Opinion

Felix Salmon

What about perpetual TIPS?

Felix Salmon
Aug 27, 2010 04:12 UTC

Eddy Elfenbein thinks the time is right for the U.S. government to issue perpetual bonds:

I say let’s float some Treasury perpetuities… say that these perpetuities aren’t callable for the next, say, 50 years. We could even call them “Obama Bonds.” I wouldn’t be surprised if we could lock-in 4%.

I wouldn’t be surprised either. Perpetual bonds are extremely convex, and investors like that. And of course there’s no reinvestment risk.

But the really valuable new instrument, I think, would be perpetual TIPS. Each one would pay a coupon of, say, $10 a month, indexed to inflation. If that 4% yield on nominal perpetual bonds is split into 2% time value of money and 2% expected inflation, then you’d expect one of these bonds, paying $120 per year in 2010 dollars forever, to cost about $6,000.

In other words, if you wanted to lock in an annual income of $60,000 which was guaranteed to rise with inflation, you’d need to pay $3 million up front. At any point, of course, you could sell your bonds to someone else: they’d fluctuate in value, to be sure, but chances are that they wouldn’t fluctuate that much. Long-duration bonds rise and fall a lot in value according to prevailing interest rates, but the main reason why long-term interest rates change is changes in long-term inflation expectations. Once those are stripped out, as they would be in perpetual TIPS, what’s left is relatively stable, in terms of its market value. To a first approximation, the value of the bond would rise in line with inflation.

Better yet, to a second approximation, the bonds would be countercyclical. They would become less attractive, and cheaper, when stocks are booming and interest rates are relatively high — just when the rest of your portfolio is likely to be doing very well. And their value would rise in times of bearishness, when most other markets were falling.

The bonds would be a great way of providing a reliable lifetime income — although of course since they would rise with inflation rather than with wages, the quality of life they buy would probably fall slowly over time. They could also provide a very handy benchmark against which to judge annuity products. On the other hand, they could worry a lot of people saving for retirement. I need $3 million to buy myself an income of $5,000 a month? That’s a scary prospect, to be sure.

COMMENT

Of course there is principal, or else, what are you loaning the government (or whoever for that matter)? The principal is the original loan and it is used to compute the coupon payments.

Posted by MRLAMF | Report as abusive

The driveway tax

Felix Salmon
Aug 26, 2010 17:31 UTC

How to get drivers to help pay for the direct costs and negative externalities they cause? A congestion charge is one obvious way, but it’s expensive and complicated to implement. A driveway tax isn’t quite as elegant, but it’s much simpler, and it seems to be catching on even outside Oregon: it’s just been implemented by Mission, Kansas.

It’s quite simple, in theory: a set of formulas is used to work out how much traffic any given property generates. A single-family home, for example, generates about 9.5 trips per day, and will pay a $72 tax; Target generates 8,500 trips per day, and will pay $64,750. All of which works out to a tax of 2 cents per trip.

There are two problems with this scheme, beyond the entirely predictable pushback it’s getting from people who will end up paying new taxes. A tax of 2 cents per trip isn’t remotely enough to change behavior; and the tax doesn’t actually encourage people to change their behavior in any case: if you sell all your cars and go everywhere by bike or foot or public transport, you still pay the same amount of tax as the five-car family next door.

But anything which moves us away from the costly world of free parking has got to be a good thing, especially if some of the proceeds are used to pay for an express bus service. And even drivers might eventually come around to liking these taxes, if and when they start reducing traffic jams and congestion.

COMMENT

“But anything which moves us away from the costly world of free parking has got
to be a good thing”

I think that is exactly right. I take it you don’t buy the assumption in the opening sentence: “How to get drivers to help pay for the direct costs and negative externalities they cause?”

I would recommend Donald Shoup’s book: http://www.amazon.com/High-Cost-Free-Par king/dp/1884829988

Posted by ScottofHybla | Report as abusive

ETFs are not created equal

Felix Salmon
Aug 26, 2010 14:36 UTC

Paul Amery grabs this chart from a recent Deutsche Bank report:

Performance_of_Euro_Stoxx_50_ETFs.jpg

The different lines are various ETFs, all of which seek to replicate the Euro Stoxx 50, which is the black line in the chart. Nearly all of them managed to outperform the index over the 20-month period in question, although if I were an investor in UBS’s ETF I’d certainly be asking questions. And it’s pretty clear that the degree of outperformance in many cases is a much larger component of total returns than is the headline expense ratio on the funds.

The chart shows post-fee performance, but it’s clear at a glance that it’s not lower fees which account for outperformance. Instead, explains Amery, a lot of it is dividend-tax jurisdiction shopping: funds will domicile themselves in countries with low dividend taxes, and/or lend out stocks over the dividend date to other funds in low-tax countries. For a fund like the Euro Stoxx 50 which comprises stocks from many different countries, the effects can be substantial.

None of which helps, particularly, in working out which fund to buy going forwards. Amery concludes:

It’s difficult to ascertain how the increased performance is actually being generated, why certain funds are doing better than others and what risks might be being incurred by the funds’ investors. In order to answer these questions in greater detail, investors would need to look more closely at securities lending activities, collateral policies and (for swap-based funds) the terms and conditions of the contracts between their ETF and the swap counterparty or counterparties. However, ETF managers’ disclosure of information in these areas is typically very limited indeed.

So, if you owned the iShares Euro Stoxx ETF, congratulations. If you owned the UBS version, commiserations. Going forwards, one can try to guess that iShares will continue to outperform. But that’s all it would be — a guess. We have no good reason to know why that might be the case.

COMMENT

Good takeaway Paul – index fund management is not passive. There are horses for courses, and each manager has their pros and cons.
[disclaimer - i am a former industry veteran who has no axe to grind here - just alot of experience with ETFs]

Posted by MilesDavis | Report as abusive

Paul Singer’s litigation strategies

Felix Salmon
Aug 26, 2010 13:44 UTC

Paul Singer’s Elliott Associates hedge fund navigated the crisis well, and kept on going strongly through 2009. In 2010, it’s had modestly positive returns: +5.3% in the first half, but just +0.4% in the second quarter.

Nothing too shocking there — unless you’re Paul Singer, learning that Absolute Return + Alpha has got a hold of the information. In which case, you decide to sue:

Elliott, a 33-year-old Fifth Avenue firm, which focuses on distressed debt, said in court papers that publication of the data will “give other market participants a competitive advantage.” …

Elliott filed a petition with the court demanding AR disclose the source of the information, saying it wants to locate, pursue and punish the leaker.

The magazine has said little about the case, beyond stating that it will respond formally on September 2. I’m sure that the magazine will prevail: it clearly can’t disclose its sources, and it equally clearly has no legal obligation to do so.

But the lawsuit is a shot across the magazine’s bows from a billionaire hedge fund manager who has made a very large chunk of his fortune from using aggressive legal strategies. It’s a great way of getting to the holy grail of uncorrelated returns: the chances of winning a court case bear no relation to what the broader market is doing. But it also means that no one wants to be on the receiving end of an Elliott Associates lawsuit: they have the best counsel in the world, and they have bottomless pockets. Even if you win, you’ll be tied up in expensive litigation for an indefinite amount of time.

Weirdly, all of this news is coming out at exactly the same time as Ken Mehlman, the former campaign manager for President George W. Bush in 2004 and chair of the Republican National Committee. Mehlman has been organizing a fundraiser for the American Foundation for Equal Rights — the entity funding the legal challenge against California’s Proposition 8. And the biggest fish that Mehlman has reeled in to support his cause is none other than Paul Singer:

“A lot of different people have come together to make this a success, but the one who has been the most generous and who is hosting it is Paul Singer,” said Mehlman, referring to the wealthy GOP donor and hedge fund executive.

The common thread here is that no matter what Singer does — run hedge funds, bully magazines, work for equal marriage rights — he does it through his lawyers. Indeed, Singer first started managing money in his spare time, while he was working as a lawyer at Donaldson Lufkin & Jenrette Real Estate; he might now be considered the best-paid lawyer in the world.

So if I was the person who leaked Elliott’s returns to AR, I’d definitely be wondering to myself whether my actions were really worth it. No one wants to be hunted down by Singer, who is surely working on many other means of identifying the leaker. The lawsuit is really just a way of announcing, in a very public manner, that leaking quarterly-return numbers is something Elliott will not tolerate. We’ll see next quarter, I guess, whether it has worked. But I suspect that Elliott Associates is no so large — it’s managing roughly $17 billion — that leaks are at this point inevitable. No matter how much Singer hates them.

COMMENT

And to refer again to your previous post, commenter HBC made some good points about how comfortable they are sitting in Republican’s pockets. Elliots’s money making strategy is pretty simple.

The leaker has to be an employee or client so they are well aware of from whom they will be hiding. If it was an employee, I would imagine they would have to be disgruntled, as a virtuous reason would be unlikely, given the vulture quality of the transactions it ventures to make.

http://blogs.reuters.com/felix-salmon/20 10/06/17/elliott-associates-goes-to-alba ny-again/

Posted by hsvkitty | Report as abusive

Getting the housing market moving

Felix Salmon
Aug 25, 2010 20:08 UTC

It’s a bit too wet to schlep into the office today, but I did manage to make it in there yesterday, and shot this reaction to the housing numbers. Warning, lots of hand-waving ahead:

The backstory here is basically the big secular shift that Richard Florida talks about a lot, especially in his latest book. In order to have more renters we’ll need more landlords, and they don’t seem to be buying, record-low mortgage rates notwithstanding. What’s going to entice them into the market? Lower prices, is my guess, along with some confidence that the market isn’t going to plunge the minute the government stops backstopping everything. Right now, there’s a massive inventory of unsold homes, along with an even bigger shadow inventory of homes which probably would be sold, either by their owners or by the banks which essentially control their fate, if only the market were healthier.

What can make the market move again? Not cheaper money and lots of liquidity, clearly: we’ve tried that. The only other option, as far as I can see, is lower prices. But the government has a vested interest in any price declines happening slowly rather than quickly. So don’t hold your breath.

COMMENT

the main problem is that the vast majority of prospective landlords are locked out by current lending standards. it’s currently REALLY HARD to get a loan on a 2nd property even if you have cash and good credit. read joe nocera’s ny times article about this from last friday.

Posted by TEP | Report as abusive

Why going to Monte Carlo loses you money

Felix Salmon
Aug 25, 2010 15:36 UTC

One of the key tools used by fixed-income analysts during the Great Moderation was their beloved Monte Carlo simulation. They would take an instrument like a CPDO or a subprime-backed CDO, and they would run it through tens of thousands of possible future worlds. If it held up in all or nearly all of those worlds, then, presto, it got a triple-A credit rating.

But Welton Investment Corporation has a great little paper out showing just how unhelpful Monte Carlo simulations can be. They applied a Monte Carlo simulation to the S&P 500 over the past 50 years, plugging in its known return and variance. Using that, they compared the predicted number of large down quarters with the actual number of large down quarters. And got this:

monte.tiff

Over the past 50 years, someone wielding a Monte Carlo simulation would expect 32 large down quarters, of more than 20%. In fact, there were 169. And they would expect no quarters at all with losses of 30% or more, when in fact there were 23. As for a loss of 40%, that simply never happens in a bell-shaped world. But it does — and did — in real life.

There’s nothing new here, as Welton notes:

It is worth establishing that the equity market’s tail risk signature is both well-known and persistent over time. Our analysis is not anomalous, and is easily replicated using any reasonably long period of historical market data. Second, it is also worth noting that this “tail risk” effect is not just confined to the S&P 500, nor is it confined to equities exclusively. Rather, this phenomenon is seen widely across capital markets and real assets.

But it’s also undeniable that a preponderance of stock-market investors don’t really grok how much risk they’re taking: they concentrate on the positive average returns, and tend to ignore the massive downside. Given enough time, some if not all of these losses can be made back. But just how much time do most investors have? And how much do they need, before investing “for the long run” starts to be a remotely safe thing to do?

(HT: Harris)

Update: My sharp-eyed readers had their coffee this morning; I clearly hadn’t. There’s something very, very odd with the numbers above: they seem to be cumulative, rather than additive. So while it might be true that there were 42 quarters with a loss of more than 20%, compared to a predicted 17, that’s a multiplier of 2.5x, not 5.3x. And it seems improbable, to say the least, that there can have been 169 quarters in the past 50 years with a loss of more than 20%, when 50 years is only 200 quarters in total. There must be a fair amount of mulitple-counting going on somewhere. On top of that, not all Monte Carlo simulations assume a normal distribution. So I have a call in to Welton, I’ll try and clear all this up.

Update 2: OK, I’ve now talked to Welton’s Chris Keenan, and have a much better idea of what’s going on here. First of all, these are rolling compound 65-day returns: the quarterly performance is calculated every day, not every quarter. So there aren’t 200 quarters in 50 years, there are about 11,000. Why would you do that? After all, who calculates their quarter-to-date performance on a daily basis? Very few people. But institutional clients, especially, pay serious attention to quarterly returns, which is one reason why they demand those numbers from money managers. And if you’re looking at stock market performance as a whole, it makes sense to get as many datapoints as possible, rather than cherry-picking 200 datapoints on the grounds of where they fall on the calendar.

In any case, Welton came up with this chart:

graph

The basic idea is to measure how fat the real-world tail is, compared to the normal distribution. The real tail is the area under the light-blue line, left of a 20% cutoff. And that tail is 5.3x fatter — its area is 5.3x larger — than the area under the dark-blue line, which represents the normal distribution assumed in much of Modern Portfolio Theory, and which in turn is used to make a lot of asset allocation decisions. I hope that helps clear things up a little.

Update 3: I’m still getting pushback on my headline, and the way that I’m blaming Monte Carlo simulations rather than just normal distributions. That’s fair: the real underlying problem with the normal distribution is the normal distribution, and if you run a Monte Carlo simulation with normally-distributed garbage in, then you’re going to get garbage out. This paper didn’t need to use Monte Carlo simulations, but it did:

We created an “Expected” return distribution for the S&P 500 Index using standard Monte Carlo simulation methods based on a normal distribution assumption with inputs derived from actual S&P 500 data for the previous 50-years.

The inputs, here, were the return and the variance of the stock market over the long term. And using those inputs, along with a silly assumption that returns were normally distributed, ended up with a very bad model when it came to predicting the fatness of the left-hand tail.

It’s entirely possible to run Monte Carlo simulations which don’t assume a normal distribution. But the fact is that most people, when they look at the results of Monte Carlo tests, don’t critically examine the assumptions behind them. And it’s very easy to get blinded by Monte Carlo science: I, for one, took a lot of the CPDO fanboys at face value because I trusted them to be using good models, when in fact they were using flawed models.

So the lesson here, I think, is mostly that stock-market tails are fat. But there is a sub-lesson, too, which is that Monte Carlo simulations can be very dangerous, if they’re implemented by people who don’t know what they’re doing. Including the quants at Moody’s.

COMMENT

We agree the most important thing with Monte Carlo simulations is actually the relevance of the stochastic model and the assumptions it is made of.

By the way, I developed a new risk analysis tool called Statscorer which allows do to Monte Carlo simulations within Excel and in-depth stochastic modeling, while remaining very simple.

I will be interested to know your opinion since it’s a bit different from its competitors: you can correlate directly input variables with formal expression (e.g.: X3=Exp(X1)+ln(X2^2+1), …), export raw data in a text file and other good stuffs.

You can download a 15-day evaluation version freely (no personal information required). Also I will give a free 3-month subscription to the readers of this blog (this offer runs until march 2011 ;-). Just send me an email to support@statscorer.com mentioning you are a reader of Reuter’s blog.

You can visit http://www.statscorer.com to get many detailed examples of how to create stochastic models in Excel with Statscorer. Finally, I will be glad to help you to define your finest financial model.

Posted by Robin75 | Report as abusive

Corporate optimism datapoint of the day

Felix Salmon
Aug 25, 2010 14:39 UTC

Randall Forsyth reports on the magical math of corporate defined-benefit pension plans:

Fitch’s analysts find the mean assumed return for corporate pension plans in 2008 and 2009 was 8%. That’s with an allocation to fixed-income assets of 34% of the total.

Obviously, there’s no way that fixed-income assets can return 8% going forwards from here. There’s also little sign that pension plans are reducing their fixed-income exposure. And I can’t imagine that fund managers genuinely believe that long-term stock returns are going to be somewhere in the teens.

As a result, any intellectually honest plan is going to have to start cutting the interest rate it’s using to calculate the net present value of its future defined liabilities. And every percentage point by which they cut that discount rate means that the present value of their liabilities soars by between 10% and 20%. Cut by two or three percentage points, and suddenly all those cash-heavy corporate balance sheets start looking a lot lighter:

That’s the thing about deflation; it’s like a neutron bomb for corporate, public-sector and consumer balance sheets. Asset values and returns get decimated while liabilities remain standing.

There’s no news here, of course. Inflation is painful for the poor, but much easier for the rich, whose wealth is tied up in things like stocks and houses which tend to retain their real value. Deflation makes goods more affordable for the poor, but is horrible for anybody counting the days until their future liabilities come due.

Still, for the time being, I’m going to place my faith in the continued ability of corporations and pension-plan trustees to delude themselves about future returns and prudent current discount rates. The 8% return assumption didn’t make much sense in 2008 or 2009 either, and so the fact that it makes even less sense in 2010 is hardly a reason to think it’ll be reduced. It’s much easier for the current tranche of executives to leave this problem to their hapless successors.

COMMENT

y2k,
I don’t understand your first comment. The mathematical “mismatch” doesn’t have anything to do with the funded status of a pension. The funded status is based on the plan assets (at fair values) relative to the firm’s benefit obligation. There’s no mechanism that virtually guarantees pension plans will be underfunded all the time.

While the benefit obligation is based on an estimated discount rate, the plan assets are not – they’re just the current market value of the firm’s pension fund. If the firm estimates a discount rate of 5% for liabilities, it doesn’t matter whether they estimate return on plan assets as 3%, 5%, or 7%. The estimated return on plan assets does not affect the the asset value, nor does it affect the plan’s funded status.

Corporations hate DB plans because they bear the financial market risk on the funding side as well as the actuarial risk on the payout side. Individuals hate DC plans because those risks are transferred from the employer to the employee. Someone has to bear the risk, though.

Posted by Beer_numbers | Report as abusive

Insider trading datapoint of the day

Felix Salmon
Aug 25, 2010 14:02 UTC

It’s barely credible, but it seems to be true:

On August 12,13, and 16, 2010, Defendant Juan Jose Fernandez Garcia (“Garcia”), a Madrid, Spain resident and the Head of European Equity Derivatives at Banco Santander, S.A., an advisor to BHP in connection with its tender offer, purchased a total of 282 call options for approximately $13,669, all of which he sold on August 17, 2010 for a profit of approximately $576,000.

That’s a 4,000% profit in the space of three business days. What on earth did he think he was doing? It’s all pretty obvious stuff: on August 12, for instance, Garcia bought 32 call options on POT with a strike of $130 and which were going to expire on August 21. On that day, POT was trading between $106.56 and $112.88 per share, and the call options cost him the grand sum of 2 cents apiece.

When POT opened on August 17 at $143.11 per share, Garcia sold his options. I’m not sure what the price was on the $130 calls, but it was probably somewhere in the region of $13 each. A nice return.

Santander has yet to comment on this case, but it’s crazy that a senior member of their equity-derivatives team would engage in something as obvious as this, using his own personal account in his own name. I suspect there’s another shoe to drop here. But there’s no doubt that this is a massive egg on Santander’s face, not least because the Chinese walls there clearly failed in the worse possible way. I’ll be fascinated to see how this case plays out: I’m quite sure there’s a very juicy story behind the scenes somewhere.

COMMENT

Um, gosh. The SEC complaint is dated Aug. 20, so that qualifies as quick work.

Posted by MattF | Report as abusive

Counterparties

Felix Salmon
Aug 25, 2010 04:38 UTC

Great clip from Inside Job, putting Ric Mishkin on the spot about why he didn’t disclose a $124,000 conflict — Yahoo

Love on the subway — Reuters

“I’ve never seen an executive lose the support of an organization then regain it” — Horowitz

Non-profits aren’t – or shouldn’t be – brands. Watch Livestrong and Demand drag each other down — Gimein

Locklin vs nanotechnology — Locklin

Matt Cooper to National Journal. Who will write the FCIC report? — Fishbowl NY

Wherein Marty Peretz apologizes to Liza Minelli, and praises her “exemplary private life” — TNR

Julian Dibbell delivers a spectacularly smart and grown-up profile of 4chan. It’ll change the way you think about it — Technology Review

COMMENT

Re:Mishkin does not do well in the hot seat. He can barely speak and when he does the lies leap out. (actually he has a liar’s stutter)

Re:4chan is the teen wet dream of sites. I am thinking I would rather teens pooped on a site and ran then poop in a bag and leave it on the neighbour’s steps. ( they actually did, but forgot to set it afire. If you are going to do an old nasty prank, at least do it right)

BTW If you are under the age of 18, or it is illegal for you to view the materials contained on 4chan, so discontinue browsing immediately. (The irony of a site developed by a 15 year old for like minds.)

Posted by hsvkitty | Report as abusive
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