Before I start, I would like to toss out the idea of an Aleph Blog Lunch to be hosted sometime in January 2010 @ 1PM, somewhere between DC and Baltimore.  Everyone pays for their own lunch, but I would bring along the review copies of many of the books that I have reviewed for attendees to take home, first come, first served.  Maybe Eddy at Crossing Wall Street would like to join in, or Accrued Interest. If you are an active economic/financial blogger in the DC/Baltimore Area, who knows, maybe we could have a panel discussion, or something else.   Just tossing out the idea, but if you think you would like to come, send me an e-mail.

Onto the comments.  I try to keep up with comments and e-mails, but I am forever falling behind.  Here is a sampling of comments that I wanted to give responses on.  Sorry if I did not pick yours.


Blog comments are in italics, my comments are in regular type.

Spot on David. I often think about the path of the exits strategy the fed may take. In order, how may it look? What comes first what comes last? Clearly this world is addicted to guarantees on everything, zirp, and fed QE policy which is building a very dangerous US dollar carry trade.

Back to the original point, I would think the order of exit may look something like:

1. First they will slowly remove emergency credit facilities, starting with those of least interest, which were aggressively used to curb the debt deflationary crisis on our banking system. The added liquidity kept our system afloat and avoided systemic collapse that would have brought a much more painful shock to the global financial system. Lehman Brothers was a mini-atom bomb test that showed the fed and gov’t would could happen – seeing that result all but solidified the ‘too big to fail’ mantra.

2. Second, they will be forced to raise rates – that’s right folks, 0% – 0.25% fed funds rates is getting closer and closer to being a hindsight policy. However, I still think rates stay low until early 2010 or unemployment proves to be stabilizing. As rates rise, watch gold for a move up on perceived future inflationary pressures.

3. Third, they can sell securities to primary dealers via POMO at the NY Fed, thereby draining liquidity from excess reserves. I think this will be a solid part of their exit strategy down the road – perhaps later in 2010 or early 2011. As of now, some $760Bln is being hoarded in excess reserves by depository institutions. That number will likely come way down once this process starts. The question is, will banks rush to lend money that was hoarded rather then be drained of freshly minted dollars from the debt monetization experiment. For now, this money is being hoarded to absorb future loan losses, cushion capital ratios and take advantage of the fed’s paid interest on excess reserves – the banks choose to hoard rather then aggressively lend to a deteriorating quality of consumer/business amid a rising unemployment environment. This is a good move by the banks as the political cries for more lending grow louder. The last thing we need is for banks to willy-nilly lend to struggling borrowers that will only prolong the pain by later on.

4. And finally, as a final and more aggressive measure, we could see capital or reserve requirements tightened on banks to hold back aggressive lending that may cause inflationary pressures and money velocity to surge. Right now, banks must retain 10% of deposits as reserves and maintain capital ratios set by regulators. Either can be tweaked to curb lending and prevent $700bln+ from entering the economy and being multiplied by our fractional reserve system.

I think we are starting to see #1 now, in some form, and will start to see the rest around the middle of 2010 and into 2011. The last item might not come until end of 2011 or even 2012 when economy is proven to be on right track and unemployment is clearly declining as companies rehire.


UD, I think you have the Fed’s Order of Battle right.  The questions will come from:

1) how much of the quantitative easing can be withdrawn without negatively affecting banks, or mortgage yields.

2) How much they can raise Fed Funds without something blowing up.  Bank profits have become very reliant on low short term funding.  I wonder who else relies on short-term finance to hold speculative positions today?

3) Finance reform to me would include bank capital reform, including changes to reflect securitization and derivatives, both of which should require capital at least as great as doing the equivalent transaction through non-derivative instruments.

A few years back you mentioned to me in an e-mail that Fabozzi was a good source for understanding bonds (thank you for that advice by the way, he is a very accessible author for what can be very complex material.)  In the review of Domash’s book you mention that he does not do a good job with financials. I was wondering, is there an author who is as accessible and clear as Fabozzi, when it comes to financials, who you would recommend.


TDL, no, I have not run across a good book for analyzing financial stocks.  Most of the specialist shops like KBW, Sandler O’Neill and Hovde have their own proprietary ways of analyzing financials.  I have summarized the main ideas in this article here.

Sorry to be a bit late to this post, but I really like this thread (bond investing with particular regard to sovereign risk). One thing I’m trying to figure out is the set of tools an individual investor needs to invest in bonds globally. In comparison to the US equities market, for which there are countless platforms, data feeds, blogs, etc., I am having trouble finding good sources of analysis, pricing, and access to product for international bonds, so here is my vote for a primer on selecting, pricing, and purchasing international bonds.

K1, there aren’t many choices to the average investor, which I why I have a post in the works on foreign and global bond funds.  There aren’t a lot of good choices that are cheap.  It is expensive to diversify out of the US dollar and maintain significant liquidity.

A couple of suggested topics that I think you could do a job with:  1) Quantitative view of how to evaluate closed end funds trading at a discount to NAV with a given NAV and discount history, fee/cost structure, and dividend history;   2) How to evaluate the fundamentals of the return of capital distributions from MLPs – e.g. what fraction of them is true dividend and what fraction is true return of capital and how should one arrive at a reasonable profile of the future to put a DCF value on it?

Josh, I think I can do #1, but I don’t understand enough about #2.  I’m adding #1 to my list.

I see that Fisher’s list reveals his blind spot–how about being born the child of wealthy parents. . .

BWDIK, Fisher is talking about “roads” to riches.  None of us can get on that “road” unless a wealthy person decided to adopt one of us.  And, that is his road #3, attach yourself to a wealthy person and do his bidding.

I am not a Ken Fisher fan, but I am a David merkel fan—so what was the advice he gave you in 2000?

Jay, what he told me was to throw away all of my models, including the CFA Syllabus, and strike out on my own, analyzing companies in ways that other people do not.  Find my competitive advantage and pursue it.

That led me to analyzing industries first, buying quality companies in industries in a cyclical slump, and the rest of my eight rules.

“The Fed has been anything but independent.  An independent Fed would have said that they have to preserve the value of the dollar, and refused to do any bailouts.”

This seems completely wrong to me.  First, the Fed’s mandate is not to preserve the value of the dollar, but to “”to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  I don’t see that bailouts are antithetical to those goals. Second, I don’t see how the Fed’s actions in 2008-2009 have particularly hurt the value of the dollar, at least not in terms of purchasing power.  Perhaps they will in the future, but it is a bit early to assert that, I think.

Matt, even in their mandates for full employment and stable prices, the Fed should have no mandate to do bailouts, and sacrifice the credit of the nation for special interests.  No one should have special privileges, whether the seeming effect of purchasing power has diminished or not.  It is monetary and credit inflation, even if it does not result in price inflation.

¨Make the Fed tighten policy when Debt/GDP goes above 200%.  We’re over 350% on that ratio now.  We need to save to bring down debt.¨

David, I fully agree (as with your other points).
However, I do not see it happening.

Why would we save when others electronically ´print´ money to buy our debt?

See todays Bloomberg News:
¨Indirect bidders, a group of investors that includes foreign central banks, purchased 45 percent of the $1.917 trillion in U.S. notes and bonds sold this year through Nov. 25, compared with 29 percent a year ago, according to Fed auction data compiled by Bloomberg News.¨

Please note that last year the amount auctioned was much lower (so foreign central banks bought a much lower percentage of a much lower total).

Please also note that all of a sudden, earlier this year, the definition of ´indirect bidders´ was changed, making it more complicated to follow this stuff. What is clear however, is that almost half of the incredible amount of $ 2 trillion, i.e. $ 1000 billion (!!), is being ´purchased´ by the printing presses of foreign central banks.

This could explain both the record amount of debt issued and the record low yields.

As the CBO has projected huge deficits PLUS huge debt roll-overs (average maturity down from 7 years to 4 years) up to at least 2019, do you think we could extend the ´printing´ by foreign central banks  — CB´s ´buying´ each others debt — for at least 10 more years?
That would free us from saving, enabling us to ´consume´ our way to reflation of the economy (as is FEDs/Treasuries attempt imo).

I´d appreciate your, and other readers´, take on this.

Carol, you are right.  I don’t see a limitation on Debt to GDP happening.

As to nations rolling over each other’s debts for 10 more years, I find that unlikely.  There will be a reason at some point to game the system on the part of those that are worst off on a cash flow basis to default.

The rollover problem for the US Treasury will get pretty severe by the mid-2010s.

Any chance of you doing portfolio updates going forward? I’d be curious to see if you still like investment grade fixed incomes, given the rally.

Matt, I would be underweighting investment grade and high yield credit at present.

As for railroads, I own Canadian National – unlike US railroads, it goes coast to coast, and slowly they are picking up more business in the US as well.

Long CNI

Did none of the bloggers raise the question of the GSEs? I can understand Treasury not wishing to tip their hands as to their future, but I would have expected their status to be a hot topic among the bloggers.

I also don’t buy the idea that the sufferings of the middle class were inevitable. Over the past 15 or so years the financial sector has grown due to the vast amount of money that it has been able to extract. Where would we be if all of those bright hard working people and capital spending had gone to the real economy? I’m not suggesting a command economy, but senior policymakers decided to let leverage and risk run to dangerous levels. Your comment seem to indicate that this was simply the landscape of the world, but it seems more to be the product of a deliberate policy from the Federal government.

Chris, no, nothing on the GSEs.  There was a lot to talk about, and little time.

I believe there have been policy errors made by our government – one the biggest being favoring debt finance over equity finance, but most bad policies of our government stem from a short-sighted culture that elects those that govern us.  That same short-sightedness has helped make us less competitive as a nation versus the rest of the world.  We rob the future to fund the present.

it’s not clear from your writing whether the treasury officials talked to you about the GSEs or whether your comments (in the paragraph beginning with “When I look at the bailouts,”) are your own. could you clarify?

q, That is my view of how the Treasury seems to be using the GSEs, based on what they are doing, not what they have said.

“There are a lot of losses to be taken by those who think they have discovered a statistical regularity in the financial markets.”
David, take a look at

Jesse, I looked at it, it seems rather fanciful.

Just wondering if there’s an omission in this line:

“The last will pay for the book on its own. I have used the technique twice before, and it works. That said, that I have used it twice before means it is not unique to the author.”

Did you mean to write “that I have used it doesn’t mean it is not unique….”

In the event it is, I’ll look it up in the book, which I intend to buy anyway.
Otherwise, may I request a post that details, a la your used car post,your approach to buying new cars?

Saloner, no omission.  I said what I meant.  I’ll try to put together a post on new car purchases.

thanks for the book review. it sounds like something that i could use to get the conversation started with my wife as she is generally smart but has little tolerance for this sort of thing.

> unhedged foreign bonds are a core part of asset allocation

i agree in principle — it would be really helpful though to have a roadmap for this. how can i know what is what?

I second that request for help in accessing unhedged foreign bonds – Maybe a post topic?

JK, q, I’ll try to get a post out on this.

to the point above, basically just an IRR right?

JRH, I don’t think it is the IRR.  The IRR is a measure of the return off of the assets, not a rate for the discount of the asset cash flows.

When I was an undergraduate (after already having been in business for a long time), I realized that M-M was erroneous, because of all the things they CP’d (ceteris paribus) away. For my own consumption, I went a long way to demonstrating that quantitatively, but children, work and family intervened, and who was I to argue with Nobel winners.

But time, experience and events convince me that I was right then and you are right now. As you’ve noted the market does not price risk well. In large part this is due to a fundamental misunderstanding of value. The professional appraisal community has a far better handle on this, exemplified by drawing the formal distinction between “fair market value as a going concern”, “investment value”, “fair market value in a orderly liquidation”, “fair market value in a forced liquidation” and so on. One corollary to the foregoing is one of those lessons that stick from sit-down education, that “Book Value” is not a standard of value but rather a mathematical identity.

Without going into a long involved academic tome, the cost of capital (and from which results the mathematical determination of value per the income approach) has a shape more approaching that of a an asymmetric parabola (if one graphs return on the y axis and equity debt weight on the x.).

If I was coming up with a new theorem, risk would be an independent variable. So for example:

WAAC = wgt avg cost of equity + wgt avg cost of debt + risk premium

You’ll note the difference that in standard WAAC formulation risk is a component of the both the equity and debt variable – and practically impossible to consistently and logically quantify. Yes, one can look to Ibbottson for historical risk premia, or leave one to the individual decision making of lenders, butt it complicates and obscures the analysis.

In the formulation above, cost of equity and cost of debt are very straightforward and can be drawn from readily available market metrics. But what does risk look like? Again if you plot risk as a % cost of capital on the y axis and on the x axis the increasing debt weight, on a absolute basis risk is lowest @ 100% equity. From there is upwards slopes. However, risk however is not linear, but rather follows a power law.

The reason risk follows a power law is that while equity is prepared to lose 100%, debt is not. Also, debt weight increases IRR to equity (in the real world) contrary to MM. Again, debt is never priced well, because issuers don’t understand orderly and forced liquidation, whereby in “orderly”, e.g. say Chapter 11,recoveries may be 80 cents on the dollar, and forced, e.g., Chapter 7, 10 cents on the dollar. One really doesn’t begin to understand the foregoing until you’ve been through it more than a few times.

So in the real world, as debt increases, equity is far more easily “playing with house money.” A recent poster child for this phenomena is the Simmons Mattress story. In the most recent go round equity was pulling cash out (playing with house money) and the bankers were either (depending on one’s POV) incredibly stupid for letting equity do so, or incredibly smart, because they got their fees and left someone else holding the bag. I’m seen some commentators say that ‘Oh it was OK because rates were so low, the debt service (the I component only) was manageable.’ Poppycock; sometime it’s the dollar value and sometimes it’s the percentage weight and sometimes it is both.

But you’ve already said that: “company specific risk is significant and varies a great deal.” I would also add that – or amplify – that in any appraisal assignment the first thing that must be set is the appraisal date. Everything drives off that and what is ‘known or knowable’ at the time.

Gaffer, thanks for your comments.  I appreciate the time and efforts you put into them.  This is an area where finance theory needs to change.

I have a DB plan with Safeway Stores-UFCW, which I’ve been collecting for a few years. I’m cooked?

Craig, not necessarily.  Ask for the form 5500, and see how underfunded the firm is.  Safeway is a solid firm, in my opinion.

Long SWY

David, I am curious about your rebalancing threshold. Do you calculate this 20% threshold using a formula like this:

= Target Size / Current Size – 1

I have a small portfolio of twenty securities. A full position size in the portfolio is 8% (position size would be 1 for an 8% holding). The position size targets are based generally on .25 increments (so a position target of .25 is 2% of the portfolio and there are 12.5 slots “available”). I used that formula above for a while, but I found that it was biased towards smaller positions.

Instead I began using this formula:

= (Target – Current Size) / .25

So a .50 sized holding and a full sized holding may have both been 2% below the target (using the first formula), but using the second formula, they would be 8% and 16% below the target respectively. I found this showed me the true deviation from the portfolio target size and put my holdings on an equal footing for rebalancing.

I was curious how you calculated your threshold, or if it was less of an issue because you tended to have full sized positions. For me, I tend to start small and build positions over time. There are certain positions I hold that I know will stay in the .25-.50 range because they either carry more risk, they are funds/ETFs, or they are paired with a similar holding that together give me the weight I want in a particular sector.

Brian, you have my calculations right.  I originally backed into the figure because concentrated funds run with between 16-40 names.  Since I concentrate in industries, I have to run with more names for diversification.  I don’t scale, typically, though occasionally I have double weights, and rarely, triple weights.  The 20% band was borrowed from three asset managers that I admire.  After some thought, I did some work calculating the threshold in my Kelly criterion piece.

A fuller explanation of the rebalancing process is here in my smarter seller pieces.

Have you seen DEG instead of SWY?
Extremely able operator. Some currency diversification as well. I’d like to know your thougts.

MLS, I don’t have a strong idea about DEG – I know that back earlier in the decade, they had their share of execution issues.  It does look cheaper than SWY, though.

Long SWY

I like your post and want to comment on a couple of items.  You point to the peak of the 1980’s inflation rates and the associated interest rates.

Robert Samuelson wrote a book called The Great Inflation and it’s Aftermath.

Basically you can explain a great deal the US stock market history of the 40 years by the spike in interest/inflation until the mid 80’s and the subsequent decline.  Since you need an interest rate to value any cash flow, the decline in interest rates made all cash flows more valuable.

The thing that is odd and sort of ties this together is the last year.  After interest rates crossed the 4% level things started blowing up.  The amount of debt that can be financed at 3% to 4% is enormous.  That is, as everyone knows, on of the root causes of the housing bubble.  Anyway, starting last year, treasury interest rates continued to decline and all other rates went through the roof.

I was looking at this chart yesterday.  _ The interesting thing to me was that when the system blew up, treasury rates continued to decline and all non guaranteed debt rates went through the roof.

Most of this is obvious and everyone knows the reasons.  The one thing that seems novel is thinking of this as the continuation of a very long secular trend — or secular cycle.  I don’t want to get overly political, but the decrease in inflation/interest in the 90’s to the present was a function of productivity/technology and Foreign/Chinese imports.  Anyway, one effect of these policies was a huge rise in asset values, especially in the FIRE (finance, insurance, real estate) sector of the economy at the expense of our industrial and manufacturing sectors.  This was also a redistribution of wealth from the rust belt to the coasts.

It is much more complicated then the hand full of influences I mentioned, but the one thing i haven’t seen discussed a lot is the connection of the current catastrophe to the long term decline in inflation/interest rates since the mid/late 1980’s.  If you think about it, declining interest rates increase the value of financial assets and are an enormous tailwind for finance.  I suppose if you had just looked at the curve, it would have been obvious that the trend couldn’t continue.  Prior to the blowup, there were lots of people financing long term assets with short term, low interest rate liabilities. That was a big part of the basic playbook for structured finance, hedge funds, etc.

The reason that the yield spread exploded is well known.  Here is a snippet from Irving Fisher.

CapVandal – Great comment.  A lot to learn from here.  I hope you come back to blogging; you have some good things to say.  Fear and greed drive correlated human behavior.

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