Forecast: The State of Student Loans and Financial Aid

My focus has always been on the markets and more macro areas of finance. But I’m working on a new series featuring the “ins and outs” of student loans. My daughter is currently applying to colleges, and as a father I wanted to learn more about the state of student loans from the perspective of a seasoned financial consultant.

So here’s part 1 of that series.

Online Programs, Student Financing
Continuing your education is a critical part of financial success in today’s economic climate. Jobs are competitive and often, applicants with a college degree and little experience have a definitive edge over experienced, seasoned potential job candidates with no degree. Obtaining a college education, however, can be expensive, and many students turn to a variety of cost saving measures to get them on the path to their degree.

Quite often, online programs and trade-oriented colleges can be the best choices for the non-traditional student because of the flexibility they can offer as well as the focus on career-oriented training and education. While many online programs tend to be profit driven and cannot offer all the amenities of traditional degree coursework, there are stalwart programs out there that can provide excellent educational opportunities. Sanford-Brown, for example, has long been a useful resource for workers who want to further their education, and the school offers many practical, career driven degree programs (like pharmacy technician and nursing, two careers in high demand), that can give students the edge they’re seeking in their current jobs, or the ability to switch career paths.

Funding Your Education in 2011

Student loans have long been the first line of defense for those who need a little help funding secondary education. While federal loan programs have been the primary source of borrowed funds for many years, private loan companies do exist and have become more prevalent in recent years as more and more people are looking for loan options due to the economy. Most financial experts (including two I talked to last week), however, still recommend using federal loan programs whenever possible due to the program’s commitment to offering low interest rates and flexible repayment options.

While qualification through a private company may be a slightly easier process (because there are not as many income guidelines and regulations), the federal student loan program offers clear advantages over the private loan market. Federal student loans typically do not begin to accumulate interest charges until the student has graduates or leaves school.

What’s more, federal student loan programs have deferral programs if a borrower meets with unexpected financial hardship during the loan repayment term. Private loan companies tend to be slightly more rigid about repayment and typically cannot offer financing terms and interest rates to rival the federal student aid program.

Stay tuned for more on the world of student loans. It’s an interesting realm ☺.

2011 Forecast: Rates on Insurance

Caught up in the holiday spirit, it’s easy to spend hundreds of dollars on gifts. But amid the spending frenzy is easy to overlook future costs, including those unassociated with shopping, such as insurance costs. Predictions for next year’s insurance costs forecast what insurance rates are likely to do. Consumers can use these forecasts to get an idea of what they’ll be spending next year on insurance.

Car Insurance
With the advent of pay-as-you go plans in California coming next February, intermittent car drivers will save tons. So far, AAA and State Farm introduced the plans for customers who seldom get behind the wheel.

The concept is simple. Drivers report their mileage to the insurance company and agents check how far drivers actually drove. AAA plans to implement a device that will report the mileage, thus speeding up the process.

Calculations for car insurance aren’t simple. Consumers that shop hard online at aggregators touting a free insurance quote or similar comparison offerings can find differences in ultimate costs due to things as specific as ZIP code.

The rates are also based on driver age, history and region. Frequency of use (mileage) does not have an affect, as some consumers have questioned recently. Drivers who don’t often use their cars pay the same rate as somebody who commutes daily. The pay-as-you-go plan will lower rates for some drivers, and if the plans go nationwide rates will fall even more.

Homeowner’s Insurance
Chances are these rates will rise in 2011. In fact, property insurance rates in general are expected to spike. A report from Moody’s last month indicated that little demand caused insurance providers to increase rates. Some states already saw rates increase from different insurers. All State and State Farm announced rate increases.

Life Insurance
Moody’s report drew similar conclusions about all casualty insurance. Back in April, Conning Research and Consulting completed a Property-Casualty Industry Forecast, which anticipated a spike in property and casualty insurance rates in 2011. Moody and Conning noted that a number of catastrophes contributed to expected rate hikes next year.

Overall, 2011 could be a revolutionary year for the car insurance industry, but a pricier year for homeowners and customers with life insurance plans.

USDA Loan Funding

USDA loans have had a rollercoaster year in 2010 with a resurgence in interest for the program, followed by an abrupt lack of funding that halted the loan program for the better part of the spring and summer. It appears, however, that USDA loans are about to receive additional funding, making it possible for more potential homebuyers to take advantage of the helpful program.

USDA home loans have long been a boon to lower and middle income homebuyers, and the program’s main goal is to ensure that even buyers who may not otherwise qualify for a traditional home loan have an opportunity for homeownership. USDA loans feature extended loan terms, an option that brings with it lower monthly payments than a traditional 30-year mortgage, and several flexible down payment and financing options.

In fact, the USDA is one of the only loan programs currently offering a zero down payment option. Borrowers who qualify for the program can choose to pay nothing down and roll closing costs into the loan, making the process very appealing to those who are unable to save up several thousand dollars for a home purchase but who do have the means to make a monthly payment. Additionally, in some cases, the USDA program allows borrowers to finance up to 103% of the purchase price of their new home in order to make repairs or upgrades to their property, making the purchase and renovation of an older home a viable economic option for buyers.

However, in early 2010, funding was quickly exhausted for this government sponsored loan program. While the USDA typically does not have the funds it needs to sustain it through the entire year, the speed at which funds were drained this year caught the attention of mortgage lenders and government officials alike. What’s more, many borrowers were left holding the bill for loans in process when funding ran out, having paid for appraisals, inspections, and surveys but being unable to actually follow through on their loans due to lack of funding. On March 21, 2010 House Representative David Obey (D-WI) introduced HR 4899 to the House of Representatives in order to help remedy this issue.

As of right now, HR 4899 has been passed. It was passed by the House of Representatives on March 24, by the Senate on May 27, and then signed by the President on July 29. Funds will be disbursed to the affected agencies as soon as the usual administrative actions have been completed. The passage of this bill could not come as more of a relief to those eager to use the USDA Direct and Guaranteed loan programs to purchase a home or other property, and lenders are beginning to take applications for the program once again.

The Correlation of Real Estate Markets and the Foreign-Exchange Market

Many new investors may be surprised to hear that an incredibly strong correlation exists between real estate markets and the foreign-exchange (FX) market. The primary driver of both real estate markets and the FX Market is risk. When investors are willing to take risk the real estate market appreciates a swarm of buyers enter the market. In the FX Market, when risk is present, investors will buy currencies that carry a high yield and sell currencies that have a low yield.

But as we all know very well from the Global Credit Crisis of 2008, when risk exits the market, and risk aversion, or an unwillingness to take risk, enters the market, then real estate values fall as there are more sellers than buyers, and currencies that have a high yield are sold and, generally, the U.S. Dollar is bought, since it is seen as the safest place to place capital during times of economic uncertainty.

Let’s take a look at a chart that depicts the movement of the U.S. Dollar before and during the Global Credit Crisis.



As you can see in this chart, the U.S. Dollar holds an inverse correlation with the Real Estate Markets. As the real estate market was booming throughout 2005-2007, due to low interest rates encouraging property speculators, the U.S. Dollar fell consistently. However, when Crisis hit in 2008 and the Sub-Prime Mortgage Crisis unfolded, the U.S. Dollar staged a remarkable bull rally as investors all over the world liquidated risky assets and put their capital in the low-yielding, but safe U.S. Dollar.

No as the economic recovery continues in the United States and around the world, it is becoming very apparent that the recovery is going to take longer than initially expected. Several months ago, in the beginning of 2010, the Federal Reserve actually began raising the discount rate in order to return to somewhat normal monetary policy. But as the recovery has continued, it is beginning to hit major roadblocks. Therefore, during the Federal Open Market Committee Notes that were released during the 2nd week of July, the Fed downgraded growth prospects in the United States, and instead of talking about when to enter a monetary tightening cycle, they actually began talking about when they may have to loosen policy again.

Much of this lagging growth in the U.S. recovery is to due to the housing sector, or the real estate market. Home values are still far off their HI’s. The housing sector did actually rebound quite nicely after the economy bottomed out in March of 2009, but the rebound was due in very large part to the economic stimulus the government had injected in the form of the $8,000 tax credit for first-time home buyers.

That tax credit was extended during the fall of 2009, but it was finally removed permanently in the Spring of 2010. Since the stimulus has been removed from the housing sector, economic figures are beginning to strongly disappoint the market. New housing starts are falling dramatically without the stimulus. This is causing the economic growth to lag in the U.S. and it is actually beginning to bring a bit of strength to the U.S. Dollar. This correlation is not perfect, and sometimes it is difficult to time the movement perfectly, but as a generality, when the housing market declines, on forex charts, the U.S. Dollar will be rising. If we continue to see a falling U.S. housing market, look for the U.S. Dollar to continue rising in the coming months.

Are you aware that Roth IRA conversion could put you into a deadly trap?

The IRS has introduced Roth conversions to the people but does not target any specific income group and also given an option for three years in 2010 to pay taxes on the conversion.
The investors or hoarders are showing a lot of interest of transferring traditional individual retirement account into Roth IRA. But they should be cautious and smart before converting their account, as there are many traps associated with it. So the investors should update him regarding Roth IRA conversion before applying for it.

But the media is not highlighting the flaws of Roth IRA conversion like the involuntary tax traps and the monetary problem that an individual might come across.

This article would shed some light on the snares laid down for you by the IRA conversion plan. And it would also help you to reconsider whether you should convert, how much to convert, or if you should convert at all. For best results consult a financial advisor.

Beware of the IRA pitfalls:

•Tax is not split but the income:
The taxpayer does not have to incorporate any conversion income on the tax return of 2010 if he converts in the same year. He can split his income into two parts one conversion can be included in 2011return and another in 2012 return. The income can be split over two years but the tax can not be split evenly as it is beyond your control as it depends on the tax rates and over all income of a person.

•Failing to meet 60 days rollover:
Trustee to trustee transfer of account is the best way to shift money from an IRA to a Roth IRA. But many companies do not support the idea of direct rollover rather they straight away address the account owner and hand over a check to him.
In this case you have to shift the fund within 60days into another retirement account that also includes a Roth IRA. But if you fail to roll over into another account within the time limit of 2 months then you are penalized. The amount becomes a taxable fund but it would not be eligible for a rollover program.

PLR as per the retirement expert have termed the private letter ruling can only settle this problem. This is an expensive and time consuming method but it does not guarantee that the Internal Revenue Service would work in your favor.

•Higher Medicare cost and Social security taxation:
If you do a Roth IRA conversion then you might have to pay higher Medicare premiums or social security payment comes under the tax. The benefits of social security are not included in the net income of a tax payer so it does not come under tax. The social security income can be included in gross income if it starts from 50% all the way up to 85% compared to other incomes then it would fall under tax.

•Fail to get a college financial aid:
While granting a financial aid for a student, the college does not keep in account a retired parent’s assets.

Income is one of the crucial areas schools keep a vigil on and if your income includes the Roth IRA conversion then it might trudge your income. But this kind of income is irregular and does not signify your typical income level. And in this way you can lose a valuable financial aid as they would find that you fall under a stable income group.

•A new beneficiary form with each new account:
It is very important to plan your savings properly so that the inheritor of the account does not face a problem after you die. When it comes to IRA and Roth IRA estate planning becomes vital as it ultimately decides who gets the account after the death of the account holder. With every new account you open you have to submit a beneficiary form absolute completed and presented. This task is quite tedious as you have to follow it with every change in the account.

•Avoid the trap of rolling to an IRA in midway:
If you decide to convert as well as roll your 401(k) plan into IRA in the same year then try to avoid this trap. If you are converting IRA, other than IRA assets no additional assets are taken into account for a pro-rata rule.

•Only eligible funds are converted into Roth IRA:
If you take Roth IRA for granted and think that anything can be converted into it then you are wrong. According to the tax code only eligible distribution can be shifted to Roth IRA.
Things that cannot be converted are as follows: hardship distribution, 72t payment, deemed distribution and so on.

•An account that can not be converted:
If you do not have a spouse and you are a beneficiary of a certified plan then you are eligible for an inherited Roth IRA conversion. This transfer must be done directly as 60 days roll over is not possible by a non spouse beneficiary. But if you have a certified plan then you can roll into an inherited Roth IRA. But if you have an IRA plan then you cannot transfer it into a Roth IRA.

•25% penalty charge:
All kinds of IRAs like SEP IRAs and SIMPLE IRAs are qualified to be converted into Roth IRAs. The traditional IRA can be converted any time and that too without the penalty charge but SIMPLE IRA comes with trap.

The SIMPLE IRAs has a catch as there is a holding period for two years and this time frame varies for each individual. The time is counted once the person makes his first contribution. The fund over here cannot be rolled into Roth IRA other than into a SIMPLE IRA for at least two years. And it also falls under taxable distribution for two long years.

So these are the traps that a person needs to be aware before conversion. If you shield yourself then you won't ensnared in this program.

Rate Increase Risk for Jumbo Loan Borrowers

The following is a guest post by Jeff Bowman of TheGreatLoanBlog. If you like the following post, show your appreciation with comments.

Ten's of millions of luxury homeowners have adjusted from an ARM with a fixed rate period into a fully adjustable jumbo loan. Following the large drop in LIBOR rates since 2007, floating with the 6-month or 1 year LIBOR index has been an excellent risk homeowners took the last few years. Even if they were not aware of the relationship of their mortgage payment and the workings of the global short-term money market.

In the last few weeks it has become crystal clear that Europe is having a massive government debt crisis which started in Greece and is spreading throughout the European Union. This crisis is causing major moves in all the various LIBOR indexes and the action in Europe will translate into higher mortgage payments in the US whenever someone reaches their semi-annual adjustment period.


The underlying rate trend in these indexes in the last few weeks is a steady march higher as governments, banks and corporations are going to market to borrow hundred of billions of Euros. This is pushing LIBOR rates up for the 6- month and 1 year about .25% within the last two weeks. All the LIBOR indexes are at the highest levels in over a year despite massive liquidity being pumped into the system by the EU Central Bank and the FED.


Now we aren’t in the danger zone yet for US based jumbo mortgage loans that are floating considering that the average margin to the 1Y LIBOR is 2.50% arriving at a current floating rate of 3.25%. But a plausible scenario of a consistent flow of gov/corp borrowers, an improving global economy over the next year could push LIBOR rates consistently higher. Any real growth in the economy will be meet with higher interest rates and this will be reflected on the hundreds of billions of dollars worth of jumbo loan mortgages that are sitting with rates of about 3.25-4% now.

We think homeowners that are floating against the LIBOR indexes without a plan to sell soon or get another ARM this year or a fixed jumbo mortgage are gambling with their mortgage payment. Not having a solid plan is a very dangerous proposition given the huge debt crisis that continues to unfold around the world. I am a firm believer in having full coverage auto insurance given the cost of coverage vs the financial risk of an accident. Millions of American’s are just waiting for a financial accident when they get their new rate increase notice. Most ARMs adjust every six months with a 30-60 day notice of the new interest rate and payment. The jumbo loan trend has only been down for the last few years as the world almost fell into a financial black hole during the 07-08 meltdown.

I think with the economic recovery gaining speed that it is only prudent to lock in another ARM or a fixed jumbo mortgage while we are at the lowest rates in history. Avoiding an interest rate increase that for millions would come as a nasty surprise. If you need to refinance your jumbo mortgage within the next few years it’s prudent to explore your jumbo loan options now.

Seeking Contributors

OK, so when I said "this coming Friday," I actually meant "a couple Mondays from now." Instead of a roundup, though, I wanted to start with something a little different: A request for help.

The days of going it alone are over. While the mission and scope of AI isn’t changing, it’s time to add some new voices. The goal is to find a few people who would be willing to contribute ongoing pieces to keep the site afloat.

This is one of the strongest and smartest readership bases in the finance world. It’s also a great platform for weekly or even on-the-spot commentary and insight. If you’re interested in contributing, send an email to accruedint at gmail.com.

Accrued Interest is Back - with Roundups

I'm bringing back the Accrued Interest blog this coming Friday, when we'll start a weekly feature of the best articles/discussions from the bond market, mortgage world, and financial industry.

With a strong readership built over the years, this can be a weekly jumping off point for thoughtful discussion of developments in these markets. (Pending Financial Regulatory overhaul anyone?)

If you have any tips for articles to feature, send them my way at accruedint on Gmail.

See you Friday!

Well, don't get all mushy on me. So long, Princess.

This may not come as a surprise to many of you since I haven't written anything in a month, but this will be my last post on Accrued Interest.

The reasons why I'm shutting it down are several. First, I have taken a much more expanded role at TheStreet.com. This is taking up some of the time and mental energy I had been using on Accrued Interest. Second, I will be starting a completely new professional endeavour within my firm. I expect this to take up vast amounts of my time in the next couple years.

The bottom line is that I don't want to be doing anything that doesn't live up to my own standards of quality. I have come to the conclusion that if I kept this blog going I'd only be writing once a week, if that, and I'm not sure the quality of even infrequent posts would be at the level I've achieved in the past.

I'd like to thank every one who ever read the blog, particularly those that I've corresponded with and gotten to know a bit. The blog covered one of the most wild times in my career, where at times I wasn't sure what the finance world would look like. I was very glad to have the outlet to express my thoughts on the direction banking and finance should take, even getting invited to the Treasury Department to discuss it with people who were shaping that direction.

I was also humbled by the level of discourse that often accompanied my own posts. While I think I'm a pretty smart guy and a half-way decent writer, nothing pleased me more than that the blog attracted people who were just as intelligent and well-spoken and who were willing to marshall a logical argument. If I could change one thing about the world, it would be to temper the hyperbole-laden and sound byte driven debate that persists in this world. To get to a place where a guy like Russ Roberts gets more attention than a guy like Marc Faber. A world where people are willing to acknowledge the opposition's argument and where we're open minded to new evidence that contrasts our own thinking. Instead we live in a world of instant analysis and where fame is equated with legitimacy.

If you'd like to keep in touch with me, please e-mail me sometime in the next few weeks and I'll give you a new e-mail address to use. After about a month I'll stop checking the accruedint e-mail.

Thanks again to all those that have supported the blog over the years.

Oh, and I just can't resist. One last surge of Star Wars geekery.


"Master Yoda, you can't die."

"Strong am I with the Force, but not that strong."

"Guards, leave us."

"Afraid I was going to leave without giving you a goodbye kiss?"

"So...you got your reward and you're just leaving then?"

"All right. Well, take care of yourself, Han. I guess that's what you're best at, isn't it?"

"What are you looking at? I know what I'm doing."

"I can't believe he's gone."

2010 Forecast: No, no different

Is it really different this time? In other words, is this recession really different from past recessions? I argue only in terms of magnitude. It was a bad recession, but it ultimately wasn't any fundamentally different. Will the recovery be muted? I actually don't think so. I just think we went down so hard that it will take a long time to recover. Unemployment, for example, will be relatively high through 2010, but mainly because it got so high in the first place. I expect fairly consistent improvement in all economic indicators through the year.

If you disagree with the above, fair enough. Clearly the Fed should accommodate if the economy isn't growing. But what if we are recovering? Even if its a slow recovery? What should the Fed do? If this time really is no different, then they should do what they always do after a recession. Tighten policy.

Milton Friedman argued, quite convincingly I think, that the perfect monetary policy was to have relatively small and stable growth in money supply year after year. He actually argued that this could be done robotically, and that actual human judgement was a detractor to the process rather than additive. While I'm very sympathetic to this view, its clear that given today's banking system, we can't measure the de facto money supply accurately enough to implement the computerized Federal Reserve that Friedman envisioned.

John Taylor then argued an alternative in the 1980's. If we can't measure money directly, let's measure its impact and try to target that. He said we could measure the output gap (difference between real GDP and potential GDP) and the difference between actual inflation and ideal inflation, then set monetary policy to push these numbers back toward the goal. This is the genesis of the Taylor Rule.

Now let's back up for a moment. Look at the history of the Taylor Rule vs. actual policy during the so-called Great Moderation.

Taylor has argued that if we look at most of this period, actual policy seems to follow the Taylor Rule quite nicely. He argues that the Great Moderation occurred because of this enlightened policy.

Then we get the 1999-2006 period.

Policy was consistently off, mostly being too low from 2001-2004. What did we get? A pretty poor decade of economic performance.

Where are we now based on the Taylor Rule? Right this minute my estimate is that its calling for Fed Funds to be -2%! Hence why I thought QE made sense. We can't get traditional monetary policy easy enough. But if GDP growth is just 2% in 1Q and 2Q and CPI hangs around 1.5, the Taylor Rule suggested Fed Funds rates jumps to 0.75%. If inflation accelerates to just 2%, the recommendation is 2% by the end of the second quarter.

Realistically, the Fed can't (or won't) hike 200bps in just a few months. They are more likely to move in 25bps or 50bps clips lest they spook the market too much. Given that they meet every six weeks, it would take them 10 months to get from 0.25% to 2% at 25bps per-meeting hikes. If we throw a couple 50bps moves in there, it still takes them 7-8 months. This is why they need to start removing extraordinary accommodation now.

Remember, that monetary policy isn't really about interest rates. Fed funds is just the tool the Fed uses to alter the money growth rate. As such, we could say that the Fed's extraordinary liquidity measures are creating a de facto funds rate well below zero. The flip side of this is that with the economy improving, the effective funds rate is even further from its proper spot. So even if the Taylor Rule suggested rate is zero, the Fed would need to slow the money growth from its current pace considerably.

Ben Bernanke is currently talking about the lessons of 1938. I say learn the lessons of the Great Moderation and stick with a stable monetary policy.

Next up... what happens if the Fed keeps rates low? (I'll tell you what, we'll all end up working for this guy or spending more time designing Facebook layouts. Scary :) )

2010 Forecast: How's the gas mine? Is it paying off for you?

Well, its forecast time. I'm going to do this over the course of four posts, I think. Maybe more. This first post is going to focus on what I see for general economic growth in 2010 assuming basic conditions that exist today persist into the new year. The next post will discuss what I expect the Fed to do in response and why that might cause some problems for risk assets. The third post will look at what happens if the Fed doesn't do what they are supposed to do (a real risk to be sure) and what the consequences will be of that. The fourth post will answer whatever questions I get on the first three.


First I'd like to say that the economy is recovering, but not in quite the same way we've seen in the past. I know its become cliche to talk about a moderate recovery, so here is some nuance you aren't reading every where.


First, the industrial sector is enjoying a strong recovery. The ISM manufacturing survey and Fed's industrial production figures show above-average activity.










Other series confirm the same ideas. Durable goods orders are strong. Capacity utilization has risen from 68.3% to 71.3% in just 5 months. After the 2001 recession, it took over 2 years for capacity utilization to recover 3 percentage points.


It isn't terribly hard to see why industrial production has recovered so much. Look at inventories.

Knowing that demand was as low as it was in 4Q '08 and 1Q '09, the severe drop off in inventories points to virtually no actual production. Thus production has recently increased in a big way mainly as catch-up. For 6-months every one was so scared they did nothing. All that while inventories dwindled. Now in order to sell anything producers need to produce.


This is, of course, one of the textbook reasons why there is typically a boom period after a recession. Inventory rebuilding. That part of the cycle is hardly over. I went back and looked at inventory levels from 1960 to today and divided it by the current dollar PCE index. Basically its an economy-wide inventory to sales ratio.




At first glance this looks like a persistent decline over time. This can be explained by everything you were taught in business school about improvements in inventory management over time.

But take a second look. Basically the ratio is oscillating in a range from 1960-1980. Then there is persistent decline until about 2001, when the ratio gets stuck in the 14-15% range until 2008. Below I've zoomed in to the recent period.



You worry about those fighters! I'll worry about the tower! If firms were to increase inventories from 12.8% of sales to 14.5% of sales, holding PCE constant, it would require a 13.4% increase in inventory levels. That could add considerably to GDP in 2010.


So that's what's booming. You can guess what's mediocre. Consumers. Here's personal income growth.


Somewhat below average. And certainly far below average if we took out recessionary periods. Then consumer spending.






Same story. Below average and a good bit below average for non-recessionary periods.

What does this point to? A business-lead recovery. Its not impossible. Business spending can and does occur in the absence of strong consumer demand. We know that businesses have spent very little on capital replenishment. Below is non-residential private investment courtesy of the BEA.

You can see that the drop off is much more severe this recession than in 2001 or 1991. In fact, fixed investment as a percentage of GDP (9.5%) is at its lowest point since the early 1960s (although about the same as the 1990-1991 recession.) Since 1960, the average capital spending level as percentage of GDP is 11%. In order to get capital spending up to 11%, businesses would have to increase capex by 16%! Again, this could add considerably to GDP without a serious ramp-up in consumer spending. In fact, I'm modeling that fixed investment adds something like 1.1% to GDP in 2010.

Bottom line: I think GDP grows above 4% on average in 1Q and 2Q 2010, then drops off a bit into the mid 3's for the second half.

Next, we'll look at why a second recession is highly likely (but its 2-3 years out) if the Fed does its job right. Then we'll look at what happens if the Fed doesn't do its job right. Hint: think bell bottoms and burnt sienna couches.

Debt Wars Episode II: Attack of the Traders

My post from last week on debt generated some conversation about leverage and the value of arbitrage-free prices. Basically I'm arguing that if leverage (a.k.a. trading debt) is exceedingly expensive, then arbitragers won't be able to perform their essential function.

I wanted to illustrate this in a bit more detail by giving a admittedly stylized example. As you are reading this, bear in mind that I'm merely explaining why some degree of leverage is needed to produce efficient markets. This shouldn't be taken as an endorsement of any particular level of leverage, simply as an argument that Wall Street leverage is basically good.

Let's pretend we live in a world where there is a discrete amount of "real" money that is investable in the short-run. That is to say that all long-term investors have fully allocated their investments and any change in their demand for investments only occurs in the long-run. We can imagine this sort of like a world of dollar cost averagers who put some set amount of money aside for investment at the end of each year. However during the course of the year, the level of investable capital is constant.

Now let's assume we're at equilibrium and the market is perfectly efficient. Suddenly a new bond issue comes to market. Who is going to buy it? Given that investors don't have any uninvested assets, the only way an investor could buy this new asset is if they sell other assets. This can't work, of course, because if one investor sells another investor has to buy. There isn't any available net capital in the system.

Now many readers are thinking to themselves that this is a dumb example, since obviously my initial assumption doesn't hold. We see capital flowing back and forth all the time. Investable assets obviously aren't fixed.

Or are they? Consider who makes up real money investors. Individuals? They might have some assets sitting in their checking account which could in theory be invested, but its clearly limited. They have bills to pay with their liquid money. Corporations? Similar to individuals. Mutual funds? On any given day, they only have what they have.

Maybe we can't say that investable assets are literally fixed, but I argue that in the short run its damn close.

Furthermore, real money isn't going to react to relatively small arbitrage opportunities. Let's assume the yield curve is dead flat at 5%. Let's further assume that ABC Corp has bonds outstanding due in 2018 currently trading with a 6% yield. Now ABC wants to sell new bonds which will have a maturity in 2019. What should the yield be? With a flat yield curve, the yield should be extremely close to the 2018 bonds.

But if real money has limited excess capital, there will be a supply/demand imbalance here. Real money will have to be enticed to bring in new capital, and therefore the absolute yield will have to be large enough to do the enticing. Relative yield doesn't apply.

Put yourself in this situation. You wake up one morning comfortable with your investments when some poor bond salesman calls you up and asks about these new ABC Corp bonds. You admit that you have some money in your checking account, but are you going to tie up your liquidity for a 6% yield? Or 6.5%? Or 7%? Depends on your own situation. Might have to be 9% or 10%.

Now let's introduce the possibility of fast money. They also have limited capital, but we'll assume they also have access to leverage.

So back to ABC Corp. They look to sell new bonds. Real money is strapped and wouldn't be enticed unless the yield is 8%. But fast money can afford to go long new bonds vs. a short of the 2018 bonds with a yield differential that is much smaller. If fast money can get 10/1 leverage, a 1% differential earns them a 10% IRR. Or even better, fast money can speculate that once ABC Corp has sold their large bond issue, the supply/demand picture will improve. That is to say, if ABC Corp wants to sell $1 billion in bonds, real money can't take it down. But once the deal clears, fast money can sell the $1 billion bonds in smaller chunks at a tighter spread. Maybe fast money would therefore take the bonds at 6.25% and try to sell them off at 6%. That would be about a 2% price gain. At 10/1 leverage, that's a 20% IRR.

Why do we care about ABC Corp's cost of funding? Because the markets are supposed to be an arbiter of capital. If the cost of capital is distorted by technicals, the market can't function in this manner.

This problem is most glaring when the market is in panic mode. Last fall, real money almost universally wanted to sell at the same time that fast money had no access to capital. Efficient markets completely broke down.

Again, it isn't that unlimited leverage is a good thing. But without leverage, markets can't work.

Debt: How am I to know the good side from the bad?

I was listening to Megan McArdle on the EconTalk podcast the other day. (By the way, I recommend the EconTalk series for any real economics wonk. The subject matter is often not particularly investment related and it usually runs about an hour, but its my clear favorite podcast.) The subject of the podcast was Megan's Atlantic article titled "Lead us not into Debt" and the subject of consumer debt generally. At one point in the conversation the question is raised, is debt inherently bad?

The host, Russ Roberts, made the point that recently many in the media have suggested that consumers need access to debt in order to finance current spending, lest we suffer some sort of economic disaster. Its clear that the Fed agrees with this sentiment given how they've pushed the TALF for consumer asset-backed securities. Roberts questions whether this is really true, whether debt isn't, at least, more bad than good.

I'm a bond trader. Debt is my life. Granted, I'm more of a lender than a borrower professionally, but long-time readers will remember my defense of both the TALF and the bank bailouts as beneficial to main street primarily because I saw a functioning debt market as a necessary condition for a modern economy to function.

Roberts isn't the only one asking this question. Based on the comments and the e-mails I receive, I think many readers are sympathetic to this view. And its a great question, especially in light of the fact that our collective debts are what caused the financial crisis. Even further, the fact that our public debt is now growing at an alarming pace, potentially setting the grounds for another crisis. Isn't all this debt just bad?

After having mulled this over for three days, here is where I come out. First let's tackle debt for consumption. Specifically I'm thinking of any consumer product cheaper than a car. I'm also thinking in terms of pure positive economics, that is I'm not layering on my own judgement, merely what I think the laws of economics have to say.

First, I think there is a presumption among some that if consumer credit were tighter, there would be less aggregate demand. I don't think there is good economic evidence for this view. If a consumer buys some product, say a television, on credit, what's really happening? They are pulling forward demand. That same consumer later has to save to repay that debt. In the absence of credit, the consumer would have to save to buy the TV. I don't see what the difference is between saving to buy the TV in the first place vs. saving to repay the debt.

Let's put some numbers to this. Say its a $500 TV that the consumer puts on a credit card at 15%. Say that debt is repaid when the consumer gets a year-end bonus in exactly 6-months. Net of interest paid, the TV cost the consumer $537.50. If credit weren't available, the consumer simply waits until the year-end bonus hits and then buys the TV. As far as I can tell, aggregate demand is the same over time. In fact, since the consumer pays interest on the debt it would seem that the consumer's budget restraint results in lower demand over time the more debt is utilized.

I think some would argue that there is a multiplier effect, where more transactions are good economically. The spending turns into someone else's income which turns into someone else's spending which turns into someone else's income. Perhaps, but its still necessary for the debt to be serviced. I have to think any multiplier benefit is offset by the negative effect future savings (or more specifically debt re-payment) has on transactions.

Let's take this multiplier theory further. If we assume a transaction today has a certain multiplier impact, call it x. So the TV purchase wasn't just worth $500 to the economy but $500 times x. If that's true, then wouldn't it be that the $37.50 in interest spent would have a negative multiplier effect of $37.50/x? If the consumer just saved and bought the TV at a later date, then the $500x multiplier would hold, just at a later date, without the debt service drag.

On the flip side, there are clear examples where debt is good. I think where consumers borrow to fund asset purchases that's basically good debt. Obviously it can go too far, as we've seen recently. But its safe to say that without debt, there really couldn't be a housing market. People just wouldn't be able to lay out the kind of cash needed to purchase a home, and in most cases home's are a reasonable store of value.

I also think a lot of business debt is good. Businesses need debt to finance capital spending. Unlike the purchases of a television, corporations investing in new plant and equipment creates value for the economy. If their ability to create value is in excess of the interest cost of the debt, then I think the economy is better off.

Unlike consumer debt, business debt should tend to generate future cash flow rather, as opposed to simply pull forward demand for consumption. Thus there really is a multiplier effect to corporate leverage. Obviously too much leverage can be bad, but not enough leverage could be bad as well.

Now this next part isn't going to be popular but I'm going to say it anyway. Another area where we really need debt is on Wall Street. Here is the reality: without leverage, arbitrage-free prices won't hold. The market couldn't serve its function of properly allocating capital through the pricing mechanism. Don't believe me? What happens if two bonds deviate from their theoretical value. Maybe its two Ford Motor bonds with similar maturities trading at wildly different yields. If dealer firms have access to short-term financing, they step in an arbitrage the differential away. If they don't, then the mis-pricing remains. Again, obviously leverage can become too great, so I'm not arguing that unlimited debt is good, but I am arguing that at the core, trading debt is good.

This brings us to public debt. I'm tempted to say its always and everywhere bad because I'd really love to live in a world of zero public debt. But truth is if the Federal government basically operated like state and local governments, I would probably label public debt as good. For the most part, local governments have to have balanced budgets. Despite some tricks governments pull (especially New Jersey and California, but that's another post), that's generally true. Where local governments issue debt its for capital projects, like school construction. Rather than raise taxes substantially every time they need to build a new school only to lower taxes after its complete, the government sells bonds to finance the construction. Where the government is acquiring a long-term asset, like a school, debt seems like a reasonable funding mechanism. Lord knows state and local government fund a variety of dumb spending. But compared to what the Feds finance? The states look like a bastion of responsibility.

Bottom line. Debt isn't bad. In fact, I still think keeping the debt markets generally open is a reasonable goal of government during a panic. However, the idea that debt-financed consumption is something that should be encouraged is highly questionable.

Bernanke: She lied to us! Terminate her immediately!

Ben Bernanke told us yesterday that inflation "could move lower from here," obviously suggesting that any Fed tightening is a long way off. These comments got the market's attention, particularly after Friday's surprisingly benign jobs number.

However, I think Bernanke is essentially telling us that the Rebel base is on Dantooine. He doesn't really think inflation is likely to fall from here. Consider his actual words: "Inflation is affected by a number of crosscurrents. High rates of resource slack are contributing to a slowing in underlying wage and price trends..." What is he saying? Currently, we have too much excess capacity to produce. Should aggregate demand expand, firms will soak up some of the slack, but its a long way from being inflationary. Its a little Keynesian, but its probably correct given the extreme amount of slack we currently have.

But that line of thinking only holds if Friday's improvement in unemployment is a one-off. And it might be. But what if it isn't? Its fair to say that this number was hardly out of the blue if you consider the previous trend. The Non-Farm Payroll statistic has been steadily improving for several moneths. Additionally, consider all the data we've seen in the last three months or so. Almost universally its been pointing to a muted recovery, but a recovery none-the-less.

The Fed won't be able to justify zero interest rates if unemployment starts falling.

There are already plenty of hawks on the FOMC. So far they haven't actually dissented but I think that merely reflects a willingness to acquiesce for now given how fragile conditions are. Read the recent speeches from hawks like Plosser or Fisher. You'll hear a consistent theme. Yes, I think extreme measures are warranted... for now.

If we see resource utilization (including labor) improving, the hawks will no longer be willing to give in "for now." Because the "now" will be something totally different. I've said it several times. There is plenty of room between zero fed funds and tight money. 0.5% would still be accommodative. 1% would still be accommodative. Hell my Taylor Rule estimate says 2% is right, so even 1.75% would be somewhat accommodative!

Now consider the position in which Bernanke finds himself. We have to remember that the man can hardly just go out there and speak his mind. When he saw the actual jobs number, (whether or not that was before the rest of us) I'm sure he was as surprised as we were. I'm sure it occurred to him that this could be a game changer. But can he come out and say that? Of course not. What if it really is just a one-off and actual job improvement is a long way off? Publicly, Bernanke has to wait until he's much more certain before saying anything too definitive.

So he goes out and tells the world that inflation could fall further, implying that monetary policy will remain as is for an extended period. I just don't buy it. If Non-Farm Payrolls turn positive in the next 2-3 months, we'll get a fed funds hike by June.

Don't get technical with me! 12/4/2009

Well! -11,000? I didn't see that coming. And I think its a game changer. There is no way the Fed can keep rates at zero while unemployment is falling. I just can't see it. I'm also willing to go out on a limb and say that one jobs start turning positive, they will stay positive. This doesn't leave me expecting blow-out GDP or anything like that. Its still a tepid recovery. But I think 4% 10s are on our target screens now.

For what its worth, here's where Fed Funds futures are. Pricing about 50% chance of hike in June. I've got to admit that you have to apply some odds to a hike in April. Suddenly my Taylor Rule post doesn't seem so crazy!


Alright on to the technical picture. Last week we bounced pretty hard off the 3.20% area which now looks like a triple bottom.

I also threw 3.48% on the chart (red line). Can't really say its a top since we broke it several times recently, but notice there's been a lot of work done right around that area. So I really wouldn't be surprised if we need to consolidate around this 3.48% area before we can push much higher in yields. Notice below that we're closing in on an over-sold area as well. (Note I'm using price of the old 10-year for this chart).



Once that happens I think its 3.71% then the recent high of 3.95%.

Meanwhile, back at Echo Base, check out the curve slope. This should be the real story when thinking about potential rate hikes. Strangely we're only 1bps flatter today. The 2-year should getting hit much harder than it is. Anyway here is a quick slope chart. Some people poo poo using resistance points with spreads but think about what the slope is. Its how much extra someone gets paid to go out the curve. Here it looks like when the spread hits about 265, investors start pushing out the curve...


Long-term I think the target might be +50 or zero, so this could be a huge play. How to play a flattener? You usually do something like short 10's and go long 2's and 30's in a certain proportion. Its a trade that often requires significant leverage and/or access to options on rate futures to really pull off. Our regular Joe readers ought to consider shorting mortgage REITs like Annaly Mortgage. They live for a steep curve.

I told you it would work!

I've said it before and gotten all sorts of criticism, but the simple fact is that the Supervisory Capital Assessment Program, a.k.a. the bank stress tests, worked. Period. Bank of America's plan to repay the TARP is just more evidence proving this point.

You have to judge any endeavour on its own merit. That is, judge it on whether it achieved its goals. For example, its unfair to judge the Clone Wars cartoon series for what a moronic character Asoka is or for how Anakin doesn't seem to be a consistent character with the movies. Hell, I was watching with my 5-year old and at one point Yoda seems to imply that the clone troopers might be Force sensitive. Seriously? But its all OK, because my 5-year old loves it, and that's for whom the show is targeted.

Similarly, the SCAP was never meant to cure all that ailed the banking system. The purpose was to make it possible for banks to raise private capital. Before the SCAP, no one knew how much capital the big banks needed. Not just because of potential losses on balance sheet (which the SCAP did nothing to address), but because no one knew how regulators were going to react to those losses. No one had any idea that Fannie and Freddie were about to be nationalized and suddenly preferred and common shareholders were wiped out. Rhetoric was coming from all corners that banks needed to be nationalized as well, including from a certain Nobel-prize winning economist who many thought could be influential with the in-coming president.

Plus remember that the big banks were forced to take TARP money regardless of their financial conditions. What was stopping the government from simply declaring that it didn't like a certain bank's balance sheet and forcing it to take even more dilutive government investment? How could anyone invest in new bank common equity with such a high degree of uncertainty?

The only way to re-open access to private capital was to tell the market exactly how much capital the government thought a given bank needed. You knew that if the government said it was comfortable with a capital ratio of x, then investors didn't need to fear sudden nationalization if the capital ratio were actually x + 1. Sure, a bank could start out at x and then the situation deteriorates to x - 1 but that's the kind of thing analysts are comfortable with calculating. The whims of government? That's something else.

What happened after the SCAP? Investors knew that if bank losses were in the range of those projected by the tests, they didn't need to worry about dilution. Only about profitability. And with bank book values so low and the yield curve so steep, investors were willing to make that bet. Even with sketchy banks like Regions and Fifth Third.

Now is everything bright and bi-sun shiny in banking? Obviously not. I've written several times that I still think banks are quite vulnerable. But as a tax payer, I'm pretty happy to be getting out of banks. The alternative was much worse.

Taylor Rule: There's nothing for me here now

We've been talking a lot about the Fed lately so I thought I'd share my version of the Taylor Rule calculation. I've built this myself so it might not exactly track other versions that are out there, but I did follow Taylor's basic methodology. Bear in mind that this isn't meant to predict Fed Funds. I use it more as a reality check. If my Taylor Rule calculation is falling I'm not likely to make a call that Fed Funds is going to be rising.

Anyway, here is a recent chart of the output. Taylor Rule in green, actual Fed Funds target in blue. I took it out to 4Q 2009 assuming that 4Q GDP and CPI comes in equal to Bloomberg's economist survey (3%).

Holy liquidity trap Batman! Its sharply negative, suggesting that monetary policy can't get easy enough. Thus it justifies the Fed's current stance.

Now consider what it looks like if I carry out the Bloomberg median survey result for both GDP and CPI through 2010.


Suddenly the "correct" Fed Funds level according to my model is 2%, by the first quarter! Will the Fed actually hike by 200bps between now and 1Q 2010? Even assuming that GDP comes in as expected in 1Q, I highly doubt the Fed gets this aggressive. But could they start hiking? I think its possible.

I think readers should consider the following:

• Potential GDP is probably falling due to a less levered economy. That means a lower level of GDP would be considered above potential and thus potentially inflationary. It probably also means a higher level of NAIRU.
• There is room to remain accommodative in policy but be above zero on Fed Funds target.
• The fact that we're far below trend GDP levels doesn't matter. In a Keynesian world, its a question of whether Aggregate Demand is outpacing Aggregate Supply. What Aggregate Demand would have been in 2006 isn't relevant.
• As a trade, if GDP does improve but the Fed doesn't hike at all, then it will be time to put on a bear steepener!

I warn you not to underestimate my power

A warning to all you exposed to the dollar carry trade, either directly or indirectly. A group which includes:

• Anyone borrowing in USD to buy short-term assets in another currency.
• Anyone borrowing short-term in USD to buy long-term USD assets, i.e., every U.S. bank.
• Any U.S.-based company selling their product to non-USD consumers.
• Anyone invested in a U.S. company who is borrowing short-term in USD and buying long-term assets and/or selling products in non-USD currencies. That is, anyone long U.S. stocks or U.S. corporate bonds.
• Any U.S.-based investor long any non-USD asset, i.e. any investor in foreign stocks or bonds.

So basically anyone holding anything other than cash.

Below is the intra-day chart on USD/EUR.

What the hell happened at noon? Bernanke made a passing reference to the dollar. That's it. Here's the whole quote:

The foreign exchange value of the dollar has moved over a wide range during the past year or so. When financial stresses were most pronounced, a flight to the deepest and most liquid capital markets resulted in a marked increase in the dollar. More recently, as financial market functioning has improved and global economic activity has stabilized, these safe haven flows have abated, and the dollar has accordingly retraced its gains. The Federal Reserve will continue to monitor these developments closely. We are attentive to the implications of changes in the value of the dollar and will continue to formulate policy to guard against risks to our dual mandate to foster both maximum employment and price stability. Our commitment to our dual objectives, together with the underlying strengths of the U.S. economy, will help ensure that the dollar is strong and a source of global financial stability.

Now really, there is absolutely nothing there that suggests the Fed is going to do anything about the weak dollar. In fact, all he's doing is justifying the recent decline in the dollar. You can think what you want about why the dollar is weak or even whether its desirable or not. Bernanke doesn't care about the dollar.

And yet with this tiny nod to doing something about the dollar, the euro plummets. Just think about what's going to happen when the Fed actually hikes rates. There are so many dollar shorts out there. We will be looking at the mother of all short covering rallies. And the carry trade crowd is going to get absolutely crushed.

Will this happen this month? This quarter? This year? I don't know. How impactful will this event be on financial markets? I think it will be quite large, although whether that means S&P -10% or -20% or -30%, I'm not sure. I'm also not sure that we don't rise 10% between then and now and only correct back to where we are. I actually think 2-5 year bonds, including Treasuries, are the most exposed U.S. assets, not stocks, but we'll see.

Either way, I'd love to see the Fed make some kind of move, even if its hiking from 0% to 0.5%, to stem the tide of constant USD selling. The dollar weak crowd is too confident and all that confidence is what causes bubbles. Alas, I don't think its going to happen.

Don't get technical with me! 11/13/09

Yesterday's long bond auction was very interesting. I had been bearish going into it, went long some TBT, was feeling very good about myself until...

That my friends, is a bullish reversal. I've circled the auction time in red. The auction was a disaster, with almost a 5bps tail. I'm sure there have been worse long bond auctions, but not many. Anyway, the sell-off lasts for about 10 minutes before the short covering began. It took us all the way to the previous high on the day (yellow line) before tailing off slightly at the end. Still, quite a move.

Interestingly, the momentum chart has converged, producing a slightly bullish signal.



Otherwise I'm having a hard time seeing much in the charts. Looks range bound to me. In fact, I ran the tick-by-tick data on the old 10-year from September to now to see where the most trading has occurred.

42% of the trades have occurred between $101.2 and $101.9, which translates to roughly 3.48% and 3.39%. I had noted the 3.48% as a major support/resistance point in the past, so this graph validates something I'd been seeing in the chart. Anyway I highlighted in yellow the price we closed at today, meaning we're right there in the thickest part of the recent range.

I wanted to put on some 10-years today thinking we'd hit 3.48%, but we just didn't quite get there. I'm going to be patient and wait for us to get back to that level, then play it from the long side. I might be willing to leg into it at a level slightly below.

Fed on Employment: Well, forget the heavy equipment

The other day I speculated that the Fed was paying less attention to employment than most marketeers seem to think. Specifically, I question whether the Fed will wait for an outright drop in unemployment before tightening monetary policy, or if other factors will be viewed as more important.

Today we're getting four Fed speeches, which gives us a chance to see exactly how employment is characterized by the various Fed officials. So the following is the quote on employment from two of the four (Dallas Fed President Fisher doesn't speak until tonight, and Boston Fed President Eric Rosengren made no mention of employment in his speech on the Too Big to Fail problem.)

Atlanta Fed President Dennis Lockhart:

At this juncture, it's hard to be encouraged about a fast rebound in job growth. As you know, last week's employment report pushed the official unemployment rate to 10.2 percent, the highest since May 1983. Net job losses continue on a monthly basis but at a declining pace. Because employment growth tends to lag recovery from a recession and because of factors such as small business credit constraints, my current outlook for employment is one of very slow net job gains once the trend reverses, in all likelihood sometime next year.

If you believe in "very slow net job gains" even once we start getting gains, the unemployment rate isn't likely to fall at all for a long time. It could even rise if employment gains aren't enough to make up for new entrants into the workforce. Still, Lockhart acknowledges that employment lags.

San Francisco Fed President Janet Yellen:

The U.S. experienced so-called jobless recoveries following the previous two recessions in 1991 and 2001, when job creation remained weak for several years following the business cycle trough. In both cases, output growth was less robust than in the typical recovery and, unfortunately, things seem to be shaping up similarly this time around.

Less verbose, but could be construed as the same basic view. Weak job growth "for several years."

My question is, could the Fed hike to some number above zero even if unemployment is above 10%? Yellen and Lockhart are describing a situation where unemployment remains high for 2-3 years at least. What if at the end of 2011 unemployment is better, but still over 9%? I've got to think the Fed would have hiked.