Tag Archives: USA

The Credit Crunch and the Market

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The past month has been a roller-coaster in the financial markets.

At the first hints of falling prices in the mortgage backed securities markets, Bear Sterns announced the bankruptcy of two large hedge funds, and 90% losses in a third fund which had $850 million invested in highly rated mortgage-backed securities. In the following weeks, other major funds also announced losses. Goldman Sachs’ Global Alpha hedge fund fell 27% this year through Aug. 13, prompting clients to ask for $1.6 billion in redemptions, investors told Bloomberg. DE Shaw, a pioneer of quantitative investing based on complex mathematical and computer techniques, has been hit hard in August. DE Shaw’s Valence fund is down more than 20% through August 24th, according to a fund of hedge fund manager.

These high-profile losses are prompting redemptions, and as cash flows out of hedge funds, managers must sell. Around the world, leveraged funds anticipate redemptions and are deleveraging (selling).

“When you can’t sell what you want, you sell what you can.”

Because the markets for mortgage-backed securities dried up so completely and so quickly, managers began selling positions that remained liquid and well-priced. In a sense, they had to sell good investments because they couldn’t sell the bad ones. What started as a series of collapsing mortgage strategies has spread into just about every other market that hedge funds touch. Prices fell in investments ranging from emerging market bonds to the price of hogs. In all, more than $1 trillion in value has been lost in US stock markets, alone. Many foreign markets and alternative asset classes suffered worse declines.

The trigger event is a credit tightening: mortgage issuers extended too much credit, were too loose with their lending standards, and may not have adequately communicated their loan terms. In response, lending standards have been increased and credit is tighter. US consumers might slow their spending, which might trigger a broader slowdown in the US economy, which might have implications for global growth. Uncertainty and fear prevail.

We view this fear as primarily psychological, wildly overestimated, and only loosely related to market fundamentals (See Figure 1). But that may not matter.


The pricing of risk is driven by psychology. Investors require compensation for the possibility of loss and also for the inconvenience of uncertainty. So rising risk can cause capital to become scarce, lending rates to go up, and spending to slow. In this sense, the psychology can impact the fundamentals in what is sometimes called a “contagion”.

The “Greenspan put” was like a safety net, providing the comfort that credit would be made available on those occasions when it was needed. Bernanke has reiterated this strategy, but it remains to be seen if he has the same appreciation for what Keynes called the “animal spirits” of the market. Contagion is a real phenomenon, generally starting with a crisis in one market or a large fund, then spreading to other asset classes as volatility rises and investors require higher premiums for risky investments.

In our view, the excessive lending in the mortgage industry could trigger a contagion in a variety of ways, such as:

  • Rising rates and tightening lending standards leads to a contraction in home prices, reducing consumer spending and slowing economic growth.
  • A new awareness for the risk of debt investments causes borrowing costs for corporations and governments to rise, reducing investment and slowing economic growth.

These risks can be self-reinforcing, and could change the fundamental characteristics of the economy. These are the type of events that could change our investment strategies if they appear to develop out of control.

So far, these contagions have not caused a significant slowdown in economic activity. Volatility triggered by major hedge fund failures is different; it generally causes sharp declines in recently popular asset classes followed by recovery. These declines can proceed in unexpected ways, and can continue for some time because each price shock runs the risk of triggering another failure. It is surprising how many hedge funds use leverage sufficient to make them incompatible with price shocks. As months pass, however, these shocks can be a blessing because they offer rare value opportunities.

We should all hope that a full-fledged contagion does not develop, and be thankful that the world’s central banks are standing guard.

The Federal Reserve

It is important for the government to intervene if a contagion might damage the economy in fundamental ways, but also important for the government to avoid interfering otherwise. The Federal Reserve and foreign central banks play an important role in managing the stability of economic growth by changing the availability of capital at money-center banks, but interventions can also cause distortions in currency exchange rates, changes in the money supply affect inflation expectations, and reliance upon government intervention can lead investors take excessive risks.

On the 17th, the Federal Reserve followed several foreign central banks (European Central Bank, Australia, Japan, and others) by pumping capital into their nations’ banking systems in response to the recent volatility. This intervention increases the monetary supply, but the psychology of selling is still driving down many market prices as global investors reduce their exposure to risk and shift their portfolios to hold more cash and US Treasury Bonds.

Credit tightening is a reasonable response to excessive lending, but the signal from global central banks is that they are ready to smooth the volatility, even if it means increasing the money supply. This indicates that they may intend to inflate their way out of potential economic pain. As a result, we are less concerned about a recession, but our long-term expectations for inflation have risen. This combination makes stocks and real assets more attractive because they are better hedges against inflation, and reduces the value of fixed income instruments (such as US Treasury Bonds). Meanwhile, the global investor crowd has been doing the opposite. If higher inflation will be the ultimate outcome of this recent roller coaster, then the massive global shift toward cash and fixed income may ultimately be reversed.

National Infrastructure Administration

A new federal agency “National Infrastructure Administration” (“NIA”) should be formed to manage a work rotation under the Army Corps of Engineers, building national infrastructure projects.

Rotations would last 6 months at a time, and would be available to any US citizen. Pay would consist of minimum wage, minimal benefits, and possibly room and board. When not in combat, Army personnel would also serve in these rotations.

Unemployment would no longer be an issue. Anyone who wanted to work could serve a rotation with the NIA. Training and experience would be valuable alongside members of the Army, and under direction of the Army Corps of Engineers. Employers would likely respect NIA experience.

The economy would grow faster, with broad prosperity. The electrical grid, 650,000 miles of roads, 78,000 bridges, 125,000 buildings, 700 miles of airport runways, and major new dams and waterways that resulted from New Deal programs are part of why economic growth was capable of such strength into and through WWII. As Americans took advantage of better energy and transportation, prosperity spread rapidly.

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Approval Voting for the President

Problem: Presidential politics is broken. Elections are negative and third party candidates have no chance. Candidates know that they can gain advantage by slandering their opponent. Because we can only vote for one candidate, it’s not enough to show your qualifications; you also have to destroy the opponents.

Solution: Approval Voting! Allow voters to vote for as many candidates as we want.

Benefits: Every candidate will try to win your vote. Campaigns would be positive and collaborative, rather than negative and combative. You can vote for several candidates if you think they would each be a good President. Voting for 3rd party candidates would no longer be a wasted vote. These candidates would finally have a chance, and would be able to run without fear of “stealing” votes from other candidates. Finally, winners of Presidential elections would have much more votes, giving the country far less partisanship, and a greater feeling of approval.

This would change the nature of Presidential politics — for the far better.

View and comment at SinceSlicedBread.

Tax Retirement Savings Fairly

Problem: The 401(k) system means that my employer determines my tax rate on retirement savings. This means that any workers who do not have access to 401(k) plans through their employers have a higher tax rate on their retiment savings. This usually means that low-wage, hourly, and part-time employees pay higher tax rates on their retirement savings; obviously unfair.

Solution: Combine 401(k) into existing IRA program and eliminate old 401(k) program. In effect, increase the IRA contribution amount to $18k and eliminate 401(k)s.

Benefit: Everyone will have access to tax-advantaged retirement savings plans, not just those fortunate enough to work for companies that offer 401(k)s. Eliminates administrative cost for businesses. Simplifies tax code. Also, this plan helps small businesses by letting them compete more fairly with large companies that can offer 401(k)s.

View and comment on SinceSlicedBread.

Social Security Reform

I am familiar with the Senators’ stated positions, and with President Bush’s proposed framework in this early stage. I think that they may be able to kill two birds with one stone if they think outside the box. What I mean is that they could achieve tax simplification, private accounts, and permanent sustainability while lowering the payroll tax rate. Let me explain:

  1. Every citizen has a private retirement account “PRA”.
  2. Contributions to PRAs are income tax deductible, investments incur no dividend or capital gains taxes, and can receive rollovers from 401(k)s and existing IRAs. Contributions default to money markets unless directed otherwise.
  3. Automatically, 10% is deducted from all pre-tax income, with no cap: 5% goes into the PRA, and 5% goes into the general Social Security fund. More can be contributed to the PRA at the discretion of each person: up to $3k + 15% of income, again, with no cap.
  4. Early withdrawal penalties from PRAs mirror IRA regulations, except that any citizen 60 or older may withdrawl from their PRA, and only those with a worthless PRA will receive Social Security benefits from the general Social Security fund (equal or better than existing Social Security Benefits).
  5. Upon death, any remaining assets in a PRA may be transferred to beneficiaries. If the beneficiary is anyone other than a spouse, transfers are treated as income to the beneficiaries.

This plan achieves tax simplification, private accounts, and permanent sustainability while lowering the payroll tax rate. It also promotes an ownership society and increases the savings incentives for rich and poor alike.

    Let me sum up:

  • This system achieves both private accounts and a stronger social safety net.
  • It requires that the wealthy contribute to social security at the same rate as everyone else, but allows for tax advantaged retirment contributions even for the wealthy.
  • It reduces the role of government because the government assists only those who have need (those who have no value left in their retirement account).
  • It strengthens the social safety net of government because it increases funding and concentrates assistance on the needy.
  • Retirement savings tax rates are no longer determined by the employer, as the 401(k) system provides.
  • A single account for tax advantaged retirement savings will make administration much easier.
  • Everyone is encouraged to get rich, and those who outlive their savings are protected.
  • If funding surpluses are too high, the tax rate can be lowered.

Please promote Social Security modernization through your representatives.