cases, were too interested in sharing in those gobs of money and not sufficiently interested in protecting the public interest. They occurred because too many people were too enthralled with fancy new marketing terms, and the few who were sufficiently quantitative and skeptical to realize that a “credit default swap” is the same as an insurance contract (and thus out to be regulated as such) were outvoted.

We had automatic stabilizers, and when we actually needed them, they weren’t there anymore. And probably in 60-80 years the automatic stabilizers that we will put in place will also be thrown away, and in 70-100 years there will another enormous crisis. Unless we truly do something different this time. But the gridlock in Washington and the entrenched resistance on Wall Street doesn’t give one any reason for optimism.

Why is it, again, that everyone who created this mess is still in power? Why are the same regulators now expected to actually enforce prudent fiscal responsibility, whose nonfeasance enabled the runaway banks to drive us to the brink of ruin? Why is the same clique of bankers still in charge of the “too big to fail” institutions, that failed and were bailed? Why are the same Congresspeople in charge, who failed to exercise their proper oversight of the executive branch agencies and ensure that regulation actually took place? Why is it that the Federal Reserve is being allowed to purchase outright securities that are not “full faith and credit” obligations of the United States Government, despite the very clear language in the Federal Reserve Charter limiting the Fed’s authority only to those securities? Where are the protests at the TARP vote (against the will of the vast majority of those willing to contact their Congress)? Where are the riots against the indentured servitude our children and grandchildren will face, paying interest on $15,000,000,000,000 in debt that they did not ask for and which does them no good? (Those used to be “astronomic” numbers… now they are “economics” numbers!)

Oh… we haven’t DEMANDED either manual OR automatic stabilizers, yet.

The crisis will continue until the national response improves.

Restoring the Federal “Reserve”

Thursday, January 14th, 2010

[Comment originally posted at <a href=”;utm_medium=feed&amp;utm_campaign=Feed%3A+typepad%2FRUQt+%28macroblog%29″>Macroblog regarding “When Independence Begets Accountability”</a> ]

The Federal Reserve should get back to its traditional role as quickly as possible, and cease trading in markets for anything other than full-faith-and-credit obligations of the United States. This includes Fannie/Freddie debt!

The more complex role that the Fed has taken on in the past 1-2 years is too politically charged, and should be abandoned. There are many other ways that the government can react to a financial crisis. If the Fed’s retreat creates a gap in the policy options, put that issue on the table. But don’t put the Fed into the gap.

The Fed should pull back from the “regulatory” roles that it’s supposed to have. That hasn’t worked out properly, and it overly entangles the Fed with the banks. The Fed was so entangled that it couldn’t take away the punch bowl at the right time. If the Fed cannot do that well, it certainly cannot afford to take the blame for failing. Let someone else have that job, but protect what is essential about the Fed.

The Fed should not be an agency of anything other than pure monetary policy. It should simply manage the elastic money supply.

The Fed should be made far more independent of the banks that it interacts with. The only way to be able to take away the punch bowl is not to be drinking at it, and not to be buddies with the drinkers either.

It’s time to restore some honor and dignity to the system.

Thoughts on hedging

Wednesday, December 30th, 2009

From July 10, 2009.  This is a comment relative to a post on Aleph Blog.  I held posting the comment here, so I could think this out more, but in the end I like the train of thought as it was and haven’t edited it much…

In the end, ownership is about the strategic selection of risks, calculated risks, where the likely rewards outweigh the risks. If the likely rewards don’t outweigh the risks then ownership (“investment”) is not a good choice. As Ben Graham put it, thorough analysis, security of principal and a reasonable return are the essential ingredients. Complexity bedevils analysis; hedging tends to involve concealment of risks to principal; financial intermediation (e.g. with a counterparty) requires sharing the expected return. The odds of mis-estimating risk become much higher.

On a more philosophical plane: I would hate to live in a world where everyone was “hedged” or “insured” and thought they had no risk, and yet would earn some kind of return. A world of prudent risk-takers, willing to put actual capital on the line because they’ve done their homework and willing to work to make their commitments work out, is better than a world of “hedged” risk-averse “free lunch” seekers who just want some counterparty to make everything all better for them if they turn out to be wrong.

There’s a moral hazard aspect to insurance — think about how popular the high-hazard “extreme” sports are, now that everyone feels entitled to having someone else pay for their wrecks. There’s also the problem that your average individual, regardless of means, is just not sufficiently sophisticated financially to make proper use of these “hedging” tools. We live in a nation where much of the population cannot do something as simple and obvious as paying off their credit cards in full each month! This applies all the way up to the highest levels of business and government — Representatives, Senators and even national presidential candidates are up to their eyeballs in debt that apparently is not in their financial interest. Should we really be turning the Wall Street marketing mafia loose with new “financial innovations”, on such ignorant prey?

My intuition tells me that it would be better for society if people who aren’t comfortable owning a particular asset were encouraged (“invisble hand” style) to stop owning it, NOT for them to maintain “ownership” but with “insurance”. Shiller and other advocates of hedging tools seem to be living in the pre-crash mentality, where financial complexity seemed like a good thing, and counterparty risks could be ignored. Such is not the case now. With the number of publicly filing businesses down about 1/3, and the number issuing “going concern” warnings rising dramatically, it’s flawed logic to assume that “insurance” (as a generic concept) is “guaranteed”. Would you sell a future on your home to the next AIG? The next Countrywide? The next Lehman Brothers? In the absence of financial transparency, how would you know?  Particularly with respect to off-balance-sheet (and allegedly “hedged”) risk exposures, there’s no way to tell that your counterparty of choice won’t blow up in the next 10 years (or whatever time horizon). In such an environment, hedging makes little sense from a Graham-ian investment perspective, because upon thorough analysis the risks are quite likely too high.

What is the Squid?

Wednesday, December 2nd, 2009

The original “Great Vampire Squid” reference was by Matt Taibbi, in “The Great American Bubble Machine“, printed in Rolling Stone in July, 2009.

Here at DoNotFeedTheSquid, I take a broader view, but let’s start with the original:

“The first thing you need to know about Goldman Sachs is that it’s everywhere. The world’s most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money. In fact, the history of the recent financial crisis, which doubles as a history of the rapid decline and fall of the suddenly swindled dry American empire, reads like a Who’s Who of Goldman Sachs graduates.”

The broader view taken here is that the Squid is a collective parasite, consisting of any person or organization (not just some parts of Goldman Sachs) which siphons human time and natural resources away from truly productive enterprises. (* This definition may evolve as we delve further, but it’s a good place to start…)

Unfortunately the examples are all too numerous. The Squid includes:

  • Failed financial and industrial corporations which squander billions of taxpayer dollars while refusing to reform their worst practices and unwise incentive structures.
  • Politicians, media, and their followers which glorify sensationalized trivia, while neglecting to study and understand the real news. (Meanwhile, bloggers eat their lunches, and historians prepare to excoriate them for nonfeasance or “failure to act properly when required to do so”.)
  • “Consumers” of all kinds, who fail to think before buying, and consequently let the squid feed on them unimpeded.
  • “Investors” of all kinds, who settle for too little and fail to demand quality products from the financial sector. (We can start with the fraud-ridden mortgage system and crappy 401(k) plans with high fees, but the list is much longer!)
  • And so on…

Part of the problem is that “We have met the Squid, and they are Us!” The Squid is not so much an organization, or a person, as it is a mindset, paradigm, or worldview. It’s a worldview which tolerates fraud, tolerates incompetence, tolerates inefficiency and waste. It’s a worldview which many of us (this blogger included) fell into during the long credit boom, when prosperity seemed boundless because money and credit were abundant… but those days are now over.

Many of us, perhaps nearly all of us who grew up during the Long Boom, were raised to believe in a system that worked for all. But we now see that the system worked far better for some than for most, and that during the Lost Decade of 2000-2009, declining incomes relative to inflation actually robbed the many to pay the few.

The Squid brought us wealth inequality and far too many individuals who feel that anything goes as long as no one catches them. As a result of this and other shortcomings, that system is now broken… and yet those most responsible for its failure have not been held accountable.

Here at Do Not Feed The Squid, the goal is to break the faulty mindset, to crack the broken paradigm, and to restore a more productive worldview. We feed the squid whenever we fail to think realistically about the human systems we have created, and let them run amok at our shared expense. We must learn from the recent failures, and fix the systems involved, but it is difficult to do so while the flawed mindset remains dominant!

I myself have much to learn, and can only dimly see the direction to go, not the destination to be reached. But I hope others will join me on this journey, and we will be able to make faster progress together. Hence doing this as a blog!

Readers may also be interested in my other blog, Investing for Sustainable Gains, which will focus more specifically on individual investing ideas. Do Not Feed The Squid is a more philosophical look at the broader national crisis.