Ditch the AMT

This article by Veronique de Rugy of the American Enterprise Institute discusses the insidious Alternative Minimum Tax (AMT) and how it going to soak more and more American Taxpayers. Originally a ploy to tax a few dozen millionaires who effectively paid no income tax (primarily because their income was inherited and primary in the form of tax-free municipal bonds), it has never been adjusted for inflation and is hitting more and more taxpayers every year.

Everyone states they wish to appeal it, but none want to forego the revenues. Solution: repeal it, along with the itemized deductions for mortgage interest and state and local taxes paid, then double the personal exemptions. That should make it flat revenue wise, plus a lot fairer to people who either rent or live in low tax states.

Plus, it would make my life easier and focus on more relevant tax planning.

More on bonds

Following up on my previous post on the S&P - there is another part of my entire deflation theme. Normally, one would think with the government issuing Treasuries like a pimp with one night to live would normally cause bond yields to spike once the Fed stops monetizing the debt.

However, one key thing to remember is that pension funds will have to be major purchasers of fixed income securities over the next twenty years - whether they like it or not. This will have many unintended consequences. Most major Western defined benefit pension plans are in the payout phase of their existence. With the baby boomers entering retirement - more and more of pension fund assets will be used to pay current benefits. This contrasts with the prior twenty years of the stock market boom where pension funds were more concerned with growing assets in order to meet future obligations.

As a result, pension funds will be shifting away more and more from total return models to duration based models - where the duration of the portfolio should be in the same range as the duration of the benefits paid (if you treat the obligation payments as a reverse bond). If you assume that equities exhibit behavior of an ultra-long term bond (i.e. a duration of 50+), we can see the overal duration of pension portfolios dropping dramatically to match their funding obligations.

This will mean a massive shift of pension assets from equities, private equity and other long-duration investments to shorter duration fixed income investments. This shift over the next few years means that there will be a lot of demand for high quality fixed income product that should keep yields suppressed for the immediate future.

The major unintended consequence of this will be that the actuarial assumptions of portfolio returns will have to be reduced significantly. Most U.S. public employee pension funds use unrealistic return assumptions; CALPERS (the California State Employees Pension Plan) assumes a 7.75% return. This return has shown to be unrealistic over the past ten years with the fund heavily invested in equities and "alternative investments", resulting in massive unfunded pension liabilities that the taxpayers are on the hook.

Even though the states are trying to grapple with these unfunded liabilities with modest reforms, they will get socked again as the actuaries have to start reducing their return rates as the funds shorten the duration of their portfolios to meet their current obligations. They will not be able to grow their way out of this mess as they will have significantly reduced equity exposure. State and local governments will be forced to allocate more and more scarce tax revenues to meet their obligations. Sadly, the bulk of the governments have not seriously addressed these problems, and the power of public employee unions bankrolling politicians (i.e. Democrats) will ensure that there ultimately will be tax hikes to make up the shortfall. These state and local tax increases (no deficit spending as they are required to balance their budgets - although they try with accounting gimmickry) will depress aggregate demand on top of the de-leveraging by the American consumer, making the deflationary cycle worse.

Ultimately, I am coming to the conclusion that defined benefit plans should be outlawed and transitioned in an equitable way to defined contribution plans. They are inherently risky for both the funders (as they will have the largest contributions required during down markets, when they are least able to do so) and beneficiaries (the risk of bankruptcy - ask the retired managers of Delphi who had their pensions cut). Add to that the political incentives for mischief (politicians let the Delphi management retirees take a haircut, but he UAW retirees, part of a favored political constituency, didn't; or the political deals to create obscene pension benefits for state employees that were hidden from the electorate) and the conclusion becomes clear: ALL DEFINED BENEFIT PLANS MUST GO!

When thinking of that last sentence, why does Oliver Cromwell come to mind?

Whiskey Tango Foxtrot

I write this today after looking at the S&P 500 stay around 1,300 or so.

Fundamentally speaking, I do not understand how equities can keep these valuations. Under classic valuation methods, a stock should be worth the net present value of its future projected cash flows. Let's keep this simple and put the time period for projecting cash flows as the next ten years.

First we need a macroeconomic view. As we are in the midst of a massive 30 year credit bubble imploding, we need to look at previous credit bubbles for guidance. If we look at the great Depression, the 1907 banking panic, the Kansas land bubble of the 1840's, etc - what we learn if after a credit bubble, we should expect deflation from depressed demand as consumers de-leverage from high debt levels. The past 30 years of debt fueled consumption has brought future consumption into the past - whether it be houses, cars, or other goods. The consumer (especially the American consumer - who has single handedly developed the Asian export market), spooked by too much debt and fearful of his employment prospects, curtails spending in order to pay off debt and save. This will curtail demand for goods - whether it be housing, electronics, cars, or any other discretionary good. All the money printed by the government will not stimulate demand. All this reflating is doing for now is increasing the national debt; when the consumer is done saving and paying off debt, he will have more taxes to pay in order to pay off government debt. All of this will keep demand suppressed and will exacerbate the deflationary cycle. Only after years of deflation from the aftershocks of the credit bubble will rapid inflation come with a vengeance.

This means that corporate earnings will remain weak going forward. Yes, companies will still restructure and increase productivity, but will be continuously cutting prices in order to maintain capacity. Couple this with expected tax increases and earnings will not be strong going forward.

Until this credit bubble is finally resolved (which will take years to unravel as the central banks and financial institutions of the world continue their "extend and pretend" strategy), stocks cannot keep up this valuation for the foreseeable future. I see the S&P 500 challenging the early 2009 lows of 800-900 range.

I think that this will pop when people finally realize that the other shoe hasn't dropped yet. It will be the banks taking massive write-downs on commercial real estate loan portfolios and a flurry of corporate defaults. But once people realize that we're not through this mess by any stretch, the stock market will eventually tank.

Rick Santelli rages against the machine - Beautiful

The natural progression of Greece

Greece is the canary in the coal mine for a lot of issues. First, we have the fiscal mess caused by unsustainable government entitlements and demographic decline. For most counties in this boat (especially the UK), it is offset by currency devaluation. However, since Greece is part of the Euro, this option is not possible and has now migrated to a sovereign debt issue. This is very similar to crises in Argentina, Mexico, and Asia over the past twenty years - where profiligate fiscal pocilies are exacerbated by arbitrary monetary systems (i.e. pegged to the U.S. Dollar). Now with the rest of Europe subsidizing Greece in order to maintain monetary union, the crisis will now impact Greek banks. Greek bank depositors are fleeing the banking system for other EU banks - on the fear of a banking collapse or a forced exchange of Greek deposits if/when Greece is kicked out of the Euro.

This is having a contagion effect - as it will move to other Euro countries with sketchy fiscal situations - primarily Italy, Portugal and Spain. Although some have said Ireland should be lumped in there, I have not on the basis that their government is actually doing something about the fiscal situation, unlike their Southern European compatriots.

We have gone through a prolonged period without any significant corporate or sovereign defaults due to the easy money policies pursued by central banks worldwide. We will be seeing a prolonged period of significant default rates as we revert to the mean - possibly rates beyond the teens.

The impact of this debt, fiscal, and banking contagion will be twofold. One - the idea of monetary systems based on fiat currencies run by enlightened civil servants also known as central bankers will be discredited. Whether we go back a gold backed currency or something else that cannot be tampered with by politicians is yet unknown, but I can see a future where the Federal Reserve, the Bank of England, and the European Central Bank will have roles considerably diminished from where they are now.

Second, actuaries have been discredited in terms of being able to run defined benefit plans. These plans are cancers on the economies of the developing world as more and more resources will be diverted into propping up excessively generous plans for retirees that are retired for more years of their lives than actually working. Defined benefit pension plans will need to be outlawed in all forms. Whether funded private sector plans, government employee plans, or ponzi schemes called Social Security. This is a drastic solution, but all plans were forced converted into defined benefit plans that must be fully funded at all times - a lot of the fiscal problems that governments and large companies have would go.

The Curley Effect

I found this paper about how politicians attempt to shape the electorate by Edward Glaeser and Andrei Shleifer of Harvard. The name of their effect comes from James Curley, a four-time mayor of Boston and politician on the Boston scene for the first half of the 20th century. However, a more recent reference is Detroit Mayor Coleman Young.

The Curley effect essentially is the act of politicians implementing long-term destructive policies in order to shape the electorate to ensure re-election. In the case of Coleman Young, who barely won his first election as mayor of Detroit, he deliberately raised taxes and let services (especially police) whither in order to drive more whites to the suburbs and improve his chances of re-election.

This paper is the first time I've read a scholarly discussion on this phenomenon. I think it is really relevant with this administration. They are hell bent on implementing policies that are disastrous long-term for the U.S. However, the Democrats seem to believe that if they can create a large enough class of people dependent on the government for their basic needs that they will ensure a permanent majority.

Quick take on proposed banking Regs

Quick take on Obama's banking regulatory proposals:

Good:

• placing limits on deposit taking institutions on leverage and size
• prohibiting proprietary trading from deposit taking institutions

Bad:

• does not get rid of "too big to fail" syndrome
• would not have stopped firms like Bear Stearns and Lehman Brothers from failing or being propped up, even though they are not deposit taking institutions.
• does not address the issue of regulatory capture
• does not address culpability of SEC, congress, and Fed in causing problem.
• Goldman Sachs comes off as a huge winner at the expense of its competition.

While we're at it - let's cripple the US debt markets - TEFRA proposals

Here is some commentary on Barney Frank's latest proposal to now destroy the US corporate debt market overseas. This is rather arcane stuff, but has massive ramifications. All in the name to have a stealth tax grab to fund the welfare state here.

Morrison Foerrster (a top tax law firm in New York) has this to say

The Bill – Sanctions on Issuances of Bearer Bonds

The Bill would end the practice of selling bearer bonds to foreign investors under TEFRA C and TEFRA D. Thus, with respect to issuers of foreign targeted bearer bonds, the Bill would repeal the exception to (i) a denial of interest deduction for interest on bearer bonds and (ii) the 1% excise tax on the principal amount of the bonds.[1] In addition, interest paid on such bonds would no longer qualify for treatment as portfolio interest, thereby subjecting such interest to a 30% withholding tax, and any gain realized by a holder of such bonds would be treated as ordinary income.

This provision would apply to debt obligations issued after the date which is 180 days after the date of enactment of the Bill.

If enacted, the collateral damage from the Bill in the capital markets could be substantial. In the first instance, U.S. issuers would have to revise their existing programs to prohibit bearer debt. More importantly, they would have a harder time raising capital in foreign jurisdictions to the extent investors in those jurisdictions are unwilling to provide the non-U.S. person certification required for registered debt (i.e., IRS Form W-8). Also, U.S. issuers could not raise debt capital from jurisdictions (e.g., Switzerland) where investors are legally barred from certifying as to residency. Finally, foreign issuers would no longer have the protection against the excise tax of TEFRA C or TEFRA D compliance and would instead run whatever risk exists that the U.S. would attempt to impose an excise tax on a purely “foreign-to-foreign” debt offering.

No, the recession is not over. Yes, it will get a LOT worse before it gets better

Don't let the recent economic numbers showing 3% + GDP growth in the US fool you. That number was a blip, primarily caused by the cash for clunkers subsidy. Things are a lot worse, and will be a lot worse - and here's why.

The stock market is considerably over-valued and will go through a significant decline. As of today, the Dow is around 9,700 and the S&P 500 is 1,036. Based on my criteria for fair value (Graham-Dodd value investing style) - we need to see at least a 20%-30% decline before we're in that territory. The reason I need to see a significant decline in valuations in order to see value is simple.

A stock is traditionally valued by determining the present value of future earning and assigning a multiple to those earnings to come to a stock price. But, both parts of this equation show that stocks are significantly overvalued. Future earnings look to be significantly lower. With credit contracting, consumers must defer spending in order to service debt, depressing earnings. With taxes, both personal and corporate going up in the future to pay for massive government spending, deficits, and entitlements - this will depress both consumer spending. It will also be a double hit for companies as not only do they get hit with lower sales due to depressed spending from taxes, and higher corporate taxes will lower earnings.

Second, inflation - which will happen - as you cannot print all this money to finance massive deficits without eventually causing it, will require a higher discount rate - thus depressing the net present value of earnings. Third, higher interest rates that are a result of inflation will also increase borrowing costs and thus lower earnings as well. Finally, with inflation being a long term issue, bond yields will eventually have to rise to account for this. This will depress the earnings multiple as it is directly related to interest rates. Low interest rates mean that earnings yield (the inverse of P/E) will be low. High interest rates mean that P/Es must drop. If long term Treasury rates hit 10% for example, the earnings yield on stocks must be at least 10% to compensate for the risks of owning stocks. This would imply a P/E of 10. Currently, the S&P 500 has a P/E of 15.44 - so with the outlook for interest rates going up - and earnings being depressed, the market will eventually have to drop significantly to reflect this reality.

Many more banks need to fail in order to get his financial mess cleaned up. The Treasury's actions in propping up de facto insolvent banks will only delay the inevitable. When you look at many of the largest banks, and you bring the liabilities for they bad CDOs back on the books, many of them are technically insolvent. What needs to happen is that bondholders for these banks need to have their debts converted into equity in order to shore up the capital to cushion these losses. Alas, the Treasury and Obama administration seem loathe to force conversions or resolutions of these Zombie banks . These inefficient banks are sucking up capital that can be better deployed better by well run banks that did not make these foolish risks.

Instead, we are now have a cabal of large banks that have the government privilege of being "too big to fail". They will have an implicit advantage in their funding costs due to their preference, and they will be able to take on additional risky behavior due to this preference. This will come at a cost to the economy as a whole, as capital will be inefficiently used to prop them up that could be used to fund other ventures.

Couple these facts with a Federal reserve that is abrogating its duties to provide a sound currency and a Congress intent on creating a welfare state via the printing press - things look pretty bleak in the near term.

The solutions, albeit unpleasant, are simple:

It is apparent that we cannot trust people with the responsibility of being guardians of currency. Fiat currency run by bureaucrats in a central bank have devastated wealth over the past century. The since the inception of the Federal Reserve in 1913 - the U.S. dollar has lost 95% of its value. Same story for the Pound Sterling. We should not be ascribing oracle like powers to men like Alan Greenspan, nor any bureaucrat. We need to go back to a gold standard. The gold standard tempers politicians. When money is backed by gold - politicians cannot print debt recklessly to bribe the electorate. If a government issues too much debt, bondholders can start demanding payment in gold rather than paper - depleting a nation's reserves. We would never be in hock to China as we are now if we had to worry about them one day demanding all our gold in lieu of paper. Gold means that politician and bureaucrats cannot debase currency and lower our standards of living. A gold standard forces governments to live within its means.

If we need a financial regulatory regime - we need to scrap the complex BASEL II schemes. BASEL II allows financial institutions to game the models, allowing excessive risk to be taken. The model itself is flawed - just due to the fact that people are not rational all the time. Complex regulation create regulatory capture, with the revolving door of experts moving back and forth between government and industry, lining their pockets at each step. Today, for all intents and purposes, the U.S. Treasury department and Federal Reserve is an agent of Goldman Sachs. Rather than make more and more complex rules - let's make a simple set of rules that apply to everyone. Simple rules for capital, and what activities may be allowed in order for a institution to be eligible for deposit insurance. Those activities not listed are not allowed and may be pursued by other firms at their own risk - if the screw up, let them fail.

Finally, we need a massive rollback on the scope of the government. A nation created on the notion of free-born citizens, free to succeed or fail and live their lives as they see fit - does not need a government that promises them a utopia free of pain or risk. This means rolling back entitlements, regulation, and the related spending. We need to remove the ability of politician and bureaucrats to meddle in private arrangements, and the opportunity for favoritism by special interests.

We can fix this now, when it will hurt a good bit, or we can fix it later, when it will be a lot more painful. Like it or not, it will need to be fixed, because all of this is not sustainable.

Arbitrage and Monopolies

I cannot think of a more worthwhile read for those who are interested in credit markets and banking (and don't have the money to subscribe to Grant's Interest Rate Observer) than The Institutional Risk Analyst.

This week's article discusses credit arbitrage and bubbles. I think the key passage of this essay is:

The "bank monopoly" problem was well-outlined in Adam Smith's treatise and well-documented in the past decade by the Cruikshank Report in the U.K. (March, 2000). In simplest terms, whenever the arbitrage process that balances markets is monopolized, crises become commonplace. It is almost definitional that a financial market monopolist cannot "hedge" its "bets." As with the famous Hunt brothers' attempt to corner the silver market, when a monopolist buyer decides to sell, there are no other buyers, so the value of the monopolized commodity falls rapidly. When that commodity is loans, the result is a financial crisis. It is the alternation of "shoot the moon" and "fire sale" which arises when government policy monopolizes credit markets that causes financial markets to vacillate between euphoric bubbles and climactic crises.

I think that it is foolish for policy makers to believe that they can regulate or legislate away volatility, and absolve the markets of booms and busts. Economic booms and busts are offshoots of human behavior: human creativity, fears, greed - all these aspects lead to the change for better or worse.