Category: Finance

Investors Should Be Prepared to Face Financial Oppression

That’s the conclusion of a new report by Morgan Stanley analyst Arnaud Mares.

And what, you may ask, is financial oppression? Speaking from the perspective of investors in sovereign debt, Mares defines it as “imposing on creditors real rates of return that are negative or artificially low.” Which doesn’t require outright default. Instead, it

[C]an take other forms: repaying debt in devalued money (e.g., through unanticipated inflation), taxation or regulatory incentives on institutions to purchase government debt at uneconomic prices.

Mares sees sovereign creditors as tempting targets when over-indebted governments decide which of their many fiscal promises they can’t keep.  After all, elderly pensioners cast more votes than coupon-clipping bond holders. And he thinks current low yields provide little protection against that threat.

His piece is definitely worth a read if you want to consider a bearish view on U.S. and European sovereign credit.

It’s Back-to-School Season, Time to Lay Your Bets

According to an article over at the Huffington Post (ht Natalie), students at 36 colleges will have a new option when they start classes this fall. Thanks to an outfit named Ultrinsic, students can now bet on whether they will get good grades. Students put up money at the start of the semester and then get payoffs at the end depending on how they do.

Calling it a bet isn’t completely fair, however, since the payoff creates an extra incentive for students to do well. So think of it as a combination of betting (if you think your odds of doing well are better than Ultrinsic thinks) and using a financial incentive to get your future self to study a bit harder. Naturally, Ultrinsic emphasizes the incentive perspective in describing its “Reward” product:

Do you like getting good grades? The right amount of cash should provide you with the needed motivation to pull all-nighters and stay awake during the lectures of your most boring professors. At Ultrinsic.com, you will be able to earn cash while working to achieve your academic goals.

Obligatory note to my new crop of students: all-nighters are generally not an optimal learning strategy.

Like a race track, the company offers packages that pay off not only if you do well on a single course, but also if you perform well in multiple courses or over an entire semester. If a new freshman is really feeling motivated, he or she can also put down $20 up front for the opportunity to win (earn?) $2,000 for maintaining a 4.0 GPA throughout college.

And if students are feeling risk-averse, they can also buy insurance against bad grades. Bomb that final and get a cash reward.

Somehow I doubt many students will want to buy such insurance. Or that Ultrinsic will want to sell it given the risks of moral hazard. Perhaps Ultrinsic will screen for “pre-existing conditions” (like failing a related class) in order to limit the adverse selection. Or just offer such high premiums that only a few extremely risk-averse (or mathematically-challenged) students will apply.

The incentives product, however, seems much more promising. Indeed, it resembles some other efforts to help people modify their own behavior through financial incentives. See, for example, the folks at stikK.com whose service allows users to create their own incentives. For example, you could commit to give $500 to your favorite charity if you fail to lose 10 pounds by Christmas. Even better, you could commit to give $500 to your least-favorite charity if you fail to drop the pounds.

Ultrinsic is just applying this logic to college grades … and kindly offering to take a cut when students fall short.

House Prices: Demographics Giveth and Taketh Away

Over at the Bank for International Settlements, Elod Takats has a new working paper that examines how demographics may affect asset prices (ht Torsten Slok). As he notes, standard economic theories suggest that aging will lead to lower asset prices. In an overlapping generations model, for example:

[T]he young save for old age by buying assets, while the old sell assets to finance retirement. This asset transfer can happen directly or through institutions such as pension funds. In this setting, the changes in the relative size of asset buyers (the young) and sellers (the old) have consequences for asset prices. In particular, the asset purchases of a large working age generation, such as the baby boomers in the United States, drives asset prices up. Conversely, if the economy is ageing, ie the subsequent young generation is relatively smaller, then asset prices decline.

Takats tests this theory on international data on house prices and finds a significant link with population age.  He uses that relationship to estimate how much demographics affected house prices in recent decades and to project, based on demographic estimates from the UN, how population aging will affect house prices in the future:

He concludes that demographic trends boosted U.S. house prices by almost 40% over the past four decades. Given current population trends, however, his model predicts that aging will trim about 30% off of house prices over the next forty years.

I should emphasize that this does not mean that house prices will actually fall over that period. Other factors, e.g., growing incomes, should continue to boost prices. But house prices will now face a demographic headwind–blowing at about 80 basis points per year–rather than a demographic tailwind.

These headwinds will be even stronger in Europe:

The Cocoa Corner: Is Choc Finger Down $150 Million?

In a front page story on Sunday, the New York Times suggests that commodity investor Anthony Ward may be trying to corner the cocoa market.  Ward–known as Choc Finger–reportedly purchased 241,000 tons of cocoa, about 7% of the world’s annual crop. The price tag? A cool $1 billion.

The NYT suggests that Ward is doing this to profit from future price increases, either natural or created by his new market power:

His play has some people up in arms. While some see it as a simple bet that cocoa prices will rise on falling supply, others say Mr. Ward has created a shortage of cocoa simply to drive up the price himself. … The fear is that Mr. Ward will become the go-to source until the annual cocoa harvest, which starts in October. With candy makers starting to stock up for the holiday season, they may be forced to pay him ever-higher prices — and cocoa has already jumped 150 percent since 2008.

“The squeeze was really timed perfectly,” said Eugen Weinberg, an analyst at Commerzbank in Frankfurt.

The corner theory is plausible, but I think the NYT committed journalistic malpractice by not reporting another salient fact: cocoa prices are now about 15% lower than when Choc Finger made his play. Ward allegedly bought at a price around 2,700 British pounds per ton of cocoa, but according to the FT the futures contract for September closed on Friday at only 2,300 pounds:

If Choc Finger’s game is to profit from future price increases, he’s sitting on $150 million in unrealized losses. Not a sweet outcome.

Of course, that arithmetic applies only if Choc Finger is playing buy-and-hold with his cocoa stash. There are many other ways he might be trying to profit from his purchase. Perhaps he owned July futures that paid off handsomely from the run-up in price (as you can see in the FT chart, July was the front-month contract until July 15th, after which the September contract, at a much lower price, took over). Or maybe he locked in higher prices from pre-arranged sales? As Craig Pirrong notes, pre-negotiated sales make good sense if you are trying to execute a corner (Paul Krugman offers another simple model). Those details matter, but you wouldn’t know it from the NYT story. (My guess, by the way, is that he’s not down $150 million, although the logic of the NYT story would suggest that. But only time will tell.)

Whatever Ward’s motivation, keep in mind that big purchases don’t always pay off. Sometimes you win, sometimes you lose. As Choc Finger knows first hand, according to Amsterdam Trader:

Press is reporting the “biggest cocoa trade in fourteen years”, but it’s not that special. Back 2002 the same cacao king Anthony Ward bought 202.000 tons, just a little less compared to the current 241.000. At the time his purchase represented 5% of the world market. He made 40 million in 2002 on the trade. Three years ago Ward was quoted as the chocolate guru : “The world’s not going to run out of cocoa, but they’ll have to pay more to get the right beans”. Most press reports refer to the biggest cocoa trade in fourteen years, but haven’t done any more research. The large cocoa trade in 1996 was done by the firm Phibro, amounting 300.000 tons. In charge of the cocoa desk at the time at Phibro, was nobody else than the same Anthony Ward. Phibro lost money on this cocoa trade by the way, and was forced to unwind their positions.

What To Do With Fannie and Freddie?

The Economist asked several experts to recommend options for resolving Fannie Mae and Freddie Mac, the two failed mortgage giants.

In addition to comments, the magazine’s web site allows users to recommend responses they like. It’s hardly scientific, but since the rankings (as of 9:15pm eastern time) work to my favor, let me rank them in declining order of recommendations:

My co-author Phill Swagel (a whopping 13 recommendations) describes our joint proposal for fully private GSEs that purchase an explicit backstop from the government for their mortgage-backed securities. Pros: The relationship is explicit and transparent, taxpayers are compensated for bearing risk, the portfolios are eliminated, the government backstop will soften severe mortgage meltdowns, and competition can discipline the Fannie and Freddie duopoly. Cons: There are still risks from the remaining government role.

Larry Kotlikoff (11 recs) outlines another proposal to restructure the companies into more sensible private entities. His model: mortgage mutual fund companies.

John Makin (7 recs) wins the award for brevity, arguing that they should be liquidated over 5 years.

Mark Thoma (4 recs) suggests a continued role for the firms, as long as they face much tighter regulation.

Tom Gallagher (4 recs) proposes putting them back on the federal budget as real agencies. This avoids some potential pitfalls of having them run as private companies.

P.S. As an anonymous commenter helpfully points out, the entries over at the Economist have these newfangled things called “dates” associated with them. Not sure how I missed that. The two highest scorers are also the oldest. Also, I must confess that I clicked the recommend button on Phill’s piece, lifting it to 14 votes. Because of some weird interaction between Safari and the Economist site, however, that resulted in it believing that I recommended all five pieces. Ah the perils of technology.

The Hot Tentacle

The World Cup started with vuvuzelas and ended with Paul the octopus. The world’s most famous cephalopod grabbed headlines by correctly predicting the winners of eight straight World Cup matches, including today’s victory by Spain over the Netherlands.

I’ve enjoyed Paul’s exploits, but his success got me wondering: just how many animals are out there picking World Cup winners? Could it be that, oh, 256 animals were making predictions when Paul started his run and he’s just the lucky one?

Well, after a little bit of internet snooping, I haven’t found all 256 yet, but I bet they are out there. For starters, there’s Mani the parakeet who called four quarterfinal matches correctly, but then fowled up by picking the Dutch over the Spaniards in the final.

And then there’s this article in the Christian Science Monitor, which recounts failed prognostications by a sloth, a hippo, and a monkey.

So that’s at least four. As for the other 251 failed psychics that I think are out there, my guess is that Google doesn’t know about them. And that, friends, is what’s known as survivorship bias. That bias is a big deal in financial markets. For example, the performance of existing mutual funds is much better than that of mutual funds generally because the laggards get closed and drop out of the data.

And so it is with animal psychics. The lucky ones grab headlines, while the laggards are forgotten. Which doesn’t mean that I begrudge Paul his fame. Indeed, I think his fame should spread right into finance and statistics classes when school starts in the fall.

Vuvuzelas, Afghanistan, and Fannie and Freddie

Updates on some previous posts:


Fannie & Freddie Reform Gets a Boost from the Washington Post

Sunday’s Washington Post has an encouraging editorial about the Fannie Mae and Freddie Mac reform proposal that Phill Swagel and I recently put forward. An excerpt:

[Their plan would] abolish the most toxic features of the old “government-sponsored enterprise” model. In particular, the plan would get Fannie and Freddie out of the business of directly purchasing mortgage-backed securities, which was highly profitable to them in large part because their implicit government guarantee enabled them to fund a large portfolio at artificially low rates. Their existing $5 trillion pile of securities and guarantees would be wound down or sold off to the private sector.

But Mr. Marron and Mr. Swagel would keep a government role in Fannie and Freddie’s other business: securitizing conventional, moderately sized “conforming loans,” which is both necessary to mortgage liquidity and relatively less risky. And instead of a non-transparent, implicit government guarantee, the new securities would carry an explicit one, for which the securitizers would pay a fee. Accumulated fees, in turn, would cover losses, thus shielding taxpayers. To promote innovation and competition, this business would be open not only to Fannie and Freddie but to any other well-capitalized financial institution capable of taking it on.

What Should We Do with Fannie and Freddie?

The past few years have demonstrated that Fannie Mae and Freddie Mac, the two mortgage giants, were built on a flawed business model. One that paired private profit in good times with taxpayer burdens in bad times; created systemic risks to the world financial system; concealed the degree of federal involvement in mortgage markets; and directed many of the benefits of government assistance to shareholders and management, rather than homeowners.

The folks at e21 asked Phill Swagel and me to ponder how Fannie and Freddie ought to be restructured when they emerge from government conservatorship.

Our proposal, “Whither Fannie and Freddie: A Proposal for Reforming the Housing GSEs” has just been released.

Here’s the gist:

The two firms would become private companies that buy conforming mortgages and bundle them into securities that are eligible for government backing. The reformed firms would not have the investment portfolios that were the main source of risk under their previous structure. The federal government would offer a guarantee on mortgage-backed securities composed of conforming loans. This guarantee would be explicit, backed by the full faith and credit of the United States. To compensate taxpayers for taking on housing risk, Fannie and Freddie would pay an actuarially fair fee to the government in return for the guarantee, and the shareholders of the firms would take losses before the government guarantee kicks in. Other private firms such as bank subsidiaries would be allowed to compete by securitizing conforming loans and purchasing the government guarantee. Over time, entry into these activities would help ensure that the benefits of the government support are passed through to homeowners and would reduce the risk that the failure of any one firm would pose a threat to the housing market or the overall economy.

Our proposal would also free Fannie and Freddie from regulatory requirements that promote affordable housing. As worthy as those efforts can be, we believe they should not be run through these reformed organizations with their narrower missions (and no investment portfolios). If policymakers think that the conforming mortgage market should help finance those efforts, that can be done through a tax on the MBS guarantees, above-and-beyond the actuarially-fair fee for the government insurance. The resulting revenue can then be directed to affordable housing programs through usual budget channels.

How did we come to this proposal? Well, we were trying to fix what we see as the major flaws of the old model (lack of transparency, uncompensated taxpayer risk, misalignment of incentives), while maintaining its benefits (e.g., that mortgage credit kept flowing for conforming loans even during the depths of the crisis and that government-insured MBS are a useful asset class when the Fed wants to do quantitative /credit  easing). In addition, we felt that some backstop role for the government is inevitable as a matter of political economics and that it ought to be explicit at the outset.

P.S. For a nice overview of the Fannie & Freddie situation, see this article by Nick Timiraos in the Wall Street Journal; it includes a brief mention of our plan.

Disclosure: I do not have any positions, long or short, in any Fannie or Freddie securities. Also, a close relative once served as a board member of one of the companies, but that ended several years ago.