Pension Funk

I haven't written on this blog for a while - been busy coping with the "aftermath" of the financial crisis on my own career :).

However, the brouhaha over pension plans and their being taken over by the proto-communist U.S. government has brought me out of my (recession-imposed) hibernation. As I had forecast 15 months ago (url: http://sin-letter.blogspot.com/2008/05/silver-lining.html), which was over four months before the Lehman Brothers crisis, public liabilities in the form of pension funds is half the problem that the U.S. establishment will tackle. The other half is the execise level of national debt.

The end game of pensions will look like this - pension funds will go into crisis mode and will get taken over by the government. This will mean that the pensioners will get paid by the taxpayers (the only productive part of the U.S. economy). Which is another way of saying that the system will start moving dollars from one pocket to the other without actually creating new wealth.

So how will the U.S. establishment manage the juggling of these financial "balls"? Simple, keep adding new balls and hope no one notices that balls keep falling out of the act. In other words, inflate until people have lost their lives savings but still get paid the amount contracted in their pension agreements.

The way to print money like Michael Schumacher drives his F1 is to drop interest rates to near zero. Which, BTW, was done many moons ago.

But there is speed bump on the way - the deflationary death spiral of global commodity prices. More on that later.

Perverse Incentive System - II

One of the factors that has never been blamed for the sub-prime fiasco is competition.

That is obvious because competition is considered the foundation of the free-market system, and hence criticizing competition is equal to challenging the market itself.

Competition is thought to lead to better products/services, which is assumed will lead to a better society, or at least a more efficient economy.

Competition is never thought to be a market destroying culprit. This is heretical.

Questioning the utility of a competitive market will naturally lead to calls for more regulation - an absolute anathema to the free-market.

So, market participants have an incentive to avoid the elephant-in-the-room.

Let's take a recent example.
The falling standards of mortgage-approval were a direct result of increasing competition.

As more mortgage-players entered the market, customers became a hot property. And in order to secure more customers, lending-standards were lowered. And they were lowered to such an extant that the ability to repay the debt was forgotten.

The mortgage companies were able to ignore the loan-worthiness of the debtors because they never expected to be paid by them - they expected to be paid by those funds and investors who would buy these packaged loans in the form of Mortgage-Backed-Securities (MBS), Collateralized-Debt-Obligation (CDO), etc.

Once these mortgages were packed into an instrument, all that the manager had to do was get a sufficiently high rating from a rating agency to justify a good return for the company and a good bonus for himself, and everybody could go home happy via a short stop at the bank.

The rating agencies had their own perverse incentive system - but that's another post.

Higher competition (for more customers) led to lower standards - which ultimately led to the blow out in the markets.

Had competitive pressures not been high, it is conceivable that the markets would not have suffered a collapse.

Perverse Incentive System - I

Perverse incentive management system created the real-estate/sub-prime fiasco

While a lot of attention has been focussed on the 'system-failure'of the financial system and regulation, not enough attention has been paid to the internal management failure in te companies themselves.

Part of the reason is the belief that companies in a free-market have the right to manage their own incentive system. That is true, but it never hurts to do a little introspection.

Fund and investment managers recieve bonuses when the fund(s) they manage beats a given benchmark. The bonus is directly proportional to the percentage of performance over-and-above the benchmark. These benchmarks can be anything like an index, or a given fund, etc.
The need to beat a benchmark propels managers to take on more risk than they normally would. This is where problems come up.

Statistically, some investment opportunities have what is called a 'fat-tail'. In other words, the investment opportunity has -
1) a large possibility of making a small profit, and
2) a small possibility of making a large loss.

The small possibility of making a large loss is a what is called a 'fat-tail' or 'black-swan' event. Because it is a rare event.

In their zeal to raise their returns, investment managers jump at the possibility of making those small gains, and tend to ignore the chance of loss.

And when the rare event of a large does occur, the managers are left holding the sack.
Now, you might wonder why are the managers not smart enough to avoid the problem area. Three reasons - greed, plain bad luck and follow-the-herd.

GREED
Although some managers may avoid the problem, it is not necessary that all would. For some people, the possuibility of making a profit is enough incentive to ignore the chance of a large loss.

PLAIN BAD LUCK
Suppose that the possibility of the loss occurs once in 10 years, and that 9 years of profit have passed. A company investing in the ninth year has a very probability of loss.
Some people just had bad timing to invest at the top of the market.

FOLLOW-THE-HERD
Imagine a manager avoiding the sub-prime market because he thinks the fundamentals are out of order. Now imagine his superior telling him about the money other managers within the company are making, and making continuously. How long would our level-headed manager be able to hold out as his peers get better reviews.

These factors lead to a permissive situation where it is a crime to hold out against joining a band-wagon.

The need to beat the market led managers to take risk more than that justified by the resulting rewards.

Japanese Rates and Sub Prime Crisis

Japanese Rates and Sub Prime Crisis

In a bid to keep its economy chugging after the great real-estate-and-stock-market boom and bust of the late 80s, Japan kept lowering its interest rates.

This continued until 1997, when rates hit rock bottom at 0.25%, and could not be lowered any more. The low Yen favored Japan-based exporters, which was OK from Japan’s point of view, given that their domestic economy was so well developed that it could no longer be a growth engine for Japanese companies.

However, Wall Street did not fully realize the potential for arbitrage (more commonly called Yen-carry trade) until around January 2006.

This presentation titled “The Broad Yen Carry Trade” (url: http://www.princeton.edu/~hsshin/www/yenliquidityslides.pdf) discusses how the Yen-carry trade affected the Western financial markets. The slide on page 5 titled “Interbank Liabilities of Foreign Banks in Japan” shows how borrowings by foreign banks really picked up around the beginning of 2006.

The Yen-carry trade made possible the low mortgage rates in the US. This is important when you consider that the sub-prime crisis started in full earnest in March 2007, just succeeding February 22 when the Bank of Japan raised its interest rates from 0.25% to 0.50%.

This is, of course, not to suggest that BoJ deliberately or consciously caused the crisis. However, circumstances do suggest that the rate hike caused problems in the sub-prime sector to become a full blown crisis – by removing liquidity at a time when it became crucial to sustain the sector.

Japanese Example

Repeat of Japanese Example

When discussing the advantage that the US economy will get from a weaker currency, the existing example of Japan is forgotten.

Japan also tries to maintain a low currency, for it aids exports. Japan however has a few natural advantages over US when it comes to such activities.

A low currency has the disadvantage that is increases import price. And if a country is not naturally well-endowed, a rise in international commodity prices can play havoc with its inflation rate.

However, Japanese population growth is well under control, and the personal consumption rates are also stable. This gives their policy makers the freedom to treat the internal economy as a constant. So, beyond a particular point, they can devote their energies to managing their ‘external’ economy – in other words, the currency rate.

It was this relative freedom from internal constraints that enabled the Japanese to keep interest rates low for such a long time.


HISTORICAL SIMILARITY
An interesting feature of the present US dilemma is that it is a repeat of what happened in Japan almost two decades ago.

The Japanese real estate prices inflated to such an extent in the late-80s that it was rumored that the land of the Imperial Palace in Tokyo was worth more than entire California.

The subsequent crash led to a decade long economic depression.

Japan eventually found its salvation when it discovered low interest rates, and maintained 0.25% since 1997 until February 22, 2007.

The low interest rates not only gave an unnatural export advantage to the Japanese economy, which suffers from an aging population, but also insulated its domestic markets from foreign competition.

America seems to have discovered the same panacea. But it is still too soon to say which way the bamboo will fall, because there still is one crucial difference in the two economies.


AHISTORICAL DISSIMILARITY
Japanese economy was driven by re-investment. The collapse of its real-estate and stock markets deprived its corporations of the wherewithal to invest, and led to the emergence of corporations from its long-standing rival South Korea.

US economy is consumption driven. The collapse of its real-estate and stock markets (not to mention the high fuel prices) will drive down consumption – and consequently the profits of all those companies whose ultimate customer is found in the US.

Rather than lead to the emergence of new rivals, this crisis is likely to have a Boa-like strangulation on (US-focused) companies across the world.

This will eventually have a sobering effect on raw-material prices.

The medium term outlook for raw-materials (perhaps excluding energy) is bearish, given the fact the bottom has been knocked out of global consumption.

Silver Lining

Benefit from the financial crisis to the US political-economy

The present financial crisis, despite its portentous appearance, does have some hidden benefits to the US economy, or at least to the political managers of the US economy.

How is that?

Well, the two most important economic issues facing the US economy for the next generation or so are its enormous external debt, and its aging population.

The external debt of the US is estimated to be around $13 trillion, according to official statistics - http://www.ustreas.gov/tic/external-debt.shtml, and is growing at the rate of $665 billion annually.

And the first of the baby-boomers started retiring in 2008.

Now, although it is commonly understood these two factors will cause strain in the US economy, what usually does not figure high in public perception is the specific nature of the impact.


Take the aging population.

We know this will reduce the percentage of workers in the US. We can infer that this will increase the burden on the younger workers – because each of them will be supporting more people.

This means higher tax burden. This further means that workers will have to have a much higher productivity in order to pay the higher tax burden. However, there is a way to instantly raise productivity levels in the international market – devalue the currency.

The current crisis allows US to do just that.


Now, take the high external debt.

A higher inflation rate will reduce the claims on US property that these debts represent. In other words, a weaker currency reduces the amount of companies that say – the Chinese sovereign fund will be able to buy.


KEYNOTE SUMMARY:
A devalued dollar:
1. Increases the international competitiveness of the US industry – reducing the pressure on the pension system.
2. Reduces the claims of the debt the US owes to the rest of the world.

Benefitting Industries

Here are some of the industries which will gain during the recession. These industries are chosen according to the principles I outlined earlier in this write-up - http://sin-letter.blogspot.com/2008/04/since-we-are-in-beginning-of-us.html.

1. Fertilizer companies:
They will benefit from the global food shortage, as well as the rising demand for higher protein diet that is coming from across the developing world as it becomes more wealthy. However, the high cost of the input like naptha or natural gas, may prove to be a dampner.

2. Service providers to Energy/Utility companies:
These companies provide logistics, maintenence services, etc. to larger oil/gas/energy or utility companies. They will benefit since their customers are facing the beautiful combination of excess cash and rising demand.

3. Medical services companies: These companies will benefit from the most significant US demographic trend going on right now - the retirement of the baby-boomer generation. The older generation will require more medical services as time goes by.

4. Agri-produce companies: Such companies will benefit from the global shortage of food.

5. US companies with high exposure to non-US economies: Since it appears that the Federal Reserve is set to devaule the Dollar, the currency will continue to fall - benefiting US exporters at the cost of foreign competition. It will also benefit those US companies which earn a significant portion of their income outside the US, as currency translation will increase its income in Dollar terms.

6. Companies providing goods and services for the infrastructure build-up in the developing countries: There is a lot of pent up demand for infrastructure in developing countries as in Africa, LatAm, besides India and China. Big beneficiaries will be shipping companies, telecom infrastructure companies, etc.