Must Read Editorials on Obamacare

Been busy…sorry for the short post.  Here’s a must read editorial from the WSJ.  And another good editorial from the NYT.

Is this where America is headed?

Here are two interesting articles (this one and this one) on Japan’s busted economy and massive debt, resulting from stimulus after stimulus (and no economic growth as a result).

Here is a chart showing Japan’s Nikkei 225 Index since 1985.  You can see their asset bubble up until 1990, melt down in the early 90’s, and successive “rallies” due to stimulus.  It’s not a pretty picture.  The Nikkei 225 is at a lower level than in 1985.

This is what happens when the government owns the economy.

More on Moral Hazards in Bank Bailouts

We’ve discussed in previous posts how the Federal Reserve helps banks earn money.  This 1993 paper discusses how banks transfer losses to taxpayers with the help of the government–recommended reading to provide insight into origins of the 2008-09 financial crisis.  The moral hazard created by bank bailouts enables what amounts to subsidized risk taking–winning year profits go to management and crisis year mega-losses go to taxpayers.  The paper also discusses methods for management to pay itself more than it deserves prior to the crisis.   Be forewarned that the paper (from the Brookings Institution) goes a bit far in describing all such actions as looting.  The implications were apparent during the 2008-2009 financial crisis as the US Government bailed out banks.  Banks were near failure and then the government bailed them out–bank shares increased since the bailouts and taxpayers now own a huge liability. 

AIG was saved by one such bailout.  On September 16, 2008 the New York Reserve Bank loaned AIG $85 billion (later reduced to $60 billion and then to $25 billion).  Additionally, the Federal Reserve loaned Maiden Lane II and Maiden Lane III LLCs approximately $56MM to purchase mortgage backed securities and collateralized debt obligations [at par value!].  In March 2009, the Federal Reserve set up a $30 billion lending facility for AIG.  In return for this bailout generosity, the Federal Reserve was granted preferred equity with provision to resembles common equity.  One consequence of the US Government and Federal Reserve bailout of AIG is that AIG shares have increased since March 2009 lows (taking into account the July 1, 2009 1:20 stock split).  However, AIG’s original equity holders were not the primary beneficiaries of the bailout.  Rather, AIG counterparts benefitted from the AIG bailout.  This chart compares the relative stock price performance of AIG and UYG since March 2009.

Why would the US Government bailout troubled firms?  Remember, during the 2008-2009 financial crisis automakers as well as financial firms received bailouts.  Well, voters feared an economic meltdown so the government took action (though by no means was this support for a bailout universal).  The Federal Reserve, of course,  is owned by member banks and will seek to support its members.  These bailouts are no different than any sort of government subsidy (eg the cash for clunker program was GREAT for car buyers…but terrible for taxpayers). 

Are the bailouts over?  I suspect not.  Zero Hedge points out, commercial real estate loans are headed for crisis territory.  Likewise, consumer credit and residential mortgage recast problems are forecast to ramp up over 2010-12.  Are we headed for more US Government and Federal Reserve sponsored bailouts?  You bet.

During the early days of 2009, I did not have time/chose not to figure out which specific banking firms would be selected for success by the US Government and the Federal Reserve.  I merely observed that the financial system as a whole could not be allowed to fail.  As such, buying depressed shares in an ETF composed of firms representing the financial industry made sense.  We may face more crisis and bailouts–and need to protect our trading and investment portfolios.

We must mentally prepare ourselves for massive bailouts that shift liabilities from private institution to taxpayers and public institutions.  This inevitably creates positive value for at least some stocks.

Practical Impact on Human Capital When Taxes Increase

This NY Post article mentions that between 2000 and 2008, New York City lost significant numbers of high wage earners due to the high cost of living and high taxes.  This should not surprise anyone, since the most productive, highest wage earners have the greatest incentive to work in the lowest region possible.

This is particularly problematic for the corporate-regulatory state (and the vast tax revenue it requires).  As high wage earners decide to move to lower tax regions or, in the extreme case, to cease working.  The consequence is that tax revenue drops precipitously. 

Specifically, taxes are a price signal (just like the price of gasoline, bread, and stereo equipment).  High prices reduce gasoline demand; high taxes reduce incentive to work (or employ others).

As with any price signal, taxes instruct people how to behave.  Consider two neighboring states (otherwise equal, but for their income tax rates).  Since productive people naturally want to remain productive (unless instructed by the government via tax rates), they quickly move to the lower income tax state.

Since Federal (and I’d suspect a great many state) income tax schedules are progressive.  This means the more a citizen earns, the higher that citizen’s tax rate. 

Productive, higher wage citizens listen hear this message loud and clear.  To protect themselves, they move from high to low taxes regions–the correct regulatory arbitrage strategy.

The pernicious combination of high taxes and no viable regulatory arbitrage simply instructs productive, high wage earners to quit working all together.

How Long Will Demand For Treasuries Last

As the Federal Reserve’s quantitative easing program winds down, demand for Treasuries remains strong.  Rising yields (that will result from low demand) will increase the value of the US Dollar relative to other currencies).  This will bring commodity and equity prices down.

I mentioned in a previous post that I flattened my equity position because:

1. my uber beta portfolio had underperformed the S&P 500 over the past 30 days
2. I feared the end of QE.

Here I sit…flat and nervous.

 in anticipation of low Treasury demand (post

I Flattened My Equity Positions On Monday

I still agree with my previous post that stocks can and will rally under the Obama Administration.

However, I flattened my personal account positions on Monday.  Everything flat.  All cash.

I’m nervous that with the end of quantitative easing, interest rates will increase, causing the US Dollar to strengthen.  If this were to happen, my uber Beta stocks would get pummelled without mercy.

So for now I’m flat.  I’ll re-assess as I see the results of Treasury bond auctions in the coming weeks.

Only time and market prices will tell me if I made the right decision.

Probability of Public Option in New Healthcare Legislation

This intrade contract tracks the probability of a “public option” in new healthcare legislation (must be passed by 10 June 2010).

We’ll keep an eye on this contract, for passage of the public option will bode ill for America.  Passage of healthcare legislation in general bodes ill for America, but the public option is an especially bad idea.

Importantly, tracking the probability of a “public option” will give us an idea of how much economic liabilities the taxpayers will assume on behalf of corporations and other private Americans.

New Branch of Economics Predicts Malthusian Disaster

This article discusses an interesting, but I think wrong minded, approach to economics.  I recommend reading it nonetheless, just to understand the roots of their logic.

Essentially, a group of physicists and biologists believe we face a negative return on energy investment (eg the amount of energy returned per unit of input) is becoming an increasingly large hurdle.  At some point, the return will become negative and then we’ll all die.  Their argument is rational on two time scales:

1. evolutionary time–eventually extreme resource scarcity overwhelms humanity’s natural ingenuity and ability to produce ever more efficiently (humanity’s slow death by starvation).
2. geologic time–long enough for some uncontrollable, massive event to force change faster than human ingenuity can solve the problem leading to human extinction and replacement by some survivor species (humanity’s fast death by geologic catastrophe).

I won’t rule out either event over a long enough time horizon.  Over the lifespan of particular human beings, both events are irrelevant.  Could a Toba style catastrophe again reduce humanity to 1,000 breeding pairs?  Definitely.  Over time scale that prices levels should be affected?  No.  (Talk about extreme price deflation if that happens!).

The NYT article also suggest that many adherents to this Malthusian line of reasoning are also peak oil believers.  Is there a finite amount of oil energy stored in the Earth?  Possibly.  Is it relevant?  In the short run–not at all.

The key logic flaw in the Malthusian argument is that higher oil prices (that reflect extreme scarcity) will not cause an end to humanity.  Rather, scarcity drives human innovation explosions as humanity faces a change or die dilemma.  Technologies to reduce or eliminate our dependence on oil will take hold and we’ll be off to the races again.

Does humanity need to obtain more energy than it uses to find that energy?  Yes.  Are we locked in to using energy stored in fossil fuels forever no matter how scarce?  No.

Some day, humanity will efficiently harness solar power (not the inefficient solar technology currently employed only with government subsidies).  Perhaps these Malthusian physicists and biologists fear the sun will snuff out in another 12 billion years and we’ll no longer have any solar power.  OK, I suppose they are right…

Trading recommendation:  11 billion years from now, buy tickets on Virgin Galactic and travel to a younger, sexier solar system.

Has the Uber Beta Trade Died?

In recent articles, I’ve been dwelling on whether my uber Beta trade has seen its highs.  Much of my upside was driven by metals and financials moving up much faster than the broader market. 

I bring readers’ attention to two articles.  The first, by Pragmatic Capitalist, has a great chart showing a time series of Residential Loan Resets.  The punch line is that America is currently in the eye of the storm–a relative calm between the just past subprime crisis and the upcoming mortgage loan recast crisis.  The latter important because a very large number of mortgages will recast from interest only to principal plus interest (making monthly payments much higher). 

Loan recasts seems potentially worse for an already damaged economy than simple foreclosures resulting from making bad loans.  Recasts may make homes unaffordable even for families with decent jobs (whereas the past crisis showed empirically that people with no job cannot pay a mortgage).

Bankers, once chastened, are now apparently preparing for this onslaught.  Rather than lending more to spur the economy, bankers are increasing their reserves.  I suppose they are creating a war chest to survive.

Consequently, I’m considering taking my money off the table.  If markets get pummeled during the upcoming mortgage recast fiasco, I’ll buy back in the uber Beta stocks again (hopefully near the lows).  I haven’t sold yet, though…

The Quest for Uber Beta

Since the beginning of 2009, I’ve been on a quest for uber Beta stocks with more success than less (as we’ve discussed in previous posts).  This past month’s performance has been disappointing for my high Beta stocks.  My personal account made money, but probably no more than had I simply owned the broader market, so I’ve been soul searching.

This chart shows my good, but mixed, success picking uber Beta shares early in 2009.  The blue line shows the S&P 500 gaining ~35% since March 20, 2009 (by which time I was “all in” uber Beta shares…I started buying in early January, 2009). 

My success stories picking uber Beta stocks include XLF.  The yellow line shows XLF gaining ~70% during that time frame–roughly double the S&P 500’s performance.  I own XLF now instead of UYG, but for most of the period in question I was long the UYG  (UYG =~2x XLF performance, so +140%).

However, I also picked Dryships (DRYS) as an uber Beta stock.  You can see by the red line on the chart that it has, at best, performed only as well as the S&P 500.  I’m convinced DRYS will become an uber Beta stock, but in retrospect I should have instead placed my early recovery bets more into financials like UYG and XLF.  DRYS will begin to outperform when the Baltic Dry Index begins to print (BDI remains languishing, given lack of actual shipping demand).

In time, I will need to shift out of the financials and into stocks more like DRYS as a rebounding economy runs up against physical logistical constraints (and shipping prices skyrocket).  Given the over hang of empty ships and a slow recovery, this may take a while.