Career trades and object lessons

The WSJ carried an interesting story today (subscription required) about hedge fund bearishness on the euro relative to the USD (i.e., a falling euro exchange rate):

Some heavyweight hedge funds have launched large bearish bets against the euro in moves that are reminiscent of the trading action at the height of the U.S. financial crisis.

The big bets are emerging amid gatherings such as an exclusive “idea dinner” earlier this month that included hedge-fund titans SAC Capital Advisors LP and Soros Fund Management LLC. During the dinner, hosted by a boutique investment bank at a private townhouse in Manhattan, a small group of all-star hedge-fund managers argued that the euro is likely to fall to “parity”—or equal on an exchange basis—with the dollar…

Our interest isn’t motivated by the anti-euro call, which is rather conventional and uninteresting (Robert Mundell, one of the intellectual architects of the EMU, has recently predicted movement towards EUR-USD parity, and USD parity is something of an underlying objective of the EMU, if not the ECB).

Rather, it’s in the social and market dynamics involved, and how strongly they illuminate the ongoing importance of financial market regulatory reform.

The WSJ notes that this was an invitation-only event at a private home, and included some major global macro hedge fund players. While that’s not a bad thing per se, it definitely creates some potential market asymmetries and risks:

• Asymmetries to the extent that a small number of players with (relatively) massive amounts of capital and the ability to take highly leveraged bets (that’s the implication of “career trade”) may all be thinking and moving in the same direction; and
• Market and economic risks may because concerted, highly leveraged bets are likely to accelerate what might otherwise be a more orderly return to parity, i.e., one that unfolds over a longer period of time that allows for interested agents to adjust without too much trouble.

That last one is the more interesting point in our opinion, because of what it implies about the theoretical ideal of market efficiency. If EUR-USD is bound to return to parity, is it less destructive to let it “happen naturally”, or is it healthier in the long term to allow levered up speculators to (attempt to) correct mispricings as soon and as quickly as possible?

We have some qualms with the latter approach, because: (1) it may create more market and economic havoc than would otherwise occur; (2) if successful, the “rents” associated with the resulting dislocation (even beyond the mere price adjustment) accrue to a small number of privileged players; and (3) if those bets go badly, the damage could very well spread beyond the hedge funds’ assets (LTCM being the archetypal example).

Of course, those rents accrue to a hedge fund’s passive partners too, so there may be outside institutions that benefit, rather than just the funds’ general partners (emphasis on “may”). But speculators aren’t just messing with an asset class here; they’re impacting the very measuring rods of economic activity and financial obligations, and some of them are able to employ astronomical leverage in doing so, if they desire. 

If the net social costs of that activity are negative, it becomes immaterial who the ultimate beneficiaries of the managing partners’ actions are. It also highlights how critical it is to do regulatory reform well, but soon. Speculators are absolutely critical to financial markets and economies, but optimization requires some degree of financial constraint. How many more ‘object lessons’ will we require on that point?

URLs:

http://online.wsj.com/article/SB10001424052748703795004575087741848074392.html

http://en.wikipedia.org/wiki/Long-Term_Capital_Management

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy.

Greece and Goldman

There’s been a good deal of news swirl about Goldman Sachs’ role in entering into swaps contracts with Greece in order to assist it in “hiding” some of its public debt as it prepared to enter the EMU.

Here’s a good primer from 2003 on these types of swaps, and an interesting thought piece on it from Ed Harrison.

URLs:

http://www.risk.net/risk-magazine/feature/1498135/revealed-goldman-sachs-mega-deal-greece

http://seekingalpha.com/article/190390-inside-the-mind-of-an-investment-banker-greece-goldman-and-derivatives

Fiduciary churn

Ouch! Research by finance professor Scott Stewart finds that the decisions made by plan sponsors on behalf of pensions, endowments, and foundations have persistently negative economic value.  

Using the most conservative approach for interpreting his results, Stewart concluded that plan sponsors had collectively squandered $170 billion in value over the two-plus decades he studied… 

“Plan sponsors never make their money back,” Stewart told me. “If they simply went on vacation, they could save their clients $170 billion – and that doesn’t count transaction costs.” 

The good news for plan sponsors? They’re less bad than most:

Plan sponsors are, of course, not unique in their ability to destroy value in this manner. Numerous studies, including those by Dalbar and Morningstar, have documented that individual investors, for example, buy mutual funds more heavily at the market peak and tend to sell them at the market bottom.  Plan sponsors should be more sophisticated than individual investors and, according to Stewart, they are. “Although they behave like retail investors,” he said, “the amount of value they destroy is a fraction of that destroyed by individuals.”

URLs:  

http://www.advisorperspectives.com/newsletters10/pdfs/How_to_Squander_$170_Billion.pdf  

How do you spell W-I-M-P-Y?

First Congressional jobs bill of 2010 has cleared the Senate:

Senate Democrats Wednesday delivered the first of several promised election-year jobs bills, passing a measure blending tax breaks for companies that hire unemployed workers with highway funding eagerly sought by the states.

The bipartisan 70-28 vote to pass the bill sends it to the House, where many Democrats say it is too puny…

We tend to agree with the House Dems. Among the bill’s measures:

Democrats promise additional measures to create jobs, promising help for small businesses having trouble getting loans, aid for cash-strapped state governments, and subsidies for people who make their homes more energy efficient…

The bill contains two major provisions. First, it would exempt businesses hiring the unemployed from the 6.2 percent Social Security payroll tax through December and give them an additional $1,000 credit if new workers stay on the job a full year. The Social Security trust funds would be reimbursed for the lost revenue.

Second, it would extend highway and mass transit programs through the end of the year and pump $20 billion into them in time for the spring construction season. The money would make up for lower-than-expected gasoline tax revenues…

And the reason it is so wimpy:

But budget deficits are a worry, and future measures are going to be more difficult to pass — especially since a top Senate Democrat has blocked unused authority from the Wall Street bailout program from being used to “pay for” jobs initiatives…

Sen. Judd Gregg of New Hampshire, top Republican on the Senate Budget Committee, blasted the measure for increasing the budget deficit to fund highway and transit programs. He said the measure made a joke of Democratic promises to adhere to “pay-as-you-go” budget rules requiring new spending programs to not increase the deficit.

“I don’t think you get people back to work in this nation by loading more and more debt onto the next generation,” Gregg said.

Sen. Gregg seems like a good man, but he just doesn’t get the underlying economics (unless he believes that the private sector is in robust shape and capable of standing on its own, which means he’s looking at different data than we are). And as we continue to point out, if he and other budget hawks are wrong about the underlying economics, then they are actually going to leave “the next generation” in even worse shape than they would be with more concerted stimulus.

Mark Zandi is cited as estimating that the Senate bill will create roughly 250,000 jobs. That number is unlikely to even make a perceptible dent in structural unemployment. By our back of the envelope calculations, the Senate bill will add about half a percentage point to GDP under the most optimistic assumptions.

We’ll close by calling again on correspondent J. Wellington Wimpy:

“You will gladly pay me today for a job that might be created tomorrow.”

URLs:

http://news.yahoo.com/s/ap/20100224/ap_on_bi_ge/us_congress_jobs

http://symmetrycapital.net/index.php/blog/2010/02/the-hawks-are-circulating/

The Deficit Commission: Hubris or Pandering?

The President signed an executive order yesterday to establish a deficit reduction commission headed by Erskine Bowles and Alan Simpson. Bowles was instrumental in the Clinton administration’s budget negotiations of the late 1990s, while Simpson helped ensure passage of the tax hikes in 1990 that torpedoed the first President Bush’s reelection.

Why do we think the commission is a display of hubris? Because there’s nothing in its mission about better understanding the nature of the problem, i.e., whether enlarged deficits and public debt ever make sense over a longer period of time, and if so, whether those conditions exist today. Instead, it seeks to cram macroeconomic orthodoxy down our throats, presumably in order to fatten up the livers of U.S. taxpayers by the arbitrarily imposed year of 2015.  But we predict that even in five years the fiscal foie gras will still be pretty lean.  According to the Washington Examiner:  

Here are the kinds of steps the panel is likely to consider as it seeks to tackle deficits that never dip below $700 billion under Obama’s budget:

_Raise the retirement age for full Social Security benefits to more than 67 years old and have benefits grow at a less generous inflation rate. Expose more income to Social Security and Medicare payroll taxes.

_Require seniors to pay more Medicare costs out of their own pockets and curb payments to health care providers.

_Raise taxes on people making less than $200,000 a year, requiring Obama to break a signature campaign pledge.

“You’re going to have to do all of the above,” said [Sen. Kent] Conrad. “You’re going to have to do all of the things that people don’t want to do.”

The first one isn’t a terrible idea, though its second part might constitute an overall tax hike on anyone earning over ~$100K per year, depending on how it is accounted for in income taxes.

The second one, although it’s a pressing issue given demographic projections, would have harsh consequences on seniors, not only in terms of out of pocket costs, but also in the availability of Medicare providers; it also renders the economics of a medical education far more difficult (if not impossible) for those who would be willing to administer primarily to the poor and the elderly.

The third one, depending on how big a hike is involved and how far down the income ladder it extends, could have negative economic consequences and profound political implications.

The long term structural issues do present a fiscal challenge. However, policymakers may be getting too far ahead of the problem, and if they are, the consequences could actually worsen the longer term fiscal outlook. And yet the president has charged the commission with lowering public deficits, period, without any consideration of what it could mean to the economy, or whether there’s any truth to his arguments that the government could “run out of money,” or that it’s subject to the same kinds of budget constraints as a household or business.

Obviously, given our take on the role of the federal budget, we would be relieved if the commission turns out to be little more than election year pandering. And the fact that it aims for budget normalization rather than budget balance, and shoots for it in five years rather than one or two, is a good sign. But based on U.S. demographic composition, we think 2018 to 2020 would make far more sense.

If the commission produces hawkish recommendations that are pursued vigorously in the coming years,  our strong dollar call will become stronger yet, and our willingness to wager on a double dip or ‘recession within a depression’ type of event would increase (2012-2013 could be interesting, and not in a good way).

URLs:

Plane hits IRS building

Normally we treat ‘tax revolt’ news items with some levity, but this one is tragic:

A software engineer furious with the Internal Revenue Service launched a suicide attack on the agency Thursday by crashing his small plane into an office building containing nearly 200 IRS employees, setting off a raging fire that sent workers fleeing for their lives.

At least one person in the building was missing.

A federal law official identified the pilot as Joseph Stack and said investigators were looking at a long anti-government screed and farewell note that he apparently posted on the Web earlier in the day as an explanation for what he was about to do.

In it, the author cited run-ins with the IRS and ranted about the tax agency, government bailouts and corporate America’s “thugs and plunderers.”

Stack’s full screed is available on The Smoking Gun website.

URLs:

http://news.yahoo.com/s/ap/20100218/ap_on_re_us/us_plane_crash_texas

http://www.thesmokinggun.com/archive/years/2010/0218102stack1.html#theLink

Miller & Chevalier Tax Policy Forecast

Miller & Chevalier’s 2010 tax policy forecast survey is out (TOH WebCPA), and it starts with this rather gloomy preface:

Although Congress and the Administration continue to focus their attention on health care reform and the continuing economic downturn, the business community can expect that there will be a significant focus on tax policy issues in 2010, including the potential for the consideration and enactment of proposals that increase the corporate tax burden.

According to survey respondents:

An increase in the U.S. taxation of international operations (74 percent), increased taxes on capital gains, dividends and interest (67 percent) and codification of the economic substance doctrine (61 percent) are named as the leading tax revenue sources to be tapped to fund Congressional initiatives in 2010.

We sure hope they’re wrong. As we’ve noted elsewhere, if the federal government makes a concerted effort to finance its spending from current and short term revenues, then economic outcomes are sure to disappoint. In the wake of a financial crisis, money is in relatively short supply (high demand), and the last thing the public sector should be doing is competing for savings.

URLs:

http://www.webcpa.com/news/Execs-Concerned-about-US-International-Tax-Policy-53296-1.html

http://tinyurl.com/miller-chevalier-2010

Marshall the Moody’s Mauler

Marshall Auerback offered up a brutal dismantling of rating agencies’ negative outlooks on sovereign debt issuers like Japan, the U.K., and the U.S.

America’s Triple AAA credit rating could be at risk should its nascent economic revival not develop into a full-blown recovery, Moody’s Investor Service warned yesterday…

Sound familiar? The so-called “Big Three” ratings agencies have been making claims like this for years: in Japan, the UK and, now, the United States. It is worth recalling that these are the same organizations which, as recently as 2007, were conferring Triple AAA ratings on subprime mortgage paper…

Unlike Moody’s, we think it is absurd to say that the government is going to ‘run out of money’ as our President has repeated. It is not dependent on China or anyone else. There is no operational limit to how much government can spend, when it wants to spend. This includes making interest payments and Social Security and Medicare and Medicaid payments. It includes all government payments made in dollars to anyone.

And if Moody’s (or any other ratings agency) genuinely thinks that government debt is intrinsically evil and that surpluses should be the stated goal of US government policy (in order to safeguard America’s Triple AAA rating) then it must spell out the full consequences of this policy choice. The ratings agencies appear incapable or (at the very least) unwilling to explain the essential sectoral relationships that link the government, private and external sectors. They seem to think that you can have everything – a budget surplus and high private saving and debt reduction. You cannot as a matter of plain accounting logic unless you suddenly start net exporting in great volumes, (which has not happened to the US in its post W.W. II history), or if the domestic private sector is either choosing to deleverage or use leverage less than in the past, that means it will take large and increasing fiscal deficits, or small and decreasing trade deficits, or some combination of the two, in order to achieve trend real GDP growth paths. Otherwise, the result is stagnation or in the extreme, debt deflation. That will not do much to enhance America’s credit rating.

If there’s one thing that Auerback and his fellow neo-chartalists stand out on, it’s this: rating agencies, policymakers, economists, pundits, and many, many others think and speak about debt, deficits, and money as if the world still operated on some type of commodity standard. It does not. Smaller economies may be forced by circumstance to be on hard currency standards, at least operationally, and that is somewhat analogous to a commodity standard. But there is no compelling reason why any issuer of the world’s major currencies (ex-ECB ) should ever miss a debt payment. It’s preposterous.

And yet people actually buy protection against default on U.S. treasury debt via credit default swaps (CDS)! That’s a financial snake oil that comes with potentially significant economic costs. Here’s why:

• Holders of Treasury debt are giving away money to the counter parties selling CDS protection.*
• If it were possible for the U.S. government to default, what counter party could possibly cover its obligations? Diligence schmiligence?
• Leverage, insufficient regulation, and herding behavior have actually made the long CDS trade a winner at times over the past several years.
• That means a greater amount of capital becomes (mis)allocated to people who have done nothing to improve overall economic well-being.
• Those winners will suffer delusions of genius, which almost guarantees they’ll make bad decisions in the future.
• If those bad decisions are levered highly enough, their errors will have systemic implications.
• Add opportunity costs to the risk of systemic damage and the net long term social costs of such behavior are almost certainly negative.

* It might not seem like much — at 50 basis points it costs $50,000 to “insure” $10MM of Treasury debt — but if we assume, for example, that a pension fund is on the long side of the swap, it’s giving away the equivalent of one or two pensioners’ incomes. And while it might look like a good move as long as speculation in Treasury CDS continues to run, the real economic value is ZERO, for the reasons outlined by Auerback.

URLs:

http://www.newdeal20.org/?p=8162

http://www.reuters.com/article/idUSN0524400220100205?loomia_ow=t0:s0:a49:g43:r1:c1.000000:b30347234:z0

Demographics and Employment in Australia

Roubini Global Economics asks in their Daily Top5 email (registration required), “Will Australian Employment Resume Rising?” They note that Australia’s labor market is in fine nick:

Australia’s unemployment rate dropped to 5.3% m/m in January 2010 from 5.5% m/m in December 2009. Employment rose in January, driven by an increase of 15,900 full-time jobs, and the total number of hours worked by Australians dipped 1% on an annual basis. Over the past five months, annualized job growth has been 4.4%, the strongest since April 2005.

We’ve been touting the power of demographic composition quite a bit, so let’s make Australia a quick and dirty test case. Here’s a population pyramid showing the sizes of each age cohort:

The three largest cohorts in the ‘bulge’ from age 31 to 45 are just entering their most productive years. That implies that the answer to RGE’s question should be an emphatic “Yes”.

URLs:

http://en.wikipedia.org/wiki/File:Population_Pyramid-_Australia_2005.svg#filelinks (retrieved 2/12/2010)

Auerback on Greece

Marshall Auerback offers an assessment of the brewing rescue package for Greece. It echoes some of the observations we recently offered about the EMU:

The insanity of self-imposed budgetary constraints will be manifest to all soon enough. Economists and the EU bureaucrats who advocate a slavish adherence to arbitrary compliance numbers fail to comprehend the basis of government spending. In imposing these voluntary financial constraints on government activity, they deny essential government services and the opportunity for full employment to their citizenry.

Score another one, then, for the high priests of fiscal rectitude. Harsh cuts, tax increases — this is by no means a recovery policy. The capital markets have got their pound of flesh. But Greece is no more able to reduce its deficit under these circumstances than it is possible to get blood out of a stone. Politically, it means ceding control of EU macro policy to an external consortium dominated by France and Germany. Greece becomes a colony.

EMU members do indeed give up a significant degree of control over macro policy. The expected tradeoff is that they’ll enjoy lower financing costs and deepening credit and other financial markets. But the balkanization of fiscal policy poses severe challenges – especially when pessimistic expectations dominate.

There’s an interesting caveat about Greece that could undermine Auerback’s ‘national suicide pact’ assessment. According to Ajay Kapur, Greece has the most attractive demographic profile in Europe (Ireland’s isn’t bad either). If Kapur’s predictions are borne out, then Greece should be A-OK in the decade ahead. In ten years they might even be able to contribute to a bailout of one or more of today’s ’colonizers’!!??

URLs:

http://www.newdeal20.org/?p=8251

http://symmetrycapital.net/index.php/blog/2010/02/global-sell-off-and-the-emu/

http://investments.miraeasset.us/en/ourMarkets/outlookView.do?board_id=1125&group_id=1&pageNo=1