Bonds are not forever the crisis facing fixed income investors 9781118659533, 9781118659700, 9781118659601, 1118659600

Table of contents :
Preface xi Acknowledgments xiii CHAPTER 1 From High School to Wall Street The Bull Market Begins 1 Inflation Memories As Bad as It Gets 4 Trading in Gilts 5 The Old Class Structure 8 A Nineteenth-Century Market 11 Finance Starts to Grow 12 Is Finance Good? 16 Investing after the Bubble 20 CHAPTER 2 A Brief History of Debt 23 Interest Rates in Ancient Times 23 Medieval Credit 26 The Beginnings of Modern-Day Finance 28 Borrowing Reaches the Mass Market 31 Student Debt 39 Big Borrowers in History 43 What We Owe Now 45 CHAPTER 3 Derivatives Growth 51 Welcome to New York 52 Early Derivatives Growth 56 Swaps Take Off 61 Size Isn t Everything 65 Derivatives Reach Omaha 67 Norwegian Wood 69 CHAPTER 4 Bond Market Inefficiencies for Retail 73 A Simple Market Model Stocks Are Fairer than Bonds 76 Why Change Is Slow 79 Structured Notes 81 The Internet Threatens the Swaps Oligopoly 84 Municipal Bonds 87 CHAPTER 5 Trading Derivatives 93 Before Banks Were Exciting Computers and Swaps 96 Should Banks Innovate? 97 Growth in Innovation 99 Volcker s Problem 102 Bring Me Clients with a Problem 103 Derivatives Missteps 105 Trading by the Book 107 An Options Book Blows Up 110 CHAPTER 6 Politics 115 Government-Controlled Investing Why Should We Worry? 116 Who Says There Is a Problem? 120 Look to the Future 128 Looking Ahead 129 Monetization A Thought Experiment 133 Imperial Overstretch 136 More Debt Means More Banking 141 CHAPTER 7 Managing Risk 1990 1998 143 Risk-Oriented Market Making Traders and Risk 145 Why Traders Are Bad at Budgeting 147 The Growth of Global Trading 149 Managing Obscure Basic Risks 152 What s the Social Purpose? 155 Wall Street Fuels the Debt Growth 156 CHAPTER 8 Inflation 165 Germany s Defining Economic Experience 167 Inflation Today 170 The Fed s Huge Mistake 174 You Can t Spend Quality Improvements 177 What Critics Say 181 Measuring What They Can, Not What Counts 183 CHAPTER 9 Bonds Are Not Forever 189 Putting It All Together Wall Street Built It 192 Make Your Own Bond 195 High Dividend, Low Beta 198 Hedged Dividend Capture 201 Master Limited Partnerships (MLPs) 202 Deep Value Equities 205 Debt Is Bad 205 Bonds Are Not Forever 207 References 209 Glossary 215 About the Author 219 Index 221

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BONDS A R E N OT FOREVER

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BONDS A R E N OT FOREVER THE CRISIS FACING FIXED INCOME INVESTORS

SIMON A. LACK

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Cover Design: Wiley Cover Image: © iStockphoto.com / alexdans Copyright © 2013 by Simon A. Lack. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923 (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley .com. For more information about Wiley products, visit www.wiley.com. Library of Congress Cataloging-in-Publication Data: Lack, Simon, 1962Bonds are not forever : the crisis facing fixed income investors / Simon A. Lack. pages cm Includes bibliographical references and index. ISBN 978-1-118-65953-3 (cloth); ISBN 978-1-118-65970-0 (ebk); ISBN 978-1-118-65960-1 (ebk) 1. Bonds. 2. Fixed-income securities. 3. Investments. 4. Capital market. I. Title. HG4651.L33 2013 332.63’23—dc23 2013019671 Printed in the United States of America 10 9

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To my grandparents, Roy and Kathleen Rogers

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CONTENTS Preface Acknowledgments CHAPTER 1

From High School to Wall Street— The Bull Market Begins Inflation Memories

xi xiii

1

As Bad as It Gets Trading in Gilts The Old Class Structure A Nineteenth-Century Market Finance Starts to Grow Is Finance Good? Investing after the Bubble

4 5 8 11 12 16 20

CHAPTER 2

A Brief History of Debt Interest Rates in Ancient Times Medieval Credit The Beginnings of Modern-Day Finance Borrowing Reaches the Mass Market Student Debt Big Borrowers in History What We Owe Now

23 23 26 28 31 39 43 45

CHAPTER 3

Derivatives Growth Welcome to New York Early Derivatives Growth

51 52 56 vii

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viii CONTENTS

CHAPTER 4

CHAPTER 5

CHAPTER 6

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Swaps Take Off Size Isn’t Everything Derivatives Reach Omaha Norwegian Wood

61 65 67 69

Bond Market Inefficiencies for Retail A Simple Market Model

73

Stocks Are Fairer than Bonds Why Change Is Slow Structured Notes The Internet Threatens the Swaps Oligopoly Municipal Bonds

76 79 81 84 87

Trading Derivatives Before Banks Were Exciting

93

Computers and Swaps Should Banks Innovate? Growth in Innovation Volcker’s Problem Bring Me Clients with a Problem Derivatives Missteps Trading by the Book An Options Book Blows Up

96 97 99 102 103 105 107 110

Politics Government-Controlled Investing

115

Why Should We Worry? Who Says There Is a Problem? Look to the Future Looking Ahead Monetization—A Thought Experiment Imperial Overstretch More Debt Means More Banking

116 120 128 129 133 136 141

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Contents CHAPTER 7

CHAPTER 8

CHAPTER 9

Managing Risk 1990–1998 Risk-Oriented Market Making

143

Traders and Risk Why Traders Are Bad at Budgeting The Growth of Global Trading Managing Obscure Basic Risks What’s the Social Purpose? Wall Street Fuels the Debt Growth

145 147 149 152 155 156

Inflation A Brief History

165

Germany’s Defining Economic Experience Inflation Today The Fed’s Huge Mistake You Can’t Spend Quality Improvements What Critics Say Measuring What They Can, Not What Counts

167 170 174 177 181 183

Bonds Are Not Forever Putting It All Together

189

Wall Street Built It Make Your Own Bond High Dividend, Low Beta Hedged Dividend Capture Master Limited Partnerships (MLPs) Deep Value Equities Debt Is Bad Bonds Are Not Forever

192 195 198 201 202 205 205 207

References Glossary About the Author Index

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PREFACE

Three big themes have linked together to dominate bond markets over the past 30 years. Since inflation peaked in the early 1980s, we’ve experienced a secular decline in interest rates, an increasing financial services sector, and sharply growing indebtedness. By sheer coincidence, my career began at approximately the same time that these three trends emerged, although my identification of them is most definitely one of hindsight rather than foresight. The 2008 financial crisis was borne out of these three trends, and its aftermath has many consequences. American economic history is full of successes, although not every economic development has been good. Many financiers have made fortunes through a bigger banking sector and more widespread indebtedness, yet the inflation-adjusted lot of the typical family has barely improved. An understandable public policy response to the financial excesses is developing around the belief that, in finance, big is bad and greater oversight is in the public interest. This swinging of the pendulum back in a more populist direction likely heralds change in other trends as well.The sharp increase in government debt as a result means the weight of financial obligations will be a prominent feature on the investment landscape for the foreseeable xi

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xii PREFACE

future.When there is an absolute abundance of public sector debt to be financed at all levels of government, the prudent investor should probably use commensurately more reticence in committing to securities with fixed returns. This book seeks to connect the three big themes of falling inflation, a growing finance sector, and huge government debt into a coherent framework for assessing future returns on fixed income. Woven into this analysis are personal anecdotes from someone who was part of the growth of Wall Street simply because that was the intersection of opportunity and personal aptitude. Bonds have been a great investment for a very long time, but Bonds Are Not Forever. This book includes a website, which can be found at www .bondsarenotforever.com. This website includes a description of the book, links to press coverage and events featuring the book, and links to the SL Advisors, LLC website for more information about the investment strategies mentioned here.

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ACKNOWLEDGMENTS

A book is a collaborative process, and this project would not have been possible without help from many people. My business partner and friend, Henry Hoffman, provided numerous recommendations for improvement and applied intellectual rigor to assertions that might otherwise have been simply opinions. Many of the conclusions drawn herein are the result of countless hours of spirited debate with Henry about investment strategies, economics, and the shortcomings of the U.S. political process. Several friends reviewed individual chapters and offered many improvements. Chapter 2, “A Brief History of Debt,” benefitted from Roger Taylor’s thoughtful input, backed by his long career in bond research. Pat Britt, with whom I worked in the early 1980s, provided insightful feedback on Chapter 3, “Derivatives Growth.” Jon Bramnick, New Jersey state assemblyman and Assembly Republican Leader, helpfully reviewed my analysis in Chapter 6, “Politics.” Jim Glassman, senior economist at JPMorgan Chase and a former colleague, provided many suggestions and corrections for Chapter 8,“Inflation.” My friend of 30 years Larry Hirshik also offered improvements and confirmed my recollection of events we shared many years ago. Fred DaVeiga cleverly suggested the title, revealing yet xiii

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another of his many talents, and my sister-in-law, Katherine Oldfield, inspired the front cover design. My mother, Jeannie Lucas, did research and initial editing and acted as cheerleader throughout. Last, but by no means least, my beautiful wife, Karen, and our three wonderful children, Jackie, Daniel, and Alexandra, provided the encouragement to pursue this endeavor and the space in which to conclude it. I am indebted to them and to all the people listed here, without whom this book would not have been written.

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CHAPTER 1

FROM HIGH SCHOOL TO WALL STREET—THE BULL MARKET BEGINS Inflation Memories

It was February 1972, and at nine years old I found playing with my toy soldiers in the flickering candlelight an exciting change from the steady illumination of incandescent bulbs. My British platoon skillfully maneuvered behind the German lines, taking advantage of the shadows to surprise and quickly overwhelm the enemy. In those days the Germans were always the competition, whether on the battlefield or the English football pitch. The change in routine caused by the loss of electricity thrilled me as a young boy, but was not so exciting for my grandparents because it was a scheduled loss of power whose timing had been announced in the daily newspaper. February in Britain is dark at the best of times. After a long winter night, a person awakes to a dull, gray sky. By the time I began my career working in London’s financial markets, the British winter, while not nearly as cold as that of New York, felt rather like two months living at the bottom of a damp, dark pit, with only an occasional glimpse of daylight through a window. However, an English evening in July, when the days are long but never humid, can be the best place in the world. 1

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Britain in the early 1970s was at the mercy of the trade unions, and a coal miners’ strike was preventing fuel from reaching the power stations around the country. The proud people of a nation that still recalled the empire on which “the sun never set” found itself powerless at home, reduced to eighteenth-century means of illumination. Arguably, Britain was continuing its steady relative decline from the late nineteenth century, at which time the United States began to surpass Britain by measures such as iron and energy production, and industrial output (Kennedy, 1987). The steady rise in importance of other powers accelerated following World War II, when victory was achieved only at an enormous financial and material cost; confirmation of Britain’s reduced status came during the 1956 Suez Crisis when U.S. pressure forced an embarrassing climb down on a once dominant power.Yet diminished global influence didn’t need to translate into self-destructive actions at home. Nonetheless, in 1972, while the trade unions and the government argued over pay, a country once described as “built on coal” was unable to use enough of it to light its homes. There were many low points for Britain and its economy in the 1970s when I was growing up, including a bailout by the International Monetary Fund (IMF) in 1974. Looking back at those times from a distance of 40 years and 3,500 miles in America, the 1970s were the most turbulent economic times since the Depression in the 1930s. Britain had its own set of homemade wounds in the form of militant trade unions, a manufacturing base that was losing out to its European competitors (especially the Germans), and a welfare state whose safety net was so generous it often made paid employment more costly than indolence. Although Britain had its own partly self-inflicted problems, rising inflation in the 1970s and early 1980s wasn’t limited to the United Kingdom. President Ford even resorted to handing out pins labeled Whip Inflation Now (WIN), perhaps revealing the paucity of more robust ideas within his administration. For much of the developed world it was the greatest inflation in living memory. Today, it is recounted through bland numbers on a statistical release from the U.K. government. In 1972, when the miners were forcing Britain to her knees, inflation the United Kingdom was 7.6 percent (see Figure 1.1).

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30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 1948 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008

FIGURE 1.1

U.K. Inflation 1948–2012

Source: U.K. Government, Office for National Statistics.

Two years later, fueled in part by generous pay settlements won by the coal miners and other unions, it was 19.2 percent. A year later, in1975, U.K. inflation reached 24.9 percent, a level at which money loses half its value in just over three years. In one month (May 1975), prices jumped 4.2 percent, an annualized inflation rate of 63.8 percent! This is an abstract notion for most Westerners today. We read about inflation in Latin America, about hyperinflation in countries such as Zimbabwe, but few of us below the age of 60 have had to manage a household budget and make personal financial decisions under such circumstances. That includes me, but memories of my mother and grandparents worrying about “the cost of living,” about weekly price increases and the ongoing failure of income to keep up with expenses remain a part of my otherwise quite happy childhood. Running commentary at the dinner table about how the price of sugar, washing powder, petrol, or school uniforms had gone up since the last time we gathered were a staple part of the conversation. Of course, nobody knew when it would end, or really even what was causing it (although the reasons seem clear enough to today’s economic historians). People blamed the trade unions for selfishly

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negotiating pay increases not backed by improved productivity, the government for conceding to their demands, and the Organization of Petroleum Exporting Countries (OPEC) for sharply hiking the price of oil. All of these were to blame. What was worse was that at the time nobody knew if double-digit inflation or worse was a permanent part of the economy.

AS BAD AS IT GETS Hard economic times were not limited to Britain, though.The 1970s were tumultuous in America as well. While American trade unions were not nearly as powerful as their U.K. counterparts, photos of gasguzzling cars lined up waiting to refill their tanks became an iconic image of that time. Shortages of basic goods, often accompanied by inflation, were a global phenomenon. The lax monetary policies followed by central banks and governments combined with some features unique to each country. In Britain, a steady loss of competitiveness, on top of an overly generous welfare state, was ultimately reversed by Maggie Thatcher when she came to power in 1979. In the United States, blame for the economic turbulence of the 1970s typically traces back to the 1960s, with the costs of financing the Vietnam War coincident with an expansion in welfare under Lyndon Johnson’s “Great Society.” The subsequent loss of confidence in the U.S. dollar led to the breakdown of the Bretton Woods Accord when President Nixon suspended its free convertibility into gold in 1971. This ushered in the current era of “fiat money,” in which a currency’s value is only as good as the market’s confidence in its government’s policies. The 1970s and early 1980s saw two major oil price hikes, economic upheaval, and ultimately strong leaders in Margaret Thatcher and Ronald Reagan, determined to lead their respective countries along a better path to smaller government, sound money, and improved living standards. Britain and America share a great deal in terms of history and values. At that time, both countries were in need of decisive leadership to promote economic growth supported by competitiveness and sound money. Both found it.

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In 1980, U.K. monthly inflation was 15 percent (in just one month, April 1980, prices rose 3.4 percent), and shortly thereafter the greatest bull market in history began in bonds. It followed the longest global bear market in history, one that began in 1946 after World War II and lasted 35 years. To illustrate, if a constant maturity 2.5 percent 30-year bond had been available throughout this period, its price would have declined from 101 to 17, a drop of 83 percent (Homer and Sylla, 2005). More than an entire generation of bond investors had lived through a relentless destruction of the purchasing power of their savings. In the years leading up to 1981 investors had been demanding ever higher yields on their fixed income investments to provide protection against the rapid erosion of purchasing power. High borrowing costs were stifling any industry that required borrowed money to operate, which is to say virtually the entire economy. As financial markets began to sense that inflation and interest rates were peaking, they bid up the prices of bonds aggressively. The long road to low and stable inflation had begun, and with it a bull market in equities as well (propelled by falling borrowing costs, which were helping so many companies).

TRADING IN GILTS By coincidence, my career in financial markets began in London within a few weeks of that peak in interest rates and inflation. I had grown up during the most extended financial turmoil in living memory, with double-digit interest rates and savings that rapidly lost their real (i.e., inflation-adjusted) value. I began my career in finance within a month or two of the very worst of high interest rates and rampant inflation. It was the threshold of the gradual return to sound money, and it would be complemented by an inexorable rise in the value of all financial assets. At the same time, finance and financial markets were set to gain enormously in importance through greater employment and would contribute a substantially larger share of overall economic output. Liberalization of markets would lead to a dizzying array of financial instruments to be traded. This occurrence combined with the relentless fall in trading costs would support the

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steady increase in financial engineering and debt creation that culminated in the crash of 2008. None of this was even remotely plausible to someone recently out of high school and beginning his career in “The City.” Yet, in hindsight, my entry into the workplace was blessed with fortunate timing. The U.K. market for government bonds, or “gilts” as they are known in Britain, has as long a history as any in the world. Consolidated annuities (known as “consols” for short) are perpetual securities that were created in 1756 by consolidating a series of already issued perpetual annuities. They have no maturity date (although theoretically the U.K. government may redeem them). Their history is detailed in a 2005 book soporifically named A History of Interest Rates by Sidney Homer and Richard Sylla. It’s probably not flying off the shelves at Amazon. Nevertheless, for those interested in such things it is a comprehensive record of the cost of borrowing that goes back to biblical times in measuring the price of credit. Bond markets are not nearly as exciting as stocks. Bonds issued by governments don’t involve colorful CEOs, corporate takeovers, or profits warnings. Bonds are boring; in fact, bonds are meant to be boring. Investors don’t buy them for excitement—for thrills they buy stocks or go to the racetrack. Because bonds move far less than stocks and are rarely prone to the extremes of greed and fear so prevalent in equity markets, the people who traffic in them tend to be more staid as well. Equity traders have been known to accuse their colleagues in bonds of being communists. On days when the government releases weak economic data, government bond prices often rise (because their yields fall), and traders in most markets generally do better when prices are rising. Economic misery, which tends to restrain inflation, causes bond traders to leap for joy while equity markets and consumer sentiment both tumble. There’s an essential difference in outlook between the two markets. Equity traders are happiest when they are optimistic on the economic outlook because higher corporate profits tend to fuel rising stock prices. By contrast, bond traders are often cheerful when everybody is miserable. Rising unemployment, slowing retail sales, and falling house prices are all associated with falling interest rates and a bull market for bonds. Try watching

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the professionals on TV from any big bond firm (Pimco, for example) sincerely lament another weak economic report while their investments are most likely rising in price. Professed and genuine concern for the newly unemployed competes with the quiet satisfaction of a more highly valued bond portfolio. The U.K. gilt market (so named after the “gilt-edged” credit quality of the bonds traded there) of 1980 operated in a way that was scarcely different from the 1880s. The market consisted of brokers, who charged a commission and traded with the public as brokers do, and jobbers who were market makers and did not deal with the public at all. The market was structured with two large jobbers named Wedd Durlacher and Akroyd and Smithers, in effect surrounded by a far larger number of brokers. Brokers were allowed to trade only with jobbers and investors, not with one another. The jobbers could not trade with anybody except the brokers or (occasionally) with other jobbers. The jobbers held a monopoly on market making, but in return had given up the ability to face investors. The brokers had the exclusive right to deal with the general public, and in exchange were allowed to act only as agents (i.e., they couldn’t take positions themselves). Business took place on the large floor of the London Stock Exchange. Jobbers stood at their “pitch,” or assigned post, while brokers moved around the floor in search of the best deal for their client. A broker would ask a jobber to quote a price that was, in the best tradition of London markets, always “two-way” (i.e., bid and offer). Years later, when I was trading U.S. government bonds in New York, I always felt that the U.S. custom, whereby the client had to disclose whether they were buying or selling before obtaining a quote from the dealer, was providing a needless advantage at the expense of the client. A U.S. government bond dealer will show only one side of a two-way market—the client will ask for “a bid on 25,” for example, or request that the trader “offer 50.” Showing a two-way market keeps the dealer honest, in that if his bid/ask spread is wide, that’s an indication that his profit margin is possibly too high and may signal the client to go elsewhere. Other markets, such as foreign exchange, always required that the market maker quote a two-way price. The trader could try to guess whether the client was buying

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or selling, but if he shaded the price the wrong way, he ran the risk of the client’s trading on the other side (i.e., buying when the dealer thought he was a seller) and perhaps profiting off the dealer’s attempt to “read” him. The London Stock Exchange in 1980 was only a few years away from “Big Bang,” the 1986 deregulation of the overall market that would radically alter almost everything about how “The City,” as London’s financial center is called, operated. Back then, the entire place followed rigid work practices, from commissions, which were uniform across all firms, to career paths and how clients transacted their business. Finance had long provided jobs for those who were quick-witted and confident. London’s financial market place is physically not far from the East End of London, with its rowhouses of tenements barely changed from World War II. Multiple paths existed for the aspiring financier: education at a private school (perversely called a “public” school in the United Kingdom) followed by a university degree, then entry to a blue-blooded stockbroker in the gilt market.This was dubbed by some the “champagne and polo crowd,” evoking the cultural background of those whose leisure regularly includes the enjoyment of both.

THE OLD CLASS STRUCTURE Another path was from comprehensive (i.e., not elite) school, and probably not university, to a job in the equity markets or the money markets, where one’s peers would be the “gin and tonic and squash crowd,” denoting less cultured and cheaper relaxation. The open outcry, rough and tumble of a large physical market was a comfortable place for someone who might just as easily be competing to sell fruit and vegetables fewer than 10 miles away for vastly different compensation. London has become a much more culturally diverse place, with little patience for the staid old ways, and that’s no doubt a good thing. Still, the London Stock Exchange in 1980 in many ways mirrored the class system of the country. Britons could instantly place someone in their appropriate class as soon as words were spoken, and, while business could be transacted across class lines, social life was rarely so flexible.

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Forest School in Snaresbrook is close to London’s East End. The surrounding forests from which it draws its name quickly give way to gritty working-class neighborhoods as you head toward the center of the city. Before reaching the gleaming towers of London’s financial district, it’s necessary to pass through run-down areas such as Leyton, Hackney, and Bethnal Green, none of which could be confused with the leafy suburbs of the stockbroker belt. Historically, immigrants to the United Kingdom have often settled in the East End, from the Huguenots fleeing religious persecution in France in the seventeenth century to the South Asians today. Forest was and remains a public school with neighbors who can only dream of affording the tuition to send their children there, and yet the presence of so many minority students highlights the economic mobility that immigrants achieve. In many ways, my alma mater, Forest School, was typical—all boys, classes that ran six days a week, with a heavy emphasis on competition across all endeavors, both academic and sporting. When I was there in the 1970s, there were many boys that didn’t look “English,” to use the terminology of that time, because they weren’t white. Today’s coeducational student body is no less diverse, and yet more “English” because the country is itself more diverse. The closely packed houses of London’s East End have usually been home to workers struggling to move up a rung or two, and also home to a fair amount of crime. A student from Forest School, easily recognizable in his uniform, would head warily in that direction to a place where looking at someone the wrong way, or indeed looking at them at all, was to invite trouble. So this public school’s catchment area for students included parts of London that wouldn’t normally send their children to one. Nonetheless, the experience was typical of most public schools. Boys were assigned to “houses,” which were the basis for intense internal competition in everything from sports to drama. In fact, competition was ever present, whether it was in class rankings for subjects or an English football game with a neighboring school. Anything that mattered was subject to comparison with your peers. “Monitors” (selected students in their senior year) were the first layer of sometimes arbitrary discipline, empowered to administer corporal punishment if they judged it appropriate. It was its

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own somewhat insular and challenging world, with far less parental involvement than is the case in most schools today. School was a tight community, where problems were invariably resolved with little outside influence.You had to figure things out within the confines of the physical boundaries and the social ones. Therefore, I found the seven years I spent there hugely impactful, as those years often are. The school’s song, in Latin, was sung on key days during the year, and portraits of headmasters past adorned the walls of the dining hall where grace was said (in Latin) before boys could eat their (usually barely edible) lunch. The hierarchy and the traditions were all part of the education, in addition to the academic experience. Although fewer than 10 percent of the population shared this type of schooling, they represented a far bigger percentage of the U.K. workforce in law, medicine, senior levels of the government, and, of course, finance. On top of this unusual mixing of social classes, I took the less conventional route out of school and went straight to work in The City, passing up university out of the poorly informed, youthful confidence that my formal education was already sufficient. I soon found myself with the champagne and polo crowd in U.K. government bonds, known as the gilt market, in spite of the absence of a university degree on my resume. I was a “blue button,” so named after the blue badge with my employer’s name on it that placed me precisely at the bottom of the ladder. In many ways, the gilt market was like starting school again, with my firm taking the place of my schoolhouse and my blue button status ensuring that the yellow badges (members) and silver badges (partners) barely even acknowledged my existence, just as senior-year students in school barely tolerate the existence of those merely a few years younger. Gilts were the preserve of the “well-spoken” public schoolboys who had grown up in elite establishments steeped in practices many decades old. In a memorable holdover from much earlier times, the employees of one stockbroking firm called Mullins were all required to wear top hat and tails every day on the trading floor. Socially, they were the top of the pyramid, drawing their employees from only the most exclusive public schools.They were truly in the champagne and polo crowd.

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A NINETEENTH-CENTURY MARKET Mullins retained a special designation in that they were the only firm allowed to trade directly with the U.K. Treasury. In an archaic structure that epitomized the Old World style of business and fed many along the food chain, the U.K. government would issue its new gilts only to Mullins. Mullins would then turn around and sell these on to the jobbers, who would buy only what they knew they could sell back to the other stockbrokers, who would then sell them at very high commissions to the investing public. It was emblematic of the closed, anticompetitive methods of the time. The brokers from Mullins followed a long tradition of dressing somewhat like the students from Eton, perhaps Britain’s most elite public school and from which, no doubt, many of them had graduated. Their nineteenth-century dress code persisted until the late twentieth century. When the Big Bang in 1986 transformed commissions, structure, and customs, this particular tradition went, too, as Mullins was absorbed by investment bank S. G. Warburg and the gilt market abandoned the physical trading floor in favor of doing business over the phone. I don’t think it’s missed, although it’s extraordinary to think that even within my 30+ year career they were part of the landscape. In addition, just as moving from first year to sixth year in school can’t realistically be completed in fewer than five years, graduating to the next level as a stockbroker in the gilt market required as much as anything that you “do your time.” The rigidity of commissions and market practices required a similarly inflexible career path, in which talent or ambition would take second place to chronologically determined promotions. For me, my impatience with this way of business culminated with a discussion of my performance and my first pay raise. I entered the boardroom to meet with my boss, having put on my suit jacket, as was the custom for such a formal discussion. My diminutive annual salary of £2,750 was surely about to be rounded up to £3,000. To my dismay a mere £200 was added, confirming my lowly position at the base of the ladder in contrast to my own inestimable self-worth. Shortly afterward, I concluded that the gilt market’s time frame and mine were at odds, and I moved to

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the money markets, where my starting salary as a trainee broker was quickly agreed at £5,000. So I left the rigid social confines of the London Stock Exchange, where your accent would assign you to the equity market (working class, gin and tonic and squash) or the gilt market (upper class, champagne and polo, although in my time there I experienced neither). Instead, I entered the money markets, where social classes mingled, the business environment was more freewheeling, and ability might just get you a step ahead.

FINANCE STARTS TO GROW I was one individual making personal decisions that were dictated by the world I found but to whose shifting circumstances I did not give much thought. The United States and Britain were at the threshold of an advance in financial services that would substantially increase their impact on future economic growth. A 2012 paper by Robin Greenwood and David Scharfstein, both of Harvard Business School and the National Bureau of Economic Research (NBER), examines this shift in some detail (Greenwood and Scharfstein, 2012).The authors focus on a concept called gross domestic product (GDP) value added. Rather than measure the simple output (i.e., revenue) of an industry, they believe the more important measure is the value added.This makes sense since any business has inputs that it needs to generate its output. To use an example, a supermarket might take in $100,000 of revenue in a week and only spend $80,000 buying all the produce from various wholesalers. The $20,000 remaining goes to pay compensation to the workers in the supermarket and profit to the owners. It’s this $20,000 that is the GDP value added measure used by the authors, essentially salaries and bonuses to the workers in financial services and profits to the owners of the businesses. As such, it excludes all the other inputs or expenses, such as leased office space, information technology (IT), and others. These are someone else’s GDP value added. They are not directly created by the bankers, brokers, and asset managers in finance. Greenwood and Scharfstein found that financial services’ share of U.S. GDP measured in this way grew from 4.9 percent in 1980 to

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9%

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U.S. Financial Services Percentage of GDP

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8.3 percent1 in 2006, where it peaked just prior to the mortgage crisis that began in 2007 (see Figure 1.2). In 1950, finance was only 2.8 percent of GDP, so although it had been growing as a proportion of GDP prior to 1980, the annual rate of growth doubled pre-1980 versus post-1980 (from 0.07 percent per annum to 0.13 percent per annum). Britain experienced a similar though less marked increase because its economy was already more biased toward finance than the United States at that time. Canada, Japan, and the Netherlands all saw an increase in finance within their economies, although it was by no means a worldwide phenomenon. In many European countries the opposite effect was observed, as other industries gained a bigger share of overall economic output. Germany, France, and Italy all saw modest falls in financial services’ share of GDP over this period, while in Norway and Sweden the share dropped by over a third. The authors don’t dwell much on the reasons behind these different outcomes. In looking at the data, it’s clear that those countries

1

Current Bureau of Economic Analysis data show finance at 8.2 percent in 2006, presumably the result of a revision in the data since the Greenwood and Scharfstein paper was published.

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with a longer history and more dominant role in financial markets were the ones that witnessed the growth. During this time, there was a growing focus on the need to be global and to have scale in order to thrive. I worked during most of this period at one large American bank, which morphed from Manufacturers Hanover Trust to Chemical Bank to Chase Manhattan, before winding up as the behemoth that is JPMorgan today. Many smaller acquisitions took place along the way, and the constant strategic justification was the need to provide a global platform to our global clients. Furthermore, banking is also heavily reliant on IT and the development of the Internet from the mid-1990s improved communications dramatically, allowing more trading functions to be managed in a smaller number of major financial centers. Language and common culture no doubt also played a role, and with spoken English as well as U.K. law already the common currency across many areas of banking, the British Empire and its former members had a big lead. The fact that the United States was the largest economy, market, and only superpower is probably a factor, too. London already had a dominant position in this sector throughout Europe. These trends probably served to marginalize centers like Brussels, Paris, and Milan. New York never really had a close competitor within its time zone, although Chicago’s futures pits made it the home for exchange traded derivatives. It’s therefore likely that for these reasons and maybe others, the Anglo-Saxon countries allowed and encouraged bankers and asset managers to play a bigger role in their economies. It’s doubtful that the political leaders of the late 1970s and early 1980s sought this transformation, and the past 30 years have witnessed an evolution with many twists along the way, as the creative destruction that defines capitalism has created winners and losers. The way the French sneer at Anglo-Saxon hedge funds and their brand of capitalism may reflect different values that led France to inhibit similar growth in their domestic markets. Perhaps it also reflects disappointment that so many young French people choose to live and work in London, where the opportunities are often far greater. The GDP data from which this analysis is drawn identifies two areas within financial services that are responsible for most of the

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growth—securities and credit intermediation. Insurance is the third big component of financial services, although its growth over this time was unremarkable and fairly steady going back as far as 1940. The securities industry, which includes everything from trading and underwriting to asset management, increased its share of GDP value added from 0.4 percent in 1980 to 1.9 percent in 2006 before falling back modestly to 1.7 percent in 2007 (see Figure 1.3). This more than quadrupling of virtually all things related to investment securities in barely more than a single generation is probably unprecedented in history. The securities industry further breaks down into subcategories, of which asset management is by far the biggest, representing over half of all securities industry activity by 2007. Credit intermediation, which includes traditional banking such as taking deposits and making loans, also saw substantial growth albeit from a higher base. This increased from 2.6 percent of GDP value added in 1980 to 3.6 percent in 2006 before dropping back in 2007 to 3.4 percent, although by 2011 it had increased modestly back to 3.6 percent (Bureau of Economic Analysis, 2013). Banking went

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from being six times as big as the securities industry in 1980 to only twice as big almost 30 years later, although it, too, represented a bigger share of the economy.

IS FINANCE GOOD? So Wall Street and Banking (and sometimes the two are synonymous) had by 2006 reached over 8 percent of the entire U.S. economy. As we all discovered during the 2007-2008 Crisis, their actual impact was substantially greater than this, since their collapse led to the worst recession most of us have ever seen and the brink of financial catastrophe.These two industries affect the lives of so many more people than simply those employed within it. As well as employing more workers, finance has contributed to the increasing dispersion of incomes within most developed countries. Many finance jobs provide more than your average middle-class income that has stagnated for the past 10 years. Indeed, from 1980 to 2006, pay in finance rose cumulatively 70 percent more than in the rest of the economy (Philippon, 2008). The growth in the securities industry and in credit intermediation were related phenomena. Much of the growth in credit intermediation was fueled by residential mortgages. The long bull market in bonds created regular incentives for homeowners to refinance their mortgages to take advantage of lower rates. At the same time, public policy became geared toward increased home ownership, while the tax deductibility of interest on home mortgages combined with the increased percentage of loans underwritten by the federal government, all contributed to the increased percentage of families living in their own homes. Data from the U.S. Census Bureau shows that the home ownership percentage was remarkably stable from 1965 until the late 1990s, fluctuating between 63 percent and 66 percent. President Clinton made increasing home ownership one of his goals, stating to the National Association of Realtors in November 1994 with his typical eloquence that “most Americans should own their homes, for reasons that are economic and tangible, and reasons that are emotional and

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intangible, but go to the heart of what it means to harbor, to nourish, to expand the American Dream” (Morgensen, 2011). Clinton enlisted support from all the stakeholders including banks, securities firms, builders, and realtors, and his strategy was greatly facilitated by the corruptly led twin federal agencies FNMA and FHMC (Fannie Mae and Freddie Mac) (Morgensen, 2011). By the late 1990s the home ownership percentage had reached the top of its multidecade band of 66 percent (see Figure 1.4). By 2000 it was at 67 percent and in 2004 it reached 69 percent before moderating for a few years and then falling more sharply back to its long-term range as the housing bubble burst. Government policies were aided by increased securitization of mortgages, and the increased securitization also led to a bigger securities market with more assets to manage for the securities industry. In this way, the two fastest-growing areas in financial services were linked and to some degree fed off one another. Some compelling questions are prompted by the developments of the past 30 years. Society may well challenge the wisdom of promoting home ownership beyond what was, in hindsight, a stable, equilibrium level. Owner-occupied homes are widely believed to promote 70 69 68 67 66 65 64 63 62 1965

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FIGURE 1.4

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U.S. Home Ownership Percentages

Source: Current Population Survey/Housing Vacancy Survey, Series H-111 Reports, Bureau of the Census, Washington, DC 20233.

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stable communities with lower crime rates and higher incomes; however, the incentives to own your own home clearly resulted in many people buying homes they could not afford, with mortgages they should not have been given. While the policies that promoted this were no doubt well intentioned, the sad outcome of so many people losing their homes, and in many cases a hard-earned down payment, exposed the flawed nature of this approach. Household debt also grew along with Wall Street. Outstanding consumer credit jumped in the 1950s, as the end of World War II brought soldiers home and ushered in the beginning of the Baby Boom and increased household formation. It then fluctuated between 10 and 13 percent of GDP during the 1960s and 1970s (see Figure 1.5). Nevertheless, from 1980 to 2003, consumer credit grew steadily from 12.6 percent of GDP to 18.6 percent. Although during recessions it shrank, the overall trend was clearly higher. There’s little doubt that securitization aided the process as banks packaged debt into bonds and moved it off their balance sheets to investors globally. Government debt (federal, state, and local) also grew strongly from 1980. No doubt, the growth of finance helped this as well. As a percentage of GDP, government debt is close to the levels following

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140% 120% 100%

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U.S. Total Government Debt Percentage of GDP 1902–2012

Source: USGovernmentSpending.com.

World War II (see Figure 1.6). When combined with household debt, our total obligations are assuredly at a record. Another important question is whether the growth in financial services has created widespread benefits for anybody beyond those directly employed in the industry. Greenwood and Scharfstein conclude that a bigger asset management industry has led to higher equity prices than would otherwise be the case through greater investor diversification. Their logic is that investors hold generally more diversified portfolios of equities, thanks to the greater use of financial advisers and mutual funds. In theory, this improved diversification should lower the return required for investors to hold equities (because portfolios are now less risky through being more diversified). A lower required return for equity investors translates directly into a lower cost of equity capital for public companies. It’s a reasonable argument, albeit hard to prove empirically. Cheaper access to equity financing is most certainly good for the broader economy, since it makes it easier for companies to finance themselves and invest in new projects, with corresponding broadbased benefits throughout the economy. Yet they also note that asset management fees have stayed surprisingly high and that there seem to be few economies of scale that pass through to the investor in

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terms of lower fees. In some respects, they echo the findings in my 2011 book, The Hedge Fund Mirage:The Illusion of Big Money and Why It’s Too Good to Be True, in which I showed that hedge fund managers had kept all the profits made with their clients’ capital through exorbitant fees.This is an extreme case of the financial services industry retaining substantially all of the benefits of a potentially good thing (active asset management). It nonetheless begs the question of whether such behavior is simply rent seeking with little added societal value. Increasing dispersion of incomes and the stagnation of median household real wealth suggest that gains have been unevenly distributed. Politically, the median voter’s economic state is far more important than the average voter’s when the two are diverging, as is the case today. As average incomes are less reflective of the average person (due to “the 1 percent” doing so well and pulling up the average), a public policy response cannot be far behind.

INVESTING AFTER THE BUBBLE Perhaps the most interesting question is the one facing investors. We are probably at an inflection point in two important ways. The collapse in the real estate bubble with its consequently deeply unpopular bank bailouts has focused attention on the securities industry, its pay practices, and what the appropriate relationship should be between banks and the society they are intended to serve. At its core, Wall Street is supposed to facilitate the channeling of savings into productive types of capital formation, which will foster economic growth and job creation as well as investor returns above inflation. To many people, Wall Street has increasingly lost sight of this goal; one simple example is the growth of computerized, high-frequency trading (HFT). Managers of HFT strategies even value physical proximity to the New York Stock Exchange so as to gain vital milliseconds in the transmission of their orders and therefore a more profitable outcome. It’s hard to come up with a more obvious case of a perfectly useless activity that is clearly part of a zero-sum game on whose other side lie conventional investors seeking a return on their capital.

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Public policy is just beginning to grapple with all the issues of a financial system that may be larger than we need, a system that although highly competitive within itself doesn’t appear to pass on the benefits of that competition to consumers in the form of lower prices. Increased regulation and higher capital requirements are the two most obvious reactions, although in time society may add further constraints. The other inflection point is surely on the level of debt outstanding. For if there’s one common thread linking up the U.S. real estate crash, the subsequent Euro sovereign debt crisis, and the looming U.S. fiscal crisis over entitlements and taxes, it must be an excess of debt across individuals and their governments. Public corporations with no taxing ability or social safety net have broadly been the sector that has been best behaved, which is why cash held by corporations is at a record high. The enormous debts incurred by individuals and their governments, including future commitments of pensions and health care that don’t show up on conventional public reporting, represent perhaps the most important consideration for investors today. Whether the huge liabilities we have created result in a lost decade like Japan’s through deflation or are highly inflationary is, to me at least, not clear. Yet, we are likely entering a period of greater populism fueled by increased income disparity, and perhaps more popular support for debtors who are both more numerous and face darkening prospects through continually stagnant middle-class wages. This book tells the story of how we arrived here, which is to say at a place with far too much debt owed by governments and individuals and with no easy ways to deal with it.The debt is not going away, and barring some unimaginable technological leap, our economies are unlikely to grow their way out of trouble. The story has two parallel strands: one describes the economic forces and trends that have been operating, in some cases the direct result of public policy decisions, while in others in spite of them. The other strand provides a groundlevel view from one participant who, for most of this time, had little understanding of the larger forces at work, but was rather reacting to market forces in a micro way, choosing jobs and opportunities whose prospects seemed most promising. Only with the benefit of hindsight

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can I regard my own past in conjunction with the broad strokes of history and appreciate that I was responding to market forces as I saw them in terms of career moves I made and jobs I held. I gave little thought at the time to the invisible hand at work in the background. This was a period of increasing financial liberalization as markets deregulated, of increased borrowing greatly aided by securitization and a heavy public policy bias toward debt and real estate, and consequently the ability to consume today at the expense of tomorrow became easier for individuals as well as governments. It would be natural to hold strong views and to express them in reviewing how we arrived here. However, there are many varied solutions, and the politics are largely for others to pursue. As an investor, you take the world as you find it, not as it should be; and while understanding the past is important in terms of planning for the future, investors need to focus themselves on likely outcomes and their probabilities and consequences, and make decisions accordingly. Most of us could solve the developed world’s debt problems easily enough, given the absolute power to do so. Futile debates on how the world should be are far less interesting than coolly assessing how it may well turn out to be. This story uses economic statistics to present the big picture combined with one individual’s personal journey through the growth of financial deregulation, securities trading, and debt. By considering how we made the journey, the story seeks to answer the question most investors have—where should I invest for tomorrow? It will be no surprise given the book’s title that the forces of economic history and politics are likely to combine in ensuring that even though fixed income has been a great place for investors over the past 30 years, the next decade is likely to be disappointing and may even be ruinous for bond investors. Those avoiding the possible risk of falling equity markets by holding bonds are most likely accepting the guarantee of negative real returns (i.e., returns below inflation, resulting in a loss of purchasing power) on their savings and a transfer of real wealth to those who have borrowed too much. Bonds have been great, to be sure, but Bonds Are Not Forever.

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CHAPTER 2

A BRIEF HISTORY OF DEBT

People have borrowed money since the beginning of recorded history. The seasonality of farming, in which a farmer’s financial net worth fluctuates with the times for planting and harvesting, was one of the earliest reasons for debt. Sidney Homer and Richard Sylla’s A History of Interest Rates finds evidence of loan rates as far back as 1800 B.C., almost 4,000 years ago. King Hammurabi of Babylonia specified the maximum rate that might be charged on a loan of grain as 33⅓ percent per annum, to be repaid in kind. Sidney Homer finds that forms of credit existed as far back as 8,000 B.C. during the Mesolithic Age, although such evidence is derived since written records do not exist that far back (Homer and Sylla 2005).

INTEREST RATES IN ANCIENT TIMES There’s reason to believe that trade between neighboring tribes 10,000 years ago represented a form of credit, as a gift from one tribe reflected the expectation of a reciprocal gift of similar value at some later date. This is a crude form of credit. Homer finds evidence of capital accumulation in the form of cattle and seed during the Neolithic Age (from 5,000 B.C.) (Homer and Sylla, 2005), and notes the derivation of words such as the Egyptian ms (interest) from another Egyptian word msj (to give birth) reflecting the concept of 23

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interest as coming from or derived from an asset. Some of the earliest interest rates are expressed in terms of a percentage of seed or cattle. Many of the earliest records of loans come from maximum rates rather than actual transactions. Records are understandably sparse for many centuries subsequent to this first known instance in Babylonia. Even so, there’s enough to show that indebtedness predated money and has remained a more or less constant aspect of commercial life ever since. Babylonian loans could be secured by assets such as land, slaves, or even one’s wife or children (Homer and Sylla, 2005). Written contracts were required and had to be witnessed. Clearly, debt finance had a role to play in commerce, and legal protections existed for both borrower and lender to ensure that contracts were enforceable on terms that were deemed fair at least by contemporary standards if not exactly common today. Twelve thousand years after the first evidence of credit, in 600 B.C., an economic crisis in ancient Athens led to widespread reductions of personal debt as well as the elimination of maximum interest rates and the forbidding of the imposition of slavery on debtors unable to repay their loans (Homer and Sylla, 2005). An excessive reliance on debt as well as multiple defaults by borrowers had resulted in widespread slavery. Periodic debt forgiveness is recounted in the Bible, and quite possibly the instances of it recounted here were not uncommon. Rome in 450 B.C. created a set of laws around lending that were made necessary by excessive debt. Interest rates were capped at 8⅓ percent per annum (Homer and Sylla, 2005) and included a penalty of fourfold damages for interest charged above this ceiling. The same rules allowed personal slavery for debt but required that the creditor feed his indebted slave. For much of human history, attitudes toward debt have reflected two moral standards. Repaying debt was a solemn obligation, and penalties for default have often been extreme. As noted, the debtor becoming a slave himself was one consequence of a failure to repay, and no doubt death was another possible outcome for a poorly treated slave. How this ultimate sanction could resolve an unpaid debt is an obvious question; no doubt it provided an incentive. In some cases, unpaid debts became the obligation of one’s children (Homer and Sylla, 2005). Roman law protecting the well-being of debt-induced

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slaves reflected this concern. Ancient societies expected debts to be discharged, and there’s scant evidence of debt forgiveness with a few exceptions (such as Athens in 600 B.C., as noted earlier). The second moral constraint attached to debt faced the lender in terms of usurious interest rates. In fact, the existence from earliest recorded history of caps on interest rates reflected a belief that an interest rate could be too high and that the government had a role to play in protecting borrowers from being charged too much by greedy lenders. This “moral” constraint on free markets and what could be charged for credit evolved into religious opposition to lending, to making “something out of nothing” (consistent with the Egyptian word for interest, ms, as described above). In the thirteenth century A.D., St. Thomas Aquinas (Homer and Sylla, 2005) cited Aristotle in arguing that money was sterile, and therefore “breeding” money from money was unnatural. In time, the Catholic church came to outlaw lending, at least among Christians. Islam still forbids Muslims from charging interest as contrary to Sharia law. Judaism adopted similar constraints on Jews charging interest to one another. Yet lending for gain outside one’s own religion was seemingly quite acceptable. This led to the prevalence of Jews as lenders, since they were typically providing credit to the far more numerous non-Jews (i.e., Christians). Possibly the disdain with which Western Christians regarded lending contributed to many of the negative stereotypes of Jews through the ages. Governments have usually been society’s largest borrower. Maintaining an army is one of the most expensive undertakings for any society, even in peacetime. Prosecuting a foreign war at almost any time in history has typically represented an enormous financial burden that requires it be either temporary or financially ruinous (and occasionally both). The need for military conquests and security and the demand for appropriate infrastructure are some of the underpinnings for the large role played by governments in the history of debt. Although interest rates on government debt are usually the lowest, given the perceived safety of lending to the government, it is fascinating to review the gyrations in the prices (and correspondingly the yields, which move inversely with prices) of government bonds in response to major military and political events.

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MEDIEVAL CREDIT It is instructive to examine medieval Venice, a powerful trading and military city-state, during the thirteenth and fourteenth centuries. Venice issued bonds called prestiti, which carried a coupon of 5 percent and therefore yielded the same when originally issued at par (see Figure 2.1). Their history can be traced back as far as the twelfth century when they forced loans, obligatory for wealthy citizens. In spite of their unwilling initial buyers, a secondary market in prestiti developed where the loans changed hands freely between willing buyers and sellers. Bonds are typically issued at a price of par, or 100, and so the original investors earn a yield that is equal to the coupon. Prestiti investors buying new bonds at 100 with a 5 percent coupon would earn an interest rate of 5 percent. Later prestiti buyers buying bonds following a price drop to, say, 90, would enjoy a higher yield. Because prestiti were perpetual bonds with no maturity date, as was common with government debt of this era, an investor’s yield can be calculated by simply dividing the 5 percent coupon by the purchase price. Buying prestiti at 80 would yield 6.25 percent (5 divided by 80). Bonds with a maturity date typically repay the principal amount

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Venetian Prestiti 1299–1502

Source: Homer, S., and Sylla, R, A History of Interest Rates (Hoboken, NJ: John Wiley & Sons, 2005).

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of par, or 100, when they mature. The government could “call” the bonds or repay them at its sole discretion whenever it wished. There exists almost 200 years of historical price information on prestiti, whose fluctuations reflected the success and failure of Venice both in commerce and at war. Peace generally meant increasing trade and wealth generation, which would swell the government’s coffers. War resulted in a need for additional funds through assessments as well as the added uncertainty over its outcome. Although the coupon payments received by investors were fixed as with most bonds, in effect prestiti represented more of an equitylike risk at times, since the existential threat faced by Venice from its sometime enemies forced investors to at least contemplate a total loss on their holdings (Homer and Sylla 2005). The price of Venetian bonds reflected the fortunes of its commercial traders and its warriors. During war with neighboring Genoa, prestiti changed hands at 60, while a generation later in 1323 faster repayments had driven the price up by 50 percent to 90. Assessments larger or smaller than expected caused regular gyrations. However, by 1375 prestiti had reached a price of 92½, at which price they yielded 5.4 percent, some 3 percent lower than in 1299. Then disaster struck, at least for investors, as a major war with Genoa resulted in very large assessments and a suspension of interest payments. One can only imagine the horror of the formerly wealthy Venetian merchants whose fortunes were no doubt tied to prestiti, as their price plunged to as low as 19 within just two years. Had prestiti been paying interest at this time, they would have yielded over 26 percent. However, it is clear that investors held considerable doubts about there being any future payments at all. The disruption of trade, so vital to Venice’s fortunes, as well as the great cost of war, must have been a doubly harsh financial blow to its mercantile class. Interest payments were subsequently restored, although their precise nature is unclear. Prestiti prices fluctuated throughout the fifteenth century, as multiple wars were fought with Hungary, Florence, Milan, and the Turks. For many years prices were in the 60s; by 1465, during a disastrous war with the Turks, they sank again to 22. Undoubtedly, the price of prestiti moved, largely based on events that were specific to Venice, and therefore reflected the likelihood

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of continued interest payments to creditors. Financial markets were hardly integrated at that time, and interest rate movements were local, based on regional business prospects and the balance of supply versus demand for credit. Clearly, a Venetian who had soured on his own government’s debt would find it challenging to diversify into bonds issued by neighboring governments, especially since it was quite possible they’d one day be at war with that nearby city-state. Financing the enemy wasn’t going to be well regarded, to say the least. There are other examples of individual securities that survived for centuries. A Dutch annuity issued in 1624 to Elsken Jorisdochter (Elsie, daughter of George) was still paying interest as recently at 1957, over three centuries later. The borrower was the Lekdyk Bovendams Company, a quasi-government entity since it had taxing authority that traced its charter back to 1323 (Homer and Sylla 2005).

THE BEGINNINGS OF MODERN-DAY FINANCE In 1694 the English government found it necessary to create “The Governor and Company of the Bank of England” (Homer and Sylla, 2005) in order to facilitate financing war with France. England and France were perennial antagonists of this era, and seven major conflicts between the two countries took place between 1689 and 1815. The new entity was granted the right to duties on “tonnage” (i.e., volumes of trade) and in exchange invested all its £1.2 million in capital in government bonds. The “tonnage bank,” as it was dubbed at the time, eventually assumed the role of Britain’s central bank, the Bank of England (Homer and Sylla, 2005). As with Venice several centuries earlier, the price of English government debt fluctuated with its fortunes in businesses and on the battlefield. Nonetheless, the movements were far less dramatic and more “bondlike” (i.e., not very exciting). Changes in prices paid by investors, or the yields demanded to lend money, were more a reflection of supply and demand than concerns about continued payment of interest. England’s issues of debt followed common practice of being perpetual in nature. One issue of 3 percent annuities spent almost the entire quarter century from 1727 to 1752 between 90 and 100. It’s

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doubtful that investors at the time experienced much excitement following such price movements—nor is it likely they wanted any. Military success has often been driven by economic strength because a country’s ability to borrow and to divert resources into armaments and military personnel is only as good as these resources. The late seventeenth and eighteenth centuries in Europe saw certain powers, especially Britain, develop quite sophisticated systems of banking and credit to pay for their wars (Kennedy 1987). For example, in the late 1780s, France and Britain both had approximately equal national debt of around £215 million; however, France’s annual interest expense of £14 million was nearly double Britain’s, a substantial disadvantage for one antagonist versus the other (Kennedy, 1987). A History of Interest Rates, by Sidney Homer and Richard Sylla, from which much of the preceding narrative is drawn, provides a fascinating perspective on global economic history reaching back to pre-biblical times. For many centuries, governments borrowed chiefly to finance wars and also to build infrastructure, like a city wall to defend against enemies or roads and sewers. The origin of private debt was agricultural, whereby a farmer would borrow seed to plant on his land and repay the loan in kind with additional seed as interest. In the 1750s in England, the chancellor of the Exchequer (equivalent in the United States to treasury secretary), Henry Pelham, sought to consolidate the various perpetual issues of debt that the English government had outstanding, and by redeeming some issues while issuing some new bonds he created the 3 percent consolidated annuities, called consols (Homer and Sylla, 2005). One of my first jobs when I worked in the U.K. gilt market in 1980 was to take a “run” of current prices on all the tradable bonds from the market maker. The bonds were arranged on the sheet by maturity with the shortest at the top and the perpetuals, with no maturity date, at the bottom. Consols were near the bottom of the list, along with another perpetual issue (“War Loan”). I didn’t realize at the time that I was recording the price of a security with over two centuries of continuous history. Each morning at the start of trading, one of the jobbers would read off a set of quotes on many of the bonds far too quickly for anyone to reasonably record them all. A partner from Akroyd and

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Smithers, one of the two dominant “jobbers” or market makers in gilts, quickly recited prices while surrounded by an eager group of trainees (“blue buttons”) like me from the many brokerage firms whose clients would shortly receive the market’s opening prices. Our presence was barely acknowledged, and his gaze was directed at some distant point far more interesting than the lowly scribes around him straining to hear every enunciated figure. It was as if he was quoting prices for his own pleasure, and the blue buttons were of no consequence.The prices were recited from memory without the use of the ubiquitous printed sheet listing all the issues. As if to demonstrate his considerable facility with bonds and the math of price/yield, both the sequence of bonds on the list and their prices were subject to instant mental recall. No other props were needed. The verbal shorthand used to quote prices speedily in fractions further raised the communication barrier between old hands and the uninitiated. Longer maturity bonds were quoted in price increments of 8ths. On the other hand, short maturity bonds whose prices are less volatile could be priced as finely as 64ths. The “big figure” was always assumed. A bond that was trading 98⅛ bid and 98¼ offered would be “an eighth a quarter.” Ninety-eight was assumed to be understood. Because “98 and 27/64ths bid and 98 and 29/64ths offered” is a mouthful even if you drop the 98, it would be, “seven clo clo around.” Translated, clo was short for “close around” meaning 1/64th either side of (in this case) seven sixteenths. As with many closed societies, grasping the language was necessary for admittance. Missing a quote for one of the bonds during the run required asking for a repeat at the end. Oliver Twist seeking more gruel in the workhouse is a good analogy; while requesting a repeat of one bond price might be tolerated, two would not. At that point, the partner would direct his intimidating glare at the partially deaf offender, often without providing the needed information. Sometimes the repeated quote was different from the original one, which caused me ever so slightly to doubt the mental skills so conspicuously on display. It was in some ways a reprise of the English public school experience. Just as in my first year at Forest School at age 11, the seniors appeared so distant and so tall.

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BORROWING REACHES THE MASS MARKET Mortgage debt existed at least as far back as the fourteenth century. Lending rates that can be traced back that long ago are generally similar to those for annuities or perpetual debt. Nevertheless, there were significant differences with today’s mortgages, which are less than 100 years old in their present form. Lenders typically required the borrower to retain substantial equity in the property being financed, often 50 percent or more. The loans were also of relatively short maturity by today’s standards, with three to five years being common and the interest rate might reset more frequently (Homer and Sylla, 2005). Generally, the expectation was that the borrower could pay off the loan within that time, although such loans were often rolled over with the interest rate reset at prevailing rates. For several hundred years, mortgage debt was typically a private transaction between an individual borrower and another wealthy individual looking for a return on investment. By the 1920s, mutual savings banks and building and loan societies were providing substantial credit to homebuyers (Hyman 2011). Yet the term of such loans remained short at three to five years (Hyman, 2011). Typically, there was no principal amortization so payments were interest only, with a balloon payment at the end. Often, the borrower would seek to refinance at maturity, and in cases where the lending bank did not wish to renew the loan, the borrower needed to find another bank or risk foreclosure on the property. The Great Depression that followed the 1929 stock market crash led to enormous financial stresses throughout the system.The Federal Reserve had been raising rates during the late 1920s in response to strong growth, and the continuation of tight money after the financial collapse was exacerbated by misguided legislation such as the 1930 Smoot-Hawley Tariff Act, which greatly harmed global trade. In the ensuing economic contraction, hundreds of savings-and-loans went bankrupt. The practice of rolling over mortgage loans came under pressure as many banks refused to, often because their own debt was being rejected by increasingly nervous investors. Within four years, housing credit had virtually disappeared and the housing industry collapsed (Hyman, 2011). The federal government under Roosevelt

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eventually responded in multiple ways, including Keynesian expansionary economic policies and overhauled regulation of the securities industry. Support for housing came in the form of the newly created Home Owners Loan Corporation, a temporary fix whose role was to provide government funds for mortgage lending through banks and arrest the slide in property prices. It was eventually superseded by the Federal Housing Administration (FHA), which in turn led to the creation of the Federal National Mortgage Association (recognizable today as FNMA or Fannie Mae), which was founded in 1938. The FHA didn’t make mortgage loans at all. It instead set standards for construction and loan terms in exchange for providing insurance. Private capital continued to be the main source for mortgages, and the FHA’s role led to common terms that allowed loans to be easily resold across the country. Until that point, mortgages rarely covered more than 50 percent of a home’s value (Hyman, 2011) and often a second mortgage was required at a much higher rate. The entry of the FHA into the home lending market made mortgages far more accessible. Subsequent decades witnessed a steady softening of terms in favor of borrowers, including smaller down payments as a percentage of purchase price and longer terms, although rates had begun their long march upward that would culminate with Paul Volcker’s leadership at the Fed. Home ownership is believed to foster more stable communities because residents appropriately feel and act as if they have a greater stake in the neighborhood if they own their home. Houses are kept in better repair, streets are cleaner, and schools are better when the community cares because they’re invested. Consequently, promoting home ownership became a legitimate public policy objective and one that has been broadly successful. Home ownership rates remained at around 45 percent from 1900 to 1930 before falling in the early 1930s as lending dried up. The availability of government-insured loans stabilized and then reversed this trend, so that from 1940 to 1960 home ownership rose from 44 percent to 62 percent (Fetter, 2012). In 1968, President Lyndon Johnson changed FNMA from a government agency into a partially private company with public stockholders. In 1970 Congress created the Federal Home Loan Mortgage Corporation (FHMC or Freddie Mac) with a similar charter to

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FNMA so as to create competition between the two.This melding of a public policy goal to increase home ownership with private, profitseeking owners led to substantial growth in government-backed mortgage lending and easier loan terms. It became a toxic combination. By 1999 Andrew Cuomo, director of the Department of Housing and Urban Development (HUD), was threatening FNMA and FHMC with daily fines of $10,000 if they failed to make half their loans to low- and moderate-income families. Successive managements engaged in earnings manipulation and accounting fraud, notably under James Johnson (CEO from 1991 to 1998) and Franklin Raines (CEO from 1998 to 2004). Both men well understood how to play off the politicians desirous of more low-income mortgages against their regulators. The hybrid public companies with government backing that Congress created led to distorted public policy and dishonest behavior (Morgensen, 2011). Over the past 50 years the home ownership rate has remained remarkably stable between 62 percent and 66 percent. The housing bubble that burst in 2007 took the rate temporarily above this range, and arguably with the benefit of hindsight this was beyond what the equilibrium should be. FNMA and FHMC’s access to funding rates virtually the same as the federal government and capital requirements subsequently shown to be completely inadequate were important factors behind this. Not everybody should own a home, and the relaxation of credit terms that was required to push this percentage of homeowners above its long-term range regrettably drew in many buyers for whom renting would no doubt have been a better choice. What is clear, though, is that mortgage debt has become everybody’s debt. Because the public sector through the federal government provides home loans on terms that the private sector can’t match, we are all collectively on the hook when things go wrong, as they did a few years ago. Although promoting home ownership is a worthy public policy objective, like most good things, it’s possible to have too much of it. Sixty-two to sixty-six percent home ownership has been shown to be sustainable. Reaching for levels above that led to disaster for many, and the cost to taxpayers was compounded by the corruption endemic to the two government agencies involved (Morgensen, 2011).

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The emergence of consumer credit during the twentieth century as an increasingly powerful engine of economic growth highlights a shift in public attitudes toward borrowing. Its beginnings can be traced back to the invention of the automobile. In the early years, cars were, of course, a rich man’s toy and were priced beyond the reach of most people. Before 1919, cars were generally bought with cash (Hyman, 2011). With the development of mass production of cars came much greater output at a cheaper price; therefore, bringing cars to the middle-class family required some form of credit to enable the purchase. The automobile manufacturers soon found themselves providing inventory financing for the dealers so they could hold a sufficient selection of cars on their lots for buyers to consider. Because financing was not initially provided directly from the manufacturers to consumers, small finance companies sprung up to fill the gap. In 1922 the Northern Illinois Finance Company was formed with $3,000 secured by the owner’s home. Five years later, volumes had exploded to where over half a billion dollars was invested in auto loans by Northern Illinois and similar firms according to one banking executive of the time (Hyman, 2011). Traditional banks and the auto manufacturers themselves initially left this new credit market to smaller firms. Attracted by the high returns on invested capital, GM soon began lending directly to the consumer. Although in 1919 General Motors Acceptance Corporation (GMAC), as the financing arm of GM was known, described their purpose as providing finance to dealers, by 1927 their annual report described providing finance to consumers of its goods as its most important function (Hyman, 2011). The development of the automobile led to the development of the suburbs. No longer was it necessary to live within a short distance of your place of work. Commuter train lines also contributed to the movement of people away from city centers. My home in Westfield, New Jersey, was built in 1928, and a copy of the marketing brochure from that time extols the bucolic suburbs now so accessible from the city. Commuting by train was recommended as allowing a period of relaxation at each end of the day,“. . . a matter of buying years of lasting health by spending minutes now, while living in the city means buying those minutes now with years of health which you must surrender in

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due time” (Wychwood 1931). Having traveled daily from the suburbs to New York for 24 years, I’d venture that attitudes toward commuting have evolved since 1931. Even if people didn’t commute from the suburbs every day, the wealthier could easily access a weekend home. Houses are bigger than apartments and need more furniture, appliances, and other essentials to fill them. So both industrialization and improved mass production contributed to the growth in demand for consumer credit. A loan secured by land or an automobile at least provided the lender with collateral to seize in the event of a default. However, small loans to consumers for minor purchases, or to cover living expenses until the weekly paycheck, could not be secured by any assets. They were far riskier and more expensive to administer. In addition, because usury laws existed in most states limiting the legal rate of interest that could be charged, lenders could not earn an economic return without lending at an illegal rate. Under such circumstances, no court would issue a judgment against a delinquent borrower, and consequently much of this type of finance occurred in the legal shadows where “loan sharks” freely operated. John Mackey is one of the better-known lenders of the era, using his inheritance in the late 1870s to start a business that over the next 50 years grew into the Household Finance Company (Hyman, 2011), then the most widespread small loan company in the United States. In the early years, Mackey charged rates as high as 10 percent per month, which compounds to 214 percent per annum. Six percent had long been the usury limit under English law, and the custom crossed the Atlantic to the States, largely surviving until the 1950s (Homer and Sylla, 2005). The concept of a maximum allowable rate of interest has existed since the beginning of recorded human history. In fact, much of the early information on borrowing rates comes not from actual transactions but from legal limits on how much a borrower could be charged. Only in the last couple of generations has debt shed much of the moral baggage it has carried since biblical times. Societies have held decidedly ambiguous attitudes toward indebtedness. While its necessity has been clear ever since a seasonally cash-poor farmer needed to borrow to plant his crops, it has long been felt right to protect the presumably more vulnerable borrower from exploitation by his lender.

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In addition, the religious constraints on lending, as noted elsewhere, further demonstrate the moral ambivalence long associated with debt. “Neither a borrower nor a lender be,” was the sage advice offered by Polonius in Shakespeare’s Hamlet. As Polonius went on to explain, lending could result in the loss of both the loan and the friendship of the borrower. Meanwhile, he believed the borrower might not work as hard (“. . . dulls the edge of husbandry . . .”) if credit allowed him to eat when he might go hungry. For example, I can remember my grandparents, who grew up during the Depression in Britain, repeating the words of Polonius to me as a child. Such advice was not delivered in jest, either, and it’s striking to consider how mores have shifted over just a couple of generations. Shakespeare presents a more severe example of the debtor’s obligation to his creditor through Shylock’s demand for his “. . . pound of flesh . . .” in the Merchant of Venice. Shylock’s evident Jewish heritage no doubt reflected and maybe even promoted the stereotypical Jewish lender and his uncompromising demand for repayment. This scene illustrates that both sides can be guilty of moral shortcomings. While Shylock’s failing is more obvious, the severe treatment contemplated for the borrower (40 pounds of flesh—in other words, death) illustrates that a solemn promise to repay was not to be taken lightly. For much of history, borrowers who were able to obtain unsecured credit or lenient terms were generally wealthy enough not to need to borrow money. The prosperous merchant or rich landowner might use short-term credit to avoid the tiresome necessity of liquidating inventory or other relatively minor assets. Borrowers at the other end of the economic spectrum were usually ashamed to need to borrow. Since loan sharks were by definition operating illegally through charging usurious rates, both sides were happy to conduct their business in secret. The finance companies that developed to service auto purchases soon diversified into other types of consumer credit, most notably household appliances. Although companies like the General Electric Contracts Corporation (GECC) specialized in financing only appliances manufactured by their parent, GE, few other companies were big enough to run a dedicated finance company. For example, the Apex Electrical Distributing Company directed its dealers to rely on

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the Republic Finance & Investment Company in a form of vertically integrated business combining manufacturing, distribution, and finance (Hyman, 2011). While such finance companies were clearly not loan sharks, unwitting consumers were surprisingly vulnerable to abuse given the inadequacy of the laws to protect them. A buyer of a set of living room furniture on credit was not deemed to possess any claim to it until the final loan payment had been made (Hyman, 2011). Quite literally, a borrower could default after two or three years of payments, perhaps due to a lost job or child’s hospital bill, and lose the property that was almost theirs. Judges often ruled that existing usury laws designed to protect unwitting borrowers from unscrupulous lenders were intended to safeguard working-class needy borrowers (Hyman, 2011). A new washing machine not funded from available cash was hardly a necessity in the opinion of Judge P. J. Trimble (GMAC v. Weinrich). Therefore, he continued, it must be a luxury purchase and not subject to the protections of the laws against usury. Repossessing property that secured a loan under such circumstances and then reselling it (albeit as used) could greatly improve the profitability of such a finance business. As the furniture and appliance manufacturers gradually handed off the financing of their sales to specialist finance companies, it weakened the incentive for unprincipled behavior. While a furniture business may be happy to repossess and resell the same living room suite multiple times, a finance company would not. As finance companies grew and began selling their loans to other entities, the link between buyer and lender was further weakened, and the type of dishonest behavior previously described became less common. Throughout the 1930s, commercial loan demand remained weak during the long years of the Depression. Many firms did not need the money that banks were trying to lend and regarded taking on debt as too risky. Every year, commercial loans represented a smaller percentage of banks’ total lending, such that by 1938 one survey found that 91 percent of firms had “no bank credit experience” (Hyman, 2011). Searching for ways to make up for lost profitability, banks began lending to consumers. Many were initially skeptical that there was much profit to be had, and indeed the conventional approach

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to lending hardly seemed appropriate when dealing with so many small borrowers. Commercial loans involved a detailed assessment of the creditworthiness of the borrower, including analyzing the balance sheet, income statement, and cash flows as well as considering business prospects, competition, liquidity, and other important drivers of overall profitability. Such a detailed approach was not workable when hundreds or thousands of small loans had to be processed quickly and accurately to generate an adequate return. So credit analysis underwent a minor revolution. Since analyzing each loan individually wasn’t economically feasible, banks instead developed scoring systems for borrowers, which eventually became the FICO system, so familiar to today’s credit card holders. Banks went for quantity and bet that over large numbers of loans the statistics reflected in their scoring systems would generate good returns with acceptable rates of default (Hyman, 2011). The other big change at this time concerned revolving credit. Traditionally, loans had a maturity date, whether it was for a building or a washing machine. The aggregation of thousands of small loans together resulted in a blended portfolio of loans with an average maturity. Consumers valued the flexibility of borrowing what they needed (up to a limit) for as long as they needed it, and the law of large numbers reduced the unpredictability that might ensue if such loans were fewer and larger. Although some big retail stores such as Macy’s questioned the wisdom of its customers remaining in perpetual debt, even if it helped sales (after all, Macy’s was looking for a “certain class of customer”), in time the increased revenues won them over (Hyman 2011). This represented the great democratization of credit, which, when combined with the use of mainframe computers to process the huge amounts of data required, led banks to be some of the biggest users of information technology. The numbers worked. A survey in 1954 among stores with over $20 million in annual sales found default rates below 1 percent (Hyman 2011). Customers who shopped regularly clearly valued maintaining their credit in good standing. In some cases, stores even accepted the higher delinquency rates that came with lowering their credit standards, reasoning that the resulting higher sales would still help the bottom line (Hyman, 2011; Auerbach and Gale, 2012).

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STUDENT DEBT Student debt has in a relatively short period of years become a substantial liability for many. By late 2012, it was estimated that $956 billion of such loans were outstanding. Comprehensive figures are available for only the past several years. Nevertheless, its growth has been staggering. As recently as 2005 the equivalent figure was $363 billion, so total student debt since then has been increasing at over 14 percent annually (Federal Reserve Bank of New York, 2012). This was the only type of household debt that increased through the Great Recession. It’s likely to represent a significant problem. As with other areas of debt buildup, the goals behind it are well intentioned.The concept of making higher education available to everyone, based on merit and regardless of means, is a sound public policy objective. Nevertheless, federal support has inadvertently fueled the very high tuition inflation that so many families wrestle with. Since loans are so freely available, consumers (i.e., students) are often less sensitive to rising prices than they would be if college had to be paid for without the use of loans. It’s also virtually impossible to default on student loans. In fact, even filing for personal bankruptcy isn’t a sufficient reason to seek an adjustment in loans outstanding. By making student loans less risky for private lenders such as banks, this virtual prohibition on default increased loan availability. The downside (in addition to fueling higher tuition as discussed) is that young people can finish college with the equivalent of a mortgage before they have even considered buying a home. As with the growth in mortgages, a public policy objective using private savings has created institutions that profit from the ambiguity in combining the two. In 2011, the Student Loan Marketing Association (SLMA or Sallie Mae) earned a net interest spread of 1.85 percent on $174 billion of student loans that are highly creditworthy because of their exemption from most forms of restructuring in the event of personal bankruptcy of the borrower. Because of this, the company operates with only $2.70 in common equity for every $100 in assets (SLMA, 2011). By contrast, JPMorgan’s balance sheet, for example, has 11 percent Basel I and 8.7 percent of Basel III Tier 1 Common Capital supporting its assets (JPMorgan Chase & Co., 2013).

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SLMA’s Principal Executive Officer Albert Lord earned almost $7 million in 2011 compensation managing this highly leveraged portfolio of government supported assets (SLM Corporation, 2012). There is a case that the private sector will extend credit to students more efficiently than if it’s done by the government; however, the profit incentive also assures that volumes will be driven by the interests of the lenders and schools rather than what’s good for the students. As was the case with housing, a sound public policy is being distorted to meet other goals. The buildup of debt by students has been mirrored by the universities themselves, in spite of the fact that one might expect improved access to financing for their clients to improve the balance sheets of the institutions themselves. A form of arms race has developed as schools compete to offer better facilities to justify annual tuition increases well ahead of inflation. Moody’s rated more than 500 institutions in 2011 and found that overall debt levels had doubled since 2000 after adjusting for inflation.To pick just one example, New York University’s debt grew from $1.2 billion in 2002 to $2.8 billion by 2011 (Martin, 2012). Harvard was the most indebted university at $6 billion although their endowment is worth substantially more. Here, too, as in so many other segments of society, debt has grown at a pace that’s not sustainable over the long run. Colleges and universities are generally poor at advising on the cost/benefit trade-off involved in borrowing money for education. The increased earnings due to a degree vary widely depending on the subject. Pretty clearly, an engineering degree is more useful than one in a foreign language. The failure of higher education institutions to provide guidance on this represents a significant moral failing on their part. For academia, all education is worthwhile, and placing a price on it can often be anathema to those who choose to teach.Yet, if universities deserve a role in educating our young people, they additionally have a responsibility to provide them with meaningful financial advice. Providing prudent financial advice to the student may conflict with the school’s own interest in recruiting tuition-paying students. University administrators recommending that the degree they offer isn’t worth it is analogous to a sales clerk at a retailer advising you to take not to make a purchase if you have to pull out a credit card.

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Collectively, the administrators of America’s colleges and universities have betrayed a significant trust. High school graduates naturally rely on the recommendations and guidance of higher education professionals, yet higher education itself has abandoned financial discipline and in the process saddled its young charges with ruinous debts. Sending young people into the world burdened by debt represents an abuse of trust. The people who run America’s institutes of higher learning are guilty of a colossal failure of leadership. In too many cases they’ve overcharged for the value that they’ve delivered. In this respect, their behavior is uncomfortably close to that of the greedy Wall Street investment bankers they readily criticize. Perhaps there would be fewer people studying philosophy if students were presented with examples of likely starting salaries for recent philosophy graduates. They would at least be better informed. As my own children have grown up, I’ve learned through them and from their friends the prevalence of significant borrowed sums; it’s become clear to me that a well-meaning public policy objective has created unintended consequences. One trillion dollars of such debt is unlikely to be repaid easily, and society will need to confront how much responsibility for full repayment can be expected of people who were often just old enough to vote when they took on significant financial obligations. Both the number of borrowers and the average balance of each borrower have increased at an annual rate of 7 percent since 2004. Student debt almost tripled during this time. Student debt is the only form of nonmortgage household debt that maintained its steady increase through the 2008 recession. As a result, over 40 percent of 25-year-olds have some form of student debt. Thirty-five percent of borrowers in repayment below 30 years old are 90-plus days delinquent (Lee, 2013). In fact, only 39 percent of borrowers in repayment are not delinquent. The proportion of parents who save for their children’s college is falling as increasingly they expect some form of financial aid or loans to be available. One third of families expect to tap into retirement savings to pay for college (Student Loan Marketing Association, 2013). Future obligations are building here, too. Tracing the evolution of debt through human history ends at a place unrecognizable from the start. The same is true of many aspects

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of human development. Farming debts to plant crops and government debts to finance war constituted the beginnings of borrowed money. Attitudes toward debt changed slowly until the past hundred years or so. Social and legal constraints on lending, on interest rates, and on publicly acknowledged borrowing all fell away. Personal bankruptcy, while rarely a pleasant choice, has lost much of its social stigma. What’s clear is that for virtually all of human history, credit has been used to invest in something (such as planting a crop) that will yield a return from which the loan plus interest can be repaid. Government debt has largely been for wars, which to widely varying degrees drew their legitimacy from the need to protect the society and ensure its survival. The concept of borrowing for consumption as opposed to investment is barely 100 years old. First individuals, and subsequently governments, have relaxed the requirement that money borrowed needs to create its own repayment through the productive use to which it’s put. As will be discussed later, when passing debt on from one generation to the next, which is increasingly how public-sector finance is driven, it’s a morally defensible obligation when the result was investment in public infrastructure or a national emergency (such as a war). However, debt incurred today to fund entitlements such as Medicare and Social Security for an older generation hardly carries with it the same solemn promise to repay.Why should a generation of Americans feel bound to repay debt incurred by earlier generations, when the need was simply to fund retirements for which earlier provision had not been made? There is no link, no tangible benefit, for later voters to feel or observe with the beneficiaries. Although there is no bright line that differentiates precisely which generations win at the expense of others, a partial remedy is already being implemented in the form of artificially low interest rates on government debt. Interest is paid by taxpayers while entitlements are received by retirees, who are often savers. The burden of funding this generational wealth transfer is already being eased through reducing the return earned by bond investors. In fact, Reinhart and Rogoff (2009) assert that ultra-low interest rates are “financial repression” and are therefore “a form of taxation.” The largely absent political criticism of such a policy highlights its potential longevity, and government

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borrowing rates below inflation would seem to benefit more people than they hurt.There’s little reason to expect this to change as long as the U.S. government is able to set its own rates through the Federal Reserve. Reinhart and Rogoff (2009) take this a step further, and ask, “Why don’t young voters periodically rise up and vote to renege on the debt . . . at the cost of less wealth for the elderly?” Young voters largely are indifferent to this issue, although in any case a stealth default through returns below inflation is already taking place. It’s less disruptive than an outright abrogation, although a quieter form of the same policy.

BIG BORROWERS IN HISTORY The list of countries that have defaulted on their external debt is a long one, and thanks to Reinhart and Rogoff it is now clearly documented. Great empires of the past have reneged on their obligation with striking regularity, even while such events must have been shocking at the time. Spain maintained the biggest army among European powers during the sixteenth and early seventeenth centuries (Kennedy, 1987). Its military was routinely twice as big as that of neighboring France in the 1630s, for example, boasting 300,000 men, more than France, England, and the United Provinces combined (Kennedy, 1987). Military power is expensive, and during a 90-year span, from 1557 to 1647, Spain defaulted six times. Between 1588 and 1788 France did so eight times. The French finance minister from 1768 to 1774, Abbe Terray, in an attempt to claim the moral high ground from France’s long-suffering creditors, advocated a default at least every 100 years or so to “restore equilibrium” (Reinhart and Rogoff, 2009). Willingness to repay debt is as important as ability, and the big European powers noted earlier were also big borrowers. Although they might have used their armies to enforce debt repayment (Britain invaded Egypt in 1882 because of a debt dispute and Istanbul following its 1876 default), such actions were not plausible to their creditors (Reinhart and Rogoff, 2009). A fascinating historical footnote

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is Newfoundland’s loss of nothing less than its sovereignty when it defaulted on its external debts in 1936. Britain’s parliament acted on the principle that democracy should be subordinate to debt and abolished Newfoundland’s parliament, in effect imposing a dictatorship on 280,000 English-speaking people. Britain then used its constitutional powers to steer Newfoundland into a federation with Canada (Reinhart and Rogoff, 2009). One notable observation is that Greece’s default on its euro loans to European Union (EU) neighbors is historically not a surprise. Although EU leaders have strained to use every available noun to characterize Greek debt “restructuring” as something other than a default, it meets the definition used by Reinhart and Rogoff and meets the reasonableness test, too. Since winning independence from Turkey in 1822, Greece has been in default on its debt a staggering 50 percent of the time (Reinhart and Rogoff, 2009).With the admitted benefit of hindsight, who could seriously have expected this pattern to change through entry to the euro? During the twentieth century, developed nation defaults have been rare. Within Europe, the turbulent years leading up to World War II saw several central European countries including Germany default. After World War II, defaults were unknown in Europe for almost 40 years until a series of East European nations such as Poland (1981) and more disruptively Russia (1991 and 1998) (Reinhart and Rogoff, 2009). Latin America’s debt crisis of the 1980s will be familiar to many readers, and the region also witnessed many defaults in the 1920s and 1930s. Nonetheless, in living memory developed country defaults barely register as a plausible risk. In 1987, Paul Kennedy published The Rise and Fall of the Great Powers. Although it’s more than a quarter century old, many of his insights are still relevant today. Economic and military dominance go hand in hand. An investor evaluating U.S. debt needs to consider that the U.S. economy is slowly losing its dominant global position as a result of the reemergence of China and India. While the increasing competition for power in Asia can take many courses, growing Asian economic output will increasingly test America’s financial ability to project military power unchallenged on the same scale as in the past.

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For an investor, a political recognition of the inevitability of a multipower world would represent a welcome restraint on defense expenditures and an improved fiscal outlook. Currently, such recognition does not appear to be present with either political party, and speeches about the limits to American power do not provide good sound bites. Paul Kennedy wrote intelligently about “Imperial Overstretch” (Kennedy, 1987), which occurs when a country’s military ambitions are not reconciled with its economic capabilities. Contemporary history shows how inevitable the Allied victory in World War II was, given their collective economies’ far greater capacity once harnessed to the production of armaments. More recently, the defense buildup under President Reagan in the 1980s is credited with exposing the vulnerability of the Soviet Union’s planned economy and its inability to divert sufficient resources to keep up. It’s worth noting the current U.S. situation. In 2011 we spent $711 billion on defense, more than the next 13 countries in the world combined (Peter G. Peterson Foundation, 2012). The United States is the world’s sole superpower and, in a historical context, is the great empire of the day. By the standards of prior world powers, the United States is incredibly benevolent, seeking to extend its influence through commerce and the promotion of core values such as democracy, respect for human rights, and free speech. Some may debate the degree of enlightenment reflected in U.S. policies. However, that is not the focus of this book. An investor in U.S. debt needs to acknowledge the historical parallels between the U.S. empire of today and the increasing drain maintaining such leadership has imposed on past empires.

WHAT WE OWE NOW During most of my career, the size of the U.S. debt has been a cause of great concern for financial commentators. With rare exceptions, the political will to tackle the issue has been absent. Countless books and articles have been published that explore the issues in considerable detail so I’ll simply provide a brief overview here by way of context. The Congressional Budget Office (CBO) regularly publishes

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detailed long-range forecasts. The Peter G. Peterson Foundation also runs a useful web site that contains projections of future indebtedness. In the CBO’s February 2013 publication, The Budget and Economic Outlook: Fiscal Years 2013–2023, they forecast that federal debt held by the public will reach 76 percent of gross domestic product (GDP) by the end of the 2013 fiscal year, the largest since 1950. While a modest improvement is forecast over the next couple of years due to the economic recovery, the increasing drag of entitlement obligations (Social Security, Medicare, and Medicaid) prevents the ratio from falling below 73 percent during the 10-year forecast horizon used by the CBO. They note that as recently as 2007 federal debt was just 36 percent of GDP. Moreover, while debt held by the public in this analysis is $12.3 trillion, it ignores an additional $4.8 trillion held by the federal government itself in trust funds to provide Social Security, Medicare, and other retirement plans.Total federal debt (“gross” as defined by CBO) is $17.1 trillion, 106 percent of GDP, or $54,500 per person. Although the near-term outlook is for some slight improvement, toward the end of the decade growing spending on entitlements will start driving up the amount of federal debt outstanding. The CBO also assumes no change in existing laws, whereas Congress routinely delays scheduled tax hikes and spending cuts (such as the 25 percent reduction in payments to physicians under Medicare, which is delayed every year). Past experience suggests fewer spending cuts and revenue increases than are incorporated in current law. The CBO forecast is by no means a worst-case outcome. Federal debt alone is already at a level that would be unsustainable for probably any other country, although Japan’s $13.3 trillion in debt means it is closer to discovering where the limit is. The U.S. dollar’s role as a reserve currency, strong economy, absence of significant military threats, and stable democracy all make the United States attractive to global investors. Nevertheless, we are testing the limits of these advantages, and nobody knows where the tipping point for debt/GDP lies. The Eurozone’s Maastricht Criteria (although they’ve long since been abandoned) originally imposed an upper limit on each country’s debt/GDP and used 60 percent as the critical level. Reinhart and Rogoff (2009) find in one study that on average a ratio of

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69 percent external debt to GDP is where countries default, although it’s lower when domestic debt is included. Regardless of which figure is right, few would argue with the notion that the United States on current policies will find out just where that limit is. In addition, we haven’t finished adding in the rest of the debt. In 2010 (the most recent data available), state and local government debt equaled $2.8 trillion (Vidal and U.S. Census Bureau, 2012). Assuming this grew at inflation, state and local government debt is currently 19 percent of GDP. This excludes unfunded pension liabilities to public-sector employees, estimated at $2.9 trillion in 2011 (Brady, 2012), also 19 percent of GDP. Public-sector pension funds routinely discount their liabilities at too high a rate, which has the effect of understating the true size of their obligations (Andonov, Bauer, & Cremers, 2012). The California Public Employees Retirement System (known as CalPERS) assumes their investments will earn 7.5 percent annually (CalPERS, 2012). How exactly they expect to earn such a return when bond yields are half that level is a mystery of arithmetic that will probably be solved by future California taxpayers. Some states are in dire trouble. Kentucky has combined obligations of 42 percent of its output. Illinois has 40 percent. California has 32 percent (Ricketts, 2012).These might be tolerable if they were independent countries and didn’t owe any other money, but they also owe their share of the federal debt described earlier. Adding that in, Kentucky owes 148 percent of its GDP.Who would ever lend money to Kentucky knowing that? So government debt at all levels is 144 percent of GDP, and that takes no account of the funding shortfalls facing entitlement programs over the next couple of decades. Household debt reached $12.8 trillion in the fourth quarter of 2012 (U.S. Federal Reserve, 2013), which is 80 percent of GDP (see Table 2.1). Student debt, which is included in household debt and which the Fed didn’t even bother measuring 10 years ago, reached $956 billion in late 2012 (6 percent of GDP). Federal, state, and local government debt combined with unfunded government pensions and household and student debt are 224 percent of GDP, or $312,000 per household. It’s safe to say we’ve never owed this much and that it’s going to get bigger. America has been on the most unimaginable debt binge.

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TABLE 2.1

Total Debt Outstanding 2012

Federal Debt Held by the Public Debt Held by Government Accounts State and Local Government Debt Unfunded State Pensions Household Debt TOTAL

Amount (TN)

% of GDP

$12.2 $4.8 $3.0 $3.0 $12.8 $35.9

76 30 19 19 80 224

The Peterson Institute projects that on current policies federal debt alone held by the public will reach 87 percent of GDP in 2022 (versus 76 percent today). This is more pessimistic than the CBO forecast. Fueled by entitlement promises to retirees and the aging of the Baby Boomer generation, debt held by the public could reach 200 percent of GDP by 2040 (Peter G. Peterson Foundation, 2013). Alan Auerbach, a professor at UC Berkley, and William Gale of the Brookings Institution, project that federal debt to GDP will exceed its 1946 high of 108.6 percent in the late 2020s with unchanged policies, also more pessimistic than the CBO (Auerbach and Gale, 2012). The Economist has a global debt clock that updates in real time for most countries in the world (www.economist.com/content/ global_debt_clock). While you can’t expect agreement on long-term forecasts such as this, there is a broad consensus that the problem is worsening. The most downbeat projections ultimately suggest a bigger financial crisis than in 2007–2008. Few forecasters believe it will happen. Either the political process will reach the necessary compromises to bring government revenues and spending into balance, or financial markets will impose their own limits on the United States’ ability to borrow. Neither outcome is especially appealing, although the latter is probably far worse. The problem is that, as dire as the fiscal future may appear, there is very little tangible cost to the typical household. Many voters accept the conceptual necessity to deal with the issue. However, low interest rates and the U.S. dollar’s role as a reserve currency shield voters from the immediate consequences of inaction. As a practical matter, there

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is little political support for taking the steps necessary to reduce our debt. Opinion polls routinely show a strong preference for reducing the deficit, while not raising taxes or cutting entitlements. Such a view is perpetuated by the absence of any visible economic pain due to current policies. In fact, fiscal prudence is likely in the near term to cause more pain (through higher taxes and reduced entitlements) than inaction, while an interest rate policy that maintains negative real returns leaves little room for rates to fall in response to such moves. As an investor, it seems a poor bet to assume the United States will become fiscally more conservative. There’s little indication that sufficient popular support exists for the trade-offs that are necessary. We can blame the politicians, although really they’re simply responding to the voters. It is democratic, if not particularly well advised. U.S. total debt (government plus household) bottomed out at its lowest since World War II in the late 1970s at around 92 percent of GDP (see Figure 9.1 in Chapter 9). By the early 1980s, falling inflation and interest rates, a growing finance sector, and the desktop computer revolution were creating new borrowers and new financial markets. Probably the most significant new market of all was that for financial derivatives.

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CHAPTER 3

DERIVATIVES GROWTH

In the early 1980s, some important trends were developing. America’s economic supremacy was reasserting itself under President Reagan following the economic turmoil and despondency under Carter. Interest rates were reaching their peak and beginning the 30-year-plus bull market that would bring them down to very low single digits within a generation. The bull market in financial markets would coincide with and most likely support a steady increase in the size of the financial services sector.The development of computing technology would transform the ability of financiers to develop products and risks previously unknown, to process volumes of transactions nobody thought possible. History shows that these were the big themes driving economic activity and particularly finance. As one individual at the beginning of his career, I was scarcely aware of the bigger picture.That the New World held out greater potential than the Old was apparent, as it had been to many millions of other immigrants in past decades. However, the decision to enter finance was not the result of careful career analysis; it was instead an obvious choice to someone who’d grown up with a grandfather who was a banker, was reasonably numerate, and was drawn to trading based on success in a game during one economics class. Britain in the 1970s was struggling with inflation, and my economics teacher in high school at that time, John Davies, devised a game to illustrate its effects. John was a wonderful teacher who made

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every lesson engaging and is responsible for my love of economics and statistics. We’ve stayed in touch, and many years later he listened happily as I told him how his classes had formed the basis for my career. In the game John devised, competing teams of two students bought and sold different colored cards with Monopoly money, with the goal of accumulating a winning portfolio of the most valuable cards. The game was repeated with more money in circulation, and naturally the prices of cards rose correspondingly. The lesson that inflation is caused by too much money chasing too few goods was duly learned, but since winning both rounds of the game required rapid yet simple mental arithmetic, the revelation that trading might be for me was an epiphany.

WELCOME TO NEW YORK I worked in London’s financial district known as The City, as described in Chapter 1, before switching jobs and persuading my new employer, Godsell LDA, a money broking firm, to transfer me to their New York office. While I believed I was grasping the opportunities as I found them, I was also one anonymous character reacting to the broad strokes of history. Arriving in New York in 1982 as an immigrant was an intoxicating feeling. Nobody who has grown up in America can truly appreciate the mesmerizing view of the United States held by those who wish to move here. As soon as I stepped off the plane, I expected to be mugged, such was the city’s then well-deserved reputation for crime. Kojak and Starsky and Hutch formed the basis for much of what I knew of the city. And, in fact, I was mugged within a couple of weeks. It was a broad daylight, inconsequential event, albeit frightening at the time. The contrast I found between working in London and New York in 1982 was stark. Before London’s “Big Bang” induced financial deregulation in 1986, competition was limited and existing stakeholders enjoyed reasonably secure profits. Back then, bankers and brokers in London probably did reflect the stereotype of reserved English formality. New York, because equity markets had already had to adapt to the

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ending of fixed commissions, but perhaps also because of its raw, inyour-face capitalism, was an adrenaline-inducing shock. Although I’d moved to Godsell’s U.S. affiliate, Mabon, Nugent Godsell (later named Prebon), and in theory they were in the same business, Prebon’s culture was loud and frantic. A transaction that might be closed with quiet efficiency and subtle humor in London required noise and drama in New York. An American would regard the British way as too comfortably laid back and lacking the urgency to maximize potential profit. The counterview saw human energy consumed far in excess of what was necessary. Such contrasts have accompanied side-by-side relations as long as there’s been a New World to challenge the Old one. Prebon was run by the short, powerfully built Peter Saad from Brooklyn. Peter’s upper body resembled an inverted pyramid as a result of many hours in the gym, and he used his physically intimidating presence with a fierce temper to impose his authority on the room full of brokers. He sat at the head of a long desk with brokers on phones down both sides. Peter was an inspirational team leader, and by varying between cheering support and fierce outbursts, he drove people to work harder and generate more commissions. Peter didn’t just bark, either—just a few weeks into my move to New York I looked on, stunned, as he grabbed another broker by the throat and thrust him upwards against a wall to settle their argument. This must be the New York way, or maybe the U.S. way, I thought at the time, so fresh and few were my impressions of America. I came to learn that while the more frenetic style of business definitely was New York, in the financial markets at least it was generally a less physically dangerous place. Meanwhile, Prebon’s business was growing. The highly decentralized U.S. banking system of the time meant that there were literally thousands of potential clients for the firm to cover in its main business of brokering eurodollar deposits. Growth quickly outran the office’s capacity to house people, resulting quite literally in brokers sitting on windowsills with a phone by their side or sitting two individuals to a desk. The big picture was that falling interest rates, as investors slowly began to hope inflation was conquered, created demand for credit, and this met an increasing supply of liquidity looking to lock in today’s interest rates before they fell.

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The eurodollar market was a consequence of U.S. regulations capping the rates of interest banks could pay on deposits. Regulation Q had existed since 1933 and was originally intended to restrict the charging of usurious rates (“loan sharking”). It had long since outlived its usefulness, and as rates had steadily risen during the 1970s, it began to impede the functioning of the money markets within the United States. As market rates moved up through the regulatory ceiling, activity moved offshore and therefore outside the U.S. regulatory framework. A U.S. dollar deposit made by, say, a French bank with a British one in London was a eurodollar deposit, beyond the control of the Federal Reserve, and so, as is often the case, the market found a way around the regulations. It was part of the recycling of “petrodollars,” the vast profits that OPEC countries were earning on their oil exports to Western countries. Even in New York, U.S. banks would trade in the name of their Nassau branch, which allowed them to operate outside the regulations. Domestic interest rates followed offshore ones higher, since the rules allowed “onshore” banks to borrow “offshore” but imposed reserves on the transaction.The effect of this was to keep onshore rates slightly lower than offshore. Dealing rooms have long been pressure cookers given the sums of money involved and need for fast, assertive decisions. Pranks as well as locker room humor long prevailed until political correctness, backed up with new laws, finally forced change. One particularly irritating woman found that her expensive shoes had been filled with water and placed on the windowsill outside (in January), causing them to split. (She complained and was reimbursed.) Another broker who was exceptionally loud and excitable fell asleep following a long and mostly liquid client lunch, only to find that his fingernails had been painted red by one of the women while he slept. It was a boisterous place, and much of the scatological humor and demeaning wisecracks would be out of place in today’s far more politically correct world. Trading rooms long ago lost their locker room demeanor. Tommy Dougherty was a slow-talking Irish American with a quick sense of humor who knew how to deliver a joke. Joe Flounders was a serious, hardworking broker who patiently covered the accounts others rejected and managed to make money out of them. Tommy

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worked, but he had fun, too. Joe just worked, and his constantly serious expression inevitably drew Tommy’s attention and friendly taunts. One day Joe had heard enough of Tommy’s Irish gabbing at his expense. Joe hurled a rolled-up ball of paper that hit Tommy smartly on the nose, to Joe’s immense satisfaction. Tommy laughed with Joe, and in his languid way moved to position the electric fan on the desk so that it was blowing cool air in Joe’s direction. Joe looked quizzically at Tommy, unsure how to interpret this concern for his comfort on such a hot summer’s day. While still retaining Joe’s gaze with his smile, Tommy slowly picked up a book and swiftly brought it down on top of the fan. Whatever commercial cleaning service Prebon employed didn’t include in its remit wiping off the cooling equipment. Consequently, the fan had over many years accumulated enormous quantities of dust, a fact that had not escaped Tommy’s attention. Quickly freed by the impact of the book, huge gobs of it blew in Joe’s direction and he was instantly transformed into a figure left in someone’s attic for 10 years. The room erupted in laughter as once again Tommy’s Irish wit had bested Joe, in this case with the help of a prop. Joe quickly gave chase and Tommy disappeared, most likely out of the building and into a bar. Some years earlier, Joe and his wife Patricia had moved to Pennsylvania, where he believed the clean, mountain air of the Poconos would aid his wife’s recovery from cancer. I remember him proudly showing me a photo of this attractive woman many years earlier before they were married. Joe had seemed to share my surprise that he’d been able to draw someone so eye catching. He willingly made the two- to three-hour daily journey each way to work and back as a result. Joe was a journeyman. He toiled away covering the smaller accounts that probably received less attention. He generally had a serious look on his face. He was likeable in his quirky way, and it’s doubtful he made many enemies. Joe’s career later took him to Eurobrokers, a competitor firm based in the World Trade Center. He was killed in the terrorist attack on September 11, 2001. Many people from Eurobrokers escaped, since their offices were in the second tower

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to be hit and they were initially ordered to evacuate following the attack on the first tower. Shortly afterward, the evacuation order was canceled and people were told it was safe to return. Those who survived made their own assessment and continued out of the building to safety. Joe had stayed to help a friend who was panic-stricken and couldn’t move, although Joe would likely have followed instructions and returned when told it was safe. Joe and many others perished when the second plane hit. On December 9, 2001, less than three months later, and no doubt grief-stricken over her husband’s death, Patricia Flounders committed suicide (Associated Press, 2001).

EARLY DERIVATIVES GROWTH The 1980s witnessed the nascent beginnings of the interest rate swap market. Risk in banking had for centuries consisted of evaluating what was on the balance sheet. Loans carried credit risk and interest rate risk. Basic measures of the profitability of a bank included its net interest spread (the difference between the interest rate earned on its loans and its cost of financing them) and leverage. Banks had long existed as institutions that largely made money by lending, and most of what they lent was borrowed. Banks typically operate with more leverage than just about any other business, which is one reason why banks can fail so suddenly. Derivatives, of which interest rate swaps was one of the earliest examples, are “off-balance-sheet” instruments. Simply put, they allow anybody using them to take on the potential risk and return of an asset such as an investment in long-maturity Treasury bonds without having to actually own anything. I may believe that Treasury bond prices will rise, and if you believe differently we could make a derivatives trade that would result in your paying me if I’m right, and vice versa. At its most basic, a derivative trade is a bet. Some of the earliest examples of swaps made use of the economic concept of comparative advantage. In a stylized world of only two products, Country A may produce both hats and hammers for less than Country B, and yet both can benefit from trading with one

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another. Country A specializes in either hats or hammers, depending on where it has the greater comparative advantage over Country B. In this simple economic model, both countries will be better off than if they hadn’t traded. It is no less than the principle supporting the case for global free trade and capitalism. A blue-chip, highly rated corporation may be able to borrow more cheaply than a lesser known company in any chosen market, and yet the same economic concept of comparative advantage will show that both will benefit if the blue-chip company borrows where it has the greatest comparative advantage (i.e., relative interest savings in this case) and then they both swap the resulting interest flows. It’s a neat trick the first time you see it, and it represented the original basis for swaps between entities with quite different access to the credit markets. The first ever swap is commonly believed to have been done between the World Bank and IBM in 1981. The World Bank wanted to borrow in Swiss francs because of their low rates but enjoyed better access to the U.S. dollar bond market. IBM had already borrowed Swiss francs but wished to replace these obligations because of a view that the Swiss franc would appreciate in value. A bank helpfully arranged for them to swap their obligation with one another, to their mutual benefit. There was no financial discovery or regulatory change that led to the fairly sudden growth of over-the-counter (OTC) derivatives in the early 1980s. OTC derivatives are not traded on an exchange, like futures, and are bilateral contracts between two counterparties, usually banks or other financial institutions. Futures trading had existed for decades in Chicago, where the need of farmers to hedge the future price they’d receive for crops or livestock led to markets for corn and pork bellies. Financial futures on interest rates began trading in Chicago in the 1970s and experienced steady growth. It was the first trades in OTC interest rate derivatives that were done as early as 1981 that led to a symbiotic relationship between the exchangetraded and OTC markets.The arbitrage possibilities between the two, and the segmented markets that resulted in some users’ preferring the uniformity of exchange-traded instruments versus the customization possible with OTC led to sharp volume growth in both. In fact, it’s

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arguable that neither market would have grown as quickly without the opportunities created by the other. Securitization of home mortgages and other loans also expanded dramatically in the 1980s, but by contrast this was the result of government policy. The Government National Mortgage Association (GNMA or Ginnie Mae) and its privately owned cousin, the Federal National Mortgage Association (FNMA or Fannie Mae) started guaranteeing home mortgages in the 1970s. Ginnie Mae “pass-throughs” were interests in pools of mortgages, and banks commonly invested in them at that time. In 1983, Fannie Mae issued the first collateralized mortgage obligation, basically a pool of mortgages all carrying an FNMA guarantee, but still subject to investment risk through interest rate movements and prepayments (Cowen, 2003). Securitization eventually expanded to other asset classes such as auto loans, credit card receivables, and others, although the initial impetus was provided by government policy. By connecting the borrower through the securitization process with the lender, it removed the need for a bank to sit in between the two, other than for a short time while enough mortgages were being assembled into a new pool. This was an example of the disintermediation that so threatened banks in the 1980s, the usurping of their centuries-old role of deposit taker and lender. Without doubt, one objective was to enhance the ability of homebuyers to access financing and was part of a long-standing public policy objective to increase home ownership. In time, though, one significant unintended consequence was a steady increase in household and ultimately government indebtedness. So one government policy of promoting home ownership led to the development of securitization. Indirectly, this caused an increase in financial services’ share of employment and output relative to the rest of the economy. These twin changes coincided with rising asset markets, the development of computers, and a fairly light regulatory philosophy, creating an environment in which financial innovation could flourish. Because it was driven by specific public policy objectives, there was little sense of the new forces that had been unleashed and very little, if any, desire to measure whether they were positive forces likely to promote higher overall economic output. Bankers used to attribute financial innovation (such as credit derivatives) to reducing

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the business cycle through more efficient distribution of risks. Alan Greenspan, in comments he no doubt came to subsequently regret, highlighted the growth in derivatives as evidence of their benefit (Greenspan, 2005). Following the financial crisis of 2007–2008 and the need for enormous federal intervention to avoid an economic collapse, there’s now broad consensus that such confidence was misplaced. The ability to profit from a move in interest rates without having to own a bond gained appeal in the 1980s as pressure on banks to control their balance sheets increased. Back then, the biggest banks were Japanese, and though it’s hard to believe nowadays, the two “lost decades” of no economic growth were still ahead of Japan.The country was regarded as an economic powerhouse, and its banks were among the most active traders as the interest rate swaps market began to grow. As if reflecting the stereotypical desire for consensus that is part of Japanese culture, all the Japanese banks seemed to hold similar views on interest rates. Running with the trend, they would invariably use interest rate swaps to position for falling rates. The eurodollar futures market was in its early stages of development as well, providing instruments that allowed anyone to hedge their exposure to short-term interest rates. However, accounting standards for banks were inadequate to properly measure interest rate swaps. Since they didn’t have to be “marked to market,” the Japanese banks loved them because they could take quite substantial risks without having to report daily swings in valuation. Accounting arbitrage is not a recent phenomenon. For most of the 1980s the yield curve was positive, meaning that long maturities had higher yields than shorter maturities. For example, 10-year U.S. government bonds consistently offered higher yields than 2-year bonds. A positive yield curve is the classic profit opportunity for banks, which generally “lend long and borrow short.” Earning a positive spread between the assets that you hold and the cost of financing them has been a reliable source of profits for banks for centuries. Even so, for much of the 1980s interest rates were falling, and so the “lend long and borrow short” strategy was generating additional profits through capital gains on long-term bonds as rates fell. This strategy worked with government bonds or corporate bonds. However, it also worked with interest rate swaps whose

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yields typically tracked those for investment-grade corporate bonds. Even better, they were off balance sheet and so required far less capital than holding bonds, yet could still allow banks to profit from the positive yield curve and increase their generation of net interest income (NII), a metric closely watched by sell-side equity analysts. Derivatives grew alongside the rediscovered animal spirits that were ignited by the twin bull markets in stocks and bonds. Interest rate swaps had other perfectly legitimate uses. Companies might issue long-term debt to ensure sufficient liquidity but then use a swap to alter their exposure to interest rates. They might desire the certainty that issuing five-year debt brings their balance sheet, yet not want to lock in a five-year fixed interest rate. Swaps allowed borrowers to separate a liquidity decision from an interest rate one. Properly used, derivatives provide important financial flexibility. Unfortunately, derivatives were later abused and accordingly maligned, most notably by none other than Warren Buffett as “financial weapons of mass destruction” in Berkshire Hathaway’s 2002 annual report.The growth in derivatives trading coincided with a more significant increase in the overall asset management industry. Some large forces were at work. There were increasing signs that inflation, the scourge of investors throughout the 1970s, had finally been conquered under Fed chairman Paul Volcker. In addition, the election of President Reagan, an actor and former governor of California, ushered in a new era of increasing American confidence, a reborn belief in the power of free-market capitalism, and an equity rally that would last more than a generation duly began. Optimism fueled by the sunny Californians, and no doubt helped by increasing federal budget deficits, provided the fuel that drove asset prices higher. During the 1980s the finance sector steadily grew from 4.9 percent of gross domestic product (GDP) to 6.0 percent.Within finance, the securities industry jumped sharply from 0.4 percent to 1.0 percent of the U.S. economy. Relative to the size of U.S. output, “Wall Street,” which broadly incorporates asset management and securities trading, increased by 150 percent (Greenwood and Scharfstein, 2012). The twin bull markets in equities and bonds fed increasing demand for active management, higher returns on capital, and risktaking in general. It was not an objective of public policy for finance

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to increase its role in the economy, although few commentators were concerned, since it went in tandem with rising optimism and markets. The 1987 stock market crash was only a brief interruption to the continued growth of Wall Street and The City.

SWAPS TAKE OFF Prebon’s newly formed department to trade interest rate swaps was a sleepy backwater. The main dealing room contained several dozen brokers, and the mornings (when trading overlapped with London’s afternoon) were especially frantic with yelling and screaming to close trades, frequent arguments over missed opportunities and invariably trade errors (known in industry parlance as “getting stuffed”) when a bid hit on behalf of a client turned out not to be there. At the time, I spent my mornings juggling two phones as I connected the prices in our New York office with brokerage firms in London. Most of the orders generated by our brokers in New York were to be “shown” to London (the most aggressive orders were executed immediately in New York and never made it across). That meant orders from New York banks were shouted down the phone to a broker in London, who would broadcast them to his colleagues while similarly communicating orders from London banks back to us. For several hours every day, from 7 a.m. until about noon, I was juggling dozens of prices from banks across North America and Europe, as they traded eurodollar deposits during the early stages of the great bull market in bonds. The New York–London “link” represented the narrow causeway that connected two active pools of liquidity into one giant market. Every transatlantic trade we did went through the link, and managing the flow of trades in both directions was high pressure, exhilarating, an absolute adrenaline rush. Sometimes, closing two or three trades within a few seconds required rapid thinking—a nod to one broker, a shaken finger to another, while yelling “done” down the phone, all while others gave rapt attention to the jargon-laced dialogue looking for a good trading opportunity. It was just heady stuff, exhilarating to have to multitask by closing several trades rapidly under pressure. It was fun—it hardly felt like work at all.

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The job no longer exists nowadays as so much trading is done electronically. When the phone was the most complex piece of technology used in finance, market-moving events typically provoked a burst of yelled prices, orders, and trades. One day many years later, when I was managing a trading room, I realized that market-moving events now turned all the brokers and traders silent. They dropped whatever casual conversations were taking place and turned to technology, to the Internet and instant messaging. All of a sudden it seemed frantic markets were silent markets except for the rapid clicking of keyboards. Moving from handling the New York–London “link” to the new interest rate swaps desk meant leaving the center of vibrant activity to join a handful of brokers who usually spent several days negotiating one transaction. I must confess I needed some persuading at the time—the enormous potential of this new market was more readily apparent to others than to me. Ira Sobel, who ran this new group and persuaded me to join, solemnly advised me in his thick Brooklyn accent that there would be “a lot of money” to be made. Ira’s optimism was well placed, and the market for derivatives began its dizzying growth. As more banks began to use swaps, there were many opportunities to explain how the instruments worked and therefore create a new client. It was still a long way from being the frantic market of later years when it would eclipse and easily surpass the eurodollar deposit market as a source of activity. Even so, new users appeared at a steady clip and volumes grew rapidly. Finance was growing through innovation, and I was one insignificant participant making a career choice framed by the larger forces at work. One of my biggest clients was Manufacturers Hanover Trust, or “Manny Hanny” as it was affectionately known. Manny Hanny was one of several large U.S. banks that would ultimately become part of JPMorgan Chase, following a series of mergers and acquisitions during the 1980s and 1990s. In most swap trades at that time, one side of the trade was typically executing an arbitrage (meaning they were hedging their risk so as to make a guaranteed profit) while the other was using the swap to create the risk exposure they desired. It was a contrast in approaches to financial markets.

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The arbitrageur was using math to put on winning trades whenever they were available. He didn’t care which way the market was going, and in fact often had no view. He was simply measuring the gap between the prices of swaps and futures, waiting for a brief opening when he could pounce and lock in a gain. Meanwhile, the speculator was relying less on math and more on his opinion of where the market was likely to go. He might be giving up what he regarded as a small advantage by using swaps instead of futures to take a position. His expectation was for a far larger gain than the small profit he was giving up to the arbitrageur, which was no more than a modest transaction cost in his view. In many cases the two types of trader went up against one another. My friend and client Larry Hirshik was the swaps trader at Manny Hanny. Larry was the new breed of trader, with a math degree from UCLA and harnessing computing power to give him an edge. Larry was an arbitrageur, indifferent to market direction and using math to move the odds relentlessly in his favor. In the other corner was Jacques Dejoux, an old-style imperious Frenchman with a fierce temper trading at Marine Midland (a U.S. bank later acquired by the British firm HSBC). Dejoux regarded the arbitrageurs with complete disdain and loved nothing more than to time his trades so that the bank taking the other side was left scrambling to hedge the trade at the worst possible moment. Knowing an arbitrageur had failed to lock in his profit after trading with Marine Midland brought Dejoux almost as much pleasure as if his own trade made money. I watched one morning as Marine Midland timed one trade with Kidder Peabody (another arbitrageur) exquisitely—the market moved just as the swap was closed, and Kidder’s trader scrambled to buy his futures hedge at far worse prices than expected. Later that day, Dejoux had already made a profit on his trade and he closed it out. Once again, Kidder Peabody was on the other side and poor timing resulted in another arbitrage loss. Dejoux, not one to pass up an opportunity to embarrass a competitor, announced that he was too busy to write up the details of two offsetting transactions done on the same day with the same counterparty with a locked-in gain. He suggested that the hapless trader at Kidder dispense with

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the formalities of documenting the two transactions and simply wire the profit from the matched trades directly to the bank. Kidder was notably less active in swaps after that. While most brokers were intimidated by Dejoux, Charlie Westbury gave as good as he got in his London Cockney accent. He’d send Dejoux a card on July 14 (Bastille Day, the day France celebrates its independence). Charlie once asked the proud Frenchman if he knew why the boulevards of Paris were lined with trees (answer: so the German soldiers can march in the shade). Most brokers were terrified of Dejoux and of losing his business and the substantial commissions he paid every month, but the absence of subservience in Charlie’s manner must have somehow endeared him. So one day, Dejoux, the trader who relied on feel and judgment, came up against my friend Larry, the math whiz with the computer. On a quiet afternoon, Dejoux orchestrated the traders working for him at Marine Midland to each select one broking firm and ensure they had Manny Hanny’s firm bid from Larry, “online” (meaning it was just reaffirmed and therefore guaranteed to be there). Unknown to any of us, in his own trading room Dejoux dropped his arm like the starter at a Formula One race indicating to each of his traders to say, “Yours!” down the phone. A split second later, five brokers all simultaneously went to hit Larry’s bid. “He’s coming at me everywhere,” Larry breathlessly informed me as he scrambled to respond to the sudden influx of trades and at the same time buy futures in far greater volume than anticipated. Dejoux sat back in satisfaction as the instinctive trader sought to get one over on the arbitrageur. As often happened, both sides made money. Larry locked in his arbitrage profit with futures, and interest rates fell, which made Marine Midland’s side profitable, too. It’s not always a zero-sum game. Although it had been a fraught few minutes, once everybody’s nerves were calmer we shared a laugh. However, time was on Larry’s side, and inevitably the use of math and information technology (IT) was going to drive out those who didn’t possess the tools. Traders like Larry were the casino to punters like Dejoux. Eventually, the Frenchman’s hand went cold and losses led to much less activity before he drifted quietly away. Larry meanwhile

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represented the future, and his career as a swaps trader continued for a great many more successful years.

SIZE ISN’T EVERYTHING Interest rate swaps grew at an enormous pace. At a fundamental level, derivatives allow for the disaggregation of risk from the asset that creates it.You can bet on interest rates falling without having to hold bonds.You can profit from rising stock prices without owning stocks. The separation of the outcomes from the asset made possible previously unimaginable portfolios. Treasury bills can be combined with stock index futures to create a fully invested portfolio of equities. A Japanese bond can be combined with a U.S. dollar/yen foreign exchange (FX) trade to create a U.S. dollar–denominated Japanese government bond, a security that doesn’t normally exist. The versatility of derivatives allowed financial engineers to let their imaginations run wild. Properly used, there’s little doubt that derivatives allow more efficient funding and investment decisions among responsible participants, even though their ease of execution and the rapid complexity that results from a portfolio of just a few trades has also caused many problems. Increasing regulatory pressure caused banks in particular to be more cautious users of their capital. Assets held on a balance sheet required equity capital to support them, and as a result moving activities off a bank’s balance sheet became ever more important. Derivatives were a vital tool that quickly became a new source of market-making profits to the biggest banks. By the end of 1991, the total of swaps outstanding had reached $1.5 trillion, from a negligible figure a decade earlier (Simmons, 1993). U.S. dollar transactions were just over 50 percent of the total, so $3 trillion had been done globally. Only four years earlier, in 1987, the International Swaps Dealers Association (ISDA), an industry body, had counted $682 billion, so the market had quadrupled in four years. As big as this figure seems, by 2010 outstanding notional had reached $467 trillion (ISDA, 2010). The numbers almost defy analysis. And yet, while their size tells you a lot has been going on,

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a number that’s almost half a quadrillion doesn’t mean the financial system has been as reckless as some might think. Measuring the “notional principal” or face value of all the trades creates a grossly misleading impression. It bears little relationship to the underlying risk of the transaction. It makes no adjustment for the maturity, so a 30-year swap counts for the same as a 1-year swap, whereas the former is roughly 15 times as risky. Notional outstanding is a very crude and really not very useful figure. Since there are two counterparties to a swap, adding up everybody’s notional exposure double counts what’s outstanding. It’s just the most easily measured number. Figuring out how much actual risk to derivatives exists has always been challenging for regulators. Statistical measures of potential exposure based on value at risk are used, and taking the unrealized profit and loss is another measure. Moreover, derivatives may be risk reducing if they offset some other, on- or off-balance-sheet risk, and so account needs to be taken of that as well. This is why in recent years the banks with the largest trading portfolios have started publishing high-level measures of risk combining on-balance-sheet and off-balance-sheet items. The stress tests that the Federal Reserve began implementing following 2008 have also helped to rebuild investor confidence in their ability to evaluate large banks with their opaque balance sheets. Whether or not derivatives are too big, what is clear is that they have facilitated decades of growth in the financial sector. They’ve aided securitization and leverage by allowing for more precise and cheaper hedging of risks. Hedging, which reduces uncertainty, is an appealing objective. It enhances the appeal of long-term investments by narrowing the range of potential outcomes, and in theory should lead to increased productivity with greater economic output. Yet it can also lead to increased financial leverage, if banks and other participants interpret the lower risk profile that hedging allows as an opportunity to build risk back up to its previous level. It’s a complicated topic and extremely hard to measure in detail. However, one can compare growth in financial services with growth in the rest of the economy. If finance exists ultimately to serve the output of goods and services by everybody else, then it seems reasonable to ask if more finance has led to more output by everybody

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else. Broadly, per-capita real GDP growth has been trending down for 50 years. There have been exceptions to this—in the late 1980s, the five-year average reached 3 percent, which is growth at a pretty good clip. However, it proved unsustainable and before long had drifted down to the 1 to 2 percent range that characterized most of the subsequent two decades.

DERIVATIVES REACH OMAHA In 1988 three traders that worked for me left to join Gen Re Securities, a new subsidiary of General Reinsurance that was created specifically to trade interest rate swaps. Because Gen Re had a triple-A credit rating, it was believed this would give it an important competitive advantage. Derivatives transactions usually involve credit risk for both sides in a deal. If your side of the transaction turns out to be profitable, you want your counterparty to remain solvent so he can continue to make the payments you’ve agreed to. In the case of long maturity transactions of 10 years or more, only the highest-rated counterparties were able to do trades. Gen Re was planning to trade very long-dated swaps, up to 30 years or more, where their credit rating would provide them the biggest advantage. It represented another way for the company to make money from its strong credit rating. The new Gen Re duly went about its task of developing a name for itself in long-dated swaps. Ten years later, in 1998, Berkshire Hathaway acquired the company including its derivatives portfolio. Warren Buffett famously referred to derivatives as “weapons of mass destruction” (as mentioned earlier), following the lengthy and expensive process to unwind the portfolio. At the time it struck me as buyer’s remorse. The normal due diligence that Berkshire or any other acquirer would carry out should have revealed the size of the portfolio and the longer-than-average maturity of the trades. Because derivatives are private transactions between two counterparties, there’s no actual security that you can sell if you want out. Whereas a portfolio of equities can be sold at a price, or even written off in the case of private equities with no known value, at its extreme, if your counterparty doesn’t want to let you out of a deal, it can be mighty

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difficult to force him. Normally, a transaction can be unwound in exchange for a mutually agreed upon up-front payment representing the value of the future payments. Or it can be assigned to a willing third party. It’s quite likely that a counterparty in a 40-year transaction with Gen Re may not be willing to substitute an alternative credit. In fact, Berkshire’s acquisition of Gen Re probably made counterparties less willing to unwind a very long-dated transaction with such a highly rated credit. It took several years, far more time and expense than Buffett had expected, to unwind the portfolio. His comments on the experience from annual reports of that time show his growing disdain for derivatives. In 1998 he described Gen Re as “first class in every way.” It wasn’t until his 2002 letter that he began discussing the derivatives portfolio that had been inherited. Berkshire had originally planned to sell the derivatives subsidiary that came with the acquisition but evidently couldn’t find a buyer. Gen Re’s underwriting results had been poor since the acquisition, and Buffett had commented on those regularly. In addition, he found the disposition of the derivatives portfolio within Gen Re Securities to be far harder and more expensive than he anticipated. Buffett was moved to write at some length about the problems of valuation and difficulties in exiting the business. In 2003 he further lamented their failure to quickly close the business down in 1998. It wasn’t until 2005 that Buffett could claim that the remaining portfolio, after four years of liquidation, which had begun in January 2002, had remaining risks that were immaterial. The point here is not to criticize Warren Buffett, whose investment performance and clear investor communication rank up there alongside the best in history. It is to show that if a highly sophisticated investor can make a misstep when traveling through the derivatives minefield, then it’s obviously not an easy neighborhood to pass through. Although Buffett’s comments about derivatives seemed more the result of unusually poor due diligence on Berkshire’s part rather than anything more fundamental, his warnings about the product turned out to be ultimately well founded. In 2008 AIG, another large insurance company, required a federal government rescue because of

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its excessively large portfolio of derivatives linked to credit default swaps, a form of credit derivative.

NORWEGIAN WOOD In 1985 I moved from being a derivatives broker to a trader when I joined my biggest client, Manny Hanny. My friend Larry Hirshik had left for a trading job in California, and, given my familiarity with their trading approach, they hired me. Because they were my former client, one of the first items of interest to me was to see how much business they’d been doing in total. Any broker retains at least a mild paranoia that he’s missing a substantial share of his client’s business. Although we’d traded a lot together, I was staggered to find that large volumes of activity had been going on with a Norwegian bank in New York, Den Norske Credit (DNC). It turned out that a trader there named Jutta Kaiser was one of the more active in the market, although for some reason she traded exclusively through a competing broker called Noonan. When I’d worked at Prebon, we had no knowledge of her activity. Channeling her business through one broker had helped maintain a low profile, although it’s not clear why such relative anonymity was in her interests. However, the trades Jutta Kaiser at DNC did with Manny Hanny were reliably profitable—for us! In fact, as I learned more, it became clear that she was committing a fairly basic math error on her trades. I watched one day as DNC came into the market. She executed a simple one-year swap with Manny Hanny. The trader on our side didn’t immediately hedge out the risk with futures, as was our custom, but waited because he knew she’d make another move. And sure enough, within a few minutes DNC came back into the market with a series of forward rate agreements (FRAs). FRAs are like the components of derivatives. Assemble them together correctly and you can make an interest rate swap. The FRAs that DNC wanted to trade were the precise components of the swap we’d just done with her. The effect of trading FRAs with her was to cancel out the risk of the swap, for both of us. She was, executing the swap transaction with us and then hedging it with a series of FRAs, also with us. The

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combination of swap and FRA trades resulted in a locked-in gain for us, and a corresponding locked-in loss for DNC. This was the quintessential zero-sum game. Between Manny Hanny and DNC, there was no money made. However, because of a simple error in calculating compound interest, DNC was locking in a guaranteed loss on the whole set of transactions. Her loss was our gain, and there was no risk involved, either. Over a period of months, she did dozens of trades like this, with many other banks in the market. As the derivatives market developed, traders often made minor pricing or even conceptual errors while people were learning (obviously, the hard way) about mistakes and refining their approach. Nevertheless, Jutta Kaiser must have assumed she was taking advantage of most of the banks with whom she traded. DNC’s accounting system was flawed and presumably Jutta Kaiser was as unaware as anybody else there. Even so, most people would stop and consider after a couple of trades, why are Manny Hanny and other banks letting me arbitrage them in the market? Jutta evidently suspended disbelief far too easily—we had the math right, and an American bank trading its home currency in New York probably had more resources in terms of smart people and relevant experience to deploy than a branch of a Scandinavian bank 4,000 miles from home trading a foreign currency. As Warren Buffett has famously said, if in a game of poker you don’t know who the patsy is, you’re the patsy. Happily for DNC, although sadly for our profitability, before too long the math error became apparent to them, probably when trades began maturing and they found themselves with less cash than their flawed accounting system had expected. Jutta Kaiser slid out of sight and DNC stopped trading swaps. Although securitization and the activities of Ginnie Mae and Fannie Mae might have been expected to increase home ownership in the United States, the percentage of households owning their home initially dropped in response to these public policy initiatives in the early 1980s. No doubt due to the recessions of 1980 and 1981– 1982, home ownership dropped from 66.0 percent in the fall of 1978 to 63.5 percent at the end of 1985. While this doesn’t seem substantial, the rate had stayed between 64.0 percent and 65.0 percent from 1969 until 1978. Consumer credit had also remained in a stable range

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at 12 to 14 percent of GDP following the run-up after World War II. After 1980 an overall trend toward greater indebtedness fluctuating with economic cycles emerged. Finance also increased its share of GDP, most notably in securitization, which doubled its relative size. Falling inflation, rising asset markets, securitization, and the development of derivatives as an important risk management tool all combined to increase the size of financial services.The steady growth in banking, leverage, and trading had only just begun their long march toward an increasingly pivotal role in the lives of consumers everywhere. However, increasingly sophisticated financial markets didn’t always lead to lower transaction costs for retail investors.

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CHAPTER 4

BOND MARKET INEFFICIENCIES FOR RETAIL A Simple Market Model

Financial firms rely enormously on information asymmetry to make money. Simply put, knowing more than their clients about the prices of securities and derivatives is a crucial part of the business model. Moreover, perpetuating this advantage in information is in the interests of those who control it, and in a type of game theory there is limited advantage for those who would seek to undercut pricing and provide more competition. It’s best described with a model. The diagram in Figure 4.1 shows a simple form of a market. There are three types of participant: banks, brokers (labeled “IDB” for interdealer broker), and clients. The banks represent the liquidity pool, where much of the trading gets done. Think of them as the wholesalers. They are connected to one another by the broker (typically, there’s more than one broker, but I’ve limited it to one for simplicity) who deals exclusively with the banks. The clients (shown as circles surrounding the banks) are the end users whose activity is sporadic and is driven by the need to do transactions when it suits their underlying business. Banks seek to make money by trading 73

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Bank

Bank

IDB

Bank

FIGURE 4.1

Bank

Market Structure for a Non-Exchange-Traded Market Such as Bonds

profitably with one another and their clients.The broker makes a commission when executing trades between two banks. Clients don’t seek to make money from transactions. They instead focus on manufacturing widgets. Clients are end users, doing transactions intermittently. In this model, the banks are making more money than is necessary to cover their expenses, including managing the risks of their transactions. And yet the model is stable with little risk of competition driving down profit margins. Although economic theory would expect pressure on profits until the next transaction is barely profitable (i.e., Marginal Revenue = Marginal Cost), in practice it never happens. The reason the model is stable is that only the banks can disrupt it, and if one bank accepts lower profitability, it will ultimately fail to gain market share, since the other banks will quickly follow suit. It is an informal cartel, not one governed by a formal agreement, but nonetheless one that can perpetuate because of the rational selfinterest of the only agent able to alter the structure. The diagram illustrates the market structure with lines representing the channels along which transactions are done. Because banks do more volume, they have better information about where the “inside” price is. Think of this as the wholesale price, the level at which very

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informed players will trade. Because volume provides information, banks benefit from trading volume by knowing at any point in time where the best offer and best bid are to be found. Crucially, the banks trade through the broker, but the clients do not. Why not? Because the banks will only do trades through the broker as long as it’s with another bank. Requiring the clients to access the liquidity of the wholesale market only through the banks is in the interest of all the banks. There are other reasons, too: clients by definition don’t trade that often, so may be more expensive to trade with; trade settlement might be more complex; and credit lines may not be set up, so they’re not well suited to trade wholesale, or interbank as it’s called. So the result is an insider’s market where banks trade with one another on very tight margins. Think of it as a wholesale market— and a retail market where clients trade with banks on prices that reflect the wholesale market but have an additional profit margin built in. The question is: Why is this model stable? If the banks are making an “excess” profit (i.e., more than is strictly necessary in order to cover all of their costs), why don’t new participants enter the market and drive pricing down, as economic theory would predict? The reason is that additional entrants require the cooperation of the banks, and the status quo suits their purposes. A new entrant to the market would need to be able to trade with the other banks through the broker in order to access the price information and liquidity that these wholesalers enjoy. Because this market model doesn’t rely on a central exchange, there is no public dissemination of prices. Most of the transactions that take place are between two banks, in effect private deals. Depending on the regulatory framework, they may need to report the transaction so that it can be disclosed publicly, although in many cases they do not. Traders at the banks know where wholesale prices are because they are constantly on the phone with the broker and are executing trades. The price information exists verbally but is not necessarily captured on a computer screen for wider publication. If a client decided it wanted to become a bank, it would need to start trading with other banks through the broker. Even so, the broker will typically not do business with this new client seeking to access wholesale pricing and trade with the other banks. Whereas the banks will all have trading and settlement arrangements in place among themselves,

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the same streamlined process may not exist between the client and all the banks, meaning that the broker may only be able to match up the client with some of the other banks on any one trade. It makes rapid execution more difficult. In addition, the banks would not be happy to see a client (or a former client) now seeking to trade with them through the broker on wholesale pricing.They may refuse to trade with the client through a broker, or even divert business away from the broker as a punishment for in effect undercutting their business model. None of this is necessarily illegal. The banks have not colluded to prevent new entrants to the market (which is illegal). However, they can all tell another bank from a client, and they recognize that their individual and collective self-interest is served by preserving the status quo. The model ensures very different access to price information for the banks compared with the clients. Since the clients execute few trades and are numerous, to obtain pricing they have to call one bank after another individually to obtain a quote for a potential transaction. As well as being time consuming, in many cases such prices are firm only while the client is on the phone with the bank. Hanging up to call a second bank risks the market’s moving and makes comparison more difficult. The solution is for the role of the broker to be fulfilled by an exchange, which nowadays is increasingly an electronic exchange. If a computer plays that central role and all transactions are executed electronically, settled and cleared through a central clearinghouse, prices can be displayed publicly and the information advantage that the banks hold over their clients dissipates. Transaction costs for the clients, who are ultimately the end users, go down. Excess profits for the banks fall. The market is more efficient. Now let’s take this theoretical model and compare it with the real world to see where clients operate at a substantial information disadvantage.

STOCKS ARE FAIRER THAN BONDS In U.S. equities, trades are generally reported within seconds from whichever exchange they occur. In addition, price information is

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broadly available, either free with a modest 15-minute delay or real time for a fee. The extremely broad price dissemination, automation, and competition have all brought the cost of transacting in equities down to virtually inconsequential levels. Online brokerage at $8.95 per trade and lower is freely available. Bid and ask prices are displayed, and the cost of buying stocks expressed as a percentage of the market value or of the expected return is extremely low. The emergence of so many day traders is further witness to the easy access to liquidity that investors enjoy in U.S. equities. There are numerous studies that show short-term traders and day traders in particular on average lose money. Trading stocks for the retail investor is little more than gambling and not to be confused with investing. However, the fact that so many do at least illustrates how cheap it is to buy and sell equities. From the perspective of access to the markets and the cost for investors of doing trades, U.S. stocks are one of the best deals around.True competition and, equally important, broadly disseminated prices have made that happen. Other markets without a central exchange put clients at a distinct disadvantage, though. Take the market for over-the-counter (OTC) derivatives, a market in which I traded for almost two decades. Interest rate swaps have long existed as private transactions between two counterparties. Most of the volume is done by banks, although there is significant business executed by hedge funds, corporations, pension funds, and others who would all fall into the category of client. Smaller, less active banks are also to some degree in the role of clients, in that they don’t receive quite the same quality of coverage from the brokers (if they trade with the brokers at all). The representation of a market shown above reflects the OTC derivatives business very well. Banks trade swaps over the phone. Although computers are heavily used to calculate prices and identify opportunities, the actual mechanics of trading have changed very little since swaps first took off in the 1980s. The technology certainly exists for screen-based trading, and once trades happen online, it’s only a small step for those prices to be disseminated to everybody. However, it hasn’t happened. And that’s not because the technology doesn’t exist, but because none of the people necessary to make it happen see it in their interest to facilitate it. To see why, you have

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to understand the motivations of the participants. Let’s take the banks in our previous example. They enjoy an informational advantage. Because they transact with one another in high volume on a regular basis, their traders are familiar with the most recent pricing of all the different structures and maturities they trade. Take a five-year interest rate swap as an example. Through reports from the broker and from constantly quoting prices, the banks know that the current swaps price is 1.25 percent bid, offered at 1.26 percent, and that a trade last took place on the bid side at 1.25 percent. The market would be quoted “2526, last at 25.” Suppose you’re a client, reliant on the banks to access this liquidity, and you’re a “fixed rate payer,” which is to say you’ll be looking for an offer (because swaps are quoted in yield terms). You call a bank asking for an offer.The trader has no current position in that maturity, and so he quotes 1.27, since if you trade with him he anticipates covering the position back in the interbank market at 1.26 percent. In fact, he may start by bidding 1.25 percent to cover since the market last traded at 1.25 percent and the seller may have more to sell. You, the client, can call a second bank. You may obtain a better price, although by hanging up on the first bank you’ll take the risk that the market will move and the best available offer to you will then be 1.28 percent. Checking around for competitive quotes is not “free” because you can’t normally expect the price to remain firm once you hang up the phone. This is a very inefficient way for the client to access liquidity for this type of transaction. In fact, booking a table at a restaurant is now more efficient than executing a swap. Since OpenTable.com offered a free service (free to the diner, that is) whereby you can go on their web site and view seating availability for restaurants at the click of a button, it’s no longer necessary to make an individual phone call to each restaurant while you try to find a table at the time you want. Booking a table for dinner requires a simple piece of information (availability) from multiple sources (restaurants).The technology exists to solve that problem, and, as with many ideas using the Internet, the more users (restaurants) are on the system, the more valuable it is. This is called network effects, and it’s analogous to liquidity in a market

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because it’s often hard to be the second-best provider of such a service. eBay, Facebook, and OpenTable all derive their market strength from being dominant, which means a new user is more likely to find useful connections for whatever it is they’re trying to achieve on the dominant platform. The providers of prices in our market model are banks. Whether it’s eBay, Expedia, or OpenTable, information technology (IT) promotes the dissemination of enormous amounts of price data to everybody, and the ease with which consumers can access it assures highly competitive pricing.

WHY CHANGE IS SLOW Banks control the price information. Since there is no exchange, the information from quotes and trades belongs to the banks, and perhaps the broker. The banks clearly have no interest in seeing price information published freely, so they don’t do it. They don’t even have to work that hard to prevent their prices from being published; they can simply not build the communication lines and software necessary to capture and disseminate it to the outside world.Why should they? There’s no gain in it for them. The broker could theoretically take the price information he has and sell it to a data provider so it’s freely available. In fact, the broker has the most accurate information because he sees every quote and does every trade among the banks in this wholesale market. So why doesn’t the broker do that? Because his clients are the banks and they don’t want him to. Could he do it anyway? If he was the only broker in the market, perhaps he could. Under those circumstances, he might feel he could ignore the interests of his clients and increase his revenue by selling price information to the ultimate clients, who sit outside the wholesale market. In practice, he probably won’t. In most markets there is more than one broker. If one decides to sell the price data, the banks may retaliate by shifting their business to the other broker, and the foregone commissions to the broker will be well in excess of any revenue earned from selling price information. In some cases brokers do sell price data, although typically mid-market pricing

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and sometimes with a delay. It’s not enough detail to meaningfully help an end-user client negotiate better terms on a transaction. In fact, one consequence of the trading profits earned by the banks is that commission rates are higher than they need to be as well.There’s no explicit deal, and when I was trading we were perennially renegotiating commission rates down. However, in my experience, commissions are related to the bid/ask spread in a market. The bid/ask is a proxy for the market-making profit that banks can earn. My rule of thumb was that the basic commission rate shouldn’t be more than one fifth of the bid/ask spread. There’s nothing magic about that number—it just seemed to be where things worked. As bid/ask spreads became narrower, we’d drive down commission rates, but volumes invariably increased, so total commission expense rarely came down and more often than not rose from one year to the next. A less efficient market results in wider bid/ask spreads than would otherwise be the case and consequently less pressure on commission rates than would otherwise be the case. None of this requires any formal understanding or agreement between the participants. There’s nothing illegal or even immoral going on as far as I can see; it’s simply a case of all the participants in the model making decisions that are in their own best interests. It is capitalism. In spite of all the improvements in technology and liquidity, by some measure financial markets are no more productive (measured as the cost of intermediation between those who need capital and those who would provide it) than in the 1920s (Philippon, 2011). This market model description applies to many markets. Stocks used to operate that way but the abolition of fixed commissions in the 1970s, along with a continued regulatory focus on greater transparency and competition, have led to a steady drop in the cost to trade equities. I think it is a regulatory success. I imagine that many people feel there is a great deal wrong with equity markets today. They read about insider trading, about initial public offering (IPO) disasters, high-frequency trading, and the flash crash, and they conclude that things are very wrong. I understand, and all of those are valid concerns. No doubt, things could be better. Having said that, the U.S. equity market is probably the most open in the world. Investors and traders have access to the market at an incredibly low cost. Commissions are low and there’s lots of liquidity. Broadly speaking, regulatory efforts

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have been successful in promoting the interests of the investor even at the cost of the vested interests such as specialists. Few other markets afford this kind of easy access to their clients. The model I’ve described here is based on interest rate swaps. It no longer applies to stocks. It used to apply to foreign exchange (FX), but the enormous depth of that market, relatively simple credit risk (transactions settle within two business days), and technology eventually led to screen-based trading replacing voice brokers for major currency pairs. Once transactions are screen based, it’s often only a short step to open up the information to all users. Equity markets generally make it hard for banks to profit as an intermediary, other than during an Initial Public Offering. When there’s an exchange and broad price dissemination, it’s difficult to add much on to the price when you’re selling stock to a client. Many other markets, including OTC derivatives, bonds, less liquid currency pairs, and parts of the commodities markets, all operate without a central exchange. To be sure, the biggest of these, such as sovereign debt in fixed income or FX, are highly liquid and prices are disseminated electronically. Nevertheless, the other markets are not. Because they have common market structures in which banks operate as market makers, they are sometimes grouped together. For example, Goldman Sachs used to have a Fixed Income, Currencies, and Commodities Division (FICC). However, 2009 was the last year for which they broke out their results in this way. The unwelcome political attention following the 2007–2008 crisis must have motivated them to present their results in a way that deflected the focus from their ability to trade so successfully. Fixed income markets, including for interest rate swaps, credit derivatives, and most bonds, have been slow to provide the same kind of transparency to clients that stocks and FX do. Even the development of Internet technology had only a limited impact.

STRUCTURED NOTES This also applies to structured notes—customized securities that are generally sold to high-net-worth investors by private banks. Their

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success partly relies on a finding from behavioral finance that holds that market participants are generally overconfident about their forecasts (Gervais, 2009). Individuals tend to be overconfident in their forecasts of many things, from the number of jelly beans in a jar to the direction of the market. Many studies have been done to show that the confidence interval people place around their forecasts is too narrow. It’s not human nature to acknowledge how uncertain the future is. Diversification and size limits on a portfolio are not for wimps, they’re an expression of humility. Structured note buyers are not overly burdened with self-doubt. They are highly confident about their outlook. They know how many jelly beans are in the jar. They need to be right in their market forecasts because the instruments they buy impose substantial hidden fees that stand between them and a profitable outcome. Exchange-traded options are the raw material that allows bankers to conjure up all kinds of seductive payoffs. Reduced to their simplest form, most structured notes are simply a bond issued by a bank with an option attached. The interest rate is lower than it would be on a normal bond of that maturity, and so the bank takes some of this “saving” in the form of reduced interest expense and uses it to buy, say, a call option on the S&P 500. The resulting combination might be a bond that pays a low interest rate of, say, 2 percent when rates are 3 percent but gives the investor an “upside participation” if stocks rise more than 5 percent. All the bank has done is bought a call option on the equity market. If gold is receiving lots of press coverage, they’ll structure bonds whose payoff is linked to gold. If stocks have been falling, they’ll use put options on equities to provide an “upside kicker” to the bond if stocks fall further. Whichever market is moving is the one they’ll use to attach options to the bond. Clients sometimes marvel at the potential payoff from certain structures, at how attractive the risk-reward looks. No doubt, some of them do look attractive. The point to remember is that the pricing of these bonds is derived from the prices of other derivatives. The bank is not taking the opposite side of the risk; if the bond provides the client upside participation in an equity market rally, you can be sure the bank has purchased equity call options to hedge the risk. When

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the client is amazed at the high potential return available on a given bond as long as the relevant market moves appropriately, it’s not magic. It’s simply a function of market prices on the pieces that are used to construct the bond. One attractive feature for the banks is that issuing structured notes provides them with cheaper financing than if they issued normal bonds themselves. In fact, they’ll ensure that once the cost of the options or other derivative protection has been figured in, they’ve borrowed money more cheaply than they could otherwise. Another highly appealing feature is that the clients have virtually no way of figuring out if they’ve received a fair price. The math required to break the structured note into its component parts and see how much profit is being made is typically beyond the resources of most clients, even the high-net-worth investors at whom these are targeted. As a result, they have no way to tell if what they’re being offered is a fair reflection of what’s possible. All they can do is judge whether they like the opportunity presented. Recognizing the excess profitability that opaque pricing generates, the Securities and Exchange Commission (SEC) is planning to require greater disclosure from banks of the pricing and valuation assumptions being used (Morrison & Foerster, 2013). Many investors will be surprised to learn that banks routinely book a profit of 1 to 2 percent of the face value of the note at the time of the trade—a sizeable markup at the expense of the client. It’s very hard to comparison shop, because structured notes are sold, not bought. That means that almost all the time it’s the bank that initiates the dialogue with the client by proposing a transaction. They’re the ones best able to see what’s possible using options from across many markets. So if one bank suggests a novel structured note to a client, even if that client has a relationship with another bank, he’s unlikely to be able to comparison shop because the second bank may not be interested in issuing that type of security. And forget about comparing pricing with other notes in the secondary market. Structured notes are far too idiosyncratic to lend themselves to easy comparison with other issues, even if the client were able to obtain pricing on older, outstanding notes. Not only that, but even when the note matures, the client will have a hard time figuring out if it was a good deal. If his forecast of

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rising equity markets is correct, he would have done better to be invested directly in stocks. In fact, once the trade is done, it’s hard to even compare pricing. Suppose you buy one of these securities on Tuesday, and by Thursday another bank does actually respond to your earlier request for a competing quote. By then, markets will have moved, parameters will have been altered, and it won’t be that clear whether the earlier price was a fair one or not. The Financial Industry Regulatory Authority (FINRA), which regulates the securities industry, even has a web site warning investors about the hidden costs and lack of liquidity. This is why private banks love structured notes. The profits are guaranteed, and the clients can rarely if ever figure out whether they received a poor deal. The fact is that unless the bank is mispricing the structured note, the client can always achieve a better result by leaving his money in a certificate of deposit (CD) and transacting whatever derivatives the bank was using to hedge the note. Some may feel it’s not worth the trouble. Just consider why banks are so keen to push these products. And if you really want to figure out how much of a bid/ask spread is being charged, try asking for a bid on the note you just bought the day before, when market prices may not have moved too far from when the transaction was done. The difference between what you paid and the price at which the bank will buy the note back from you is a measure of the profit they’ve locked in on the transaction.

THE INTERNET THREATENS THE SWAPS OLIGOPOLY In the late 1990s, the Internet revolution was gathering pace. Since banks make so much of their money from information asymmetry, the potential threat to trading revenues was very real. By providing virtually free access to information, the Internet upset all kinds of business models over the years. Just ask Blockbuster. The early fear of many corporate executives was to avoid being “Amazoned” as the new disruptive technology crushed existing business models. Sure enough, competitive threats showed up in the derivatives market. Several start-ups were formed with the objective of replacing expensive voice brokers with technology that would do the same job

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for far less. Electronic trading is far superior to the old way of dealing over the phone. It’s faster, more accurate, and cheaper. Humans really slow the entire process down. At Chase Manhattan at the time, we were spending tens of millions of dollars annually on commissions to trade interest rate swaps. The start-ups, with names like Icor and Blackbird, sought to do the job for far less, and as a result argued that we’d save many millions in commissions. It was a fair argument. Nevertheless, it was also a complete nonstarter because anybody could see that once swap trades are being done online, the segregated market structure that forced the clients to transact through the banks would be at risk. No longer would a client have to laboriously call each bank to obtain multiple quotes in order to find out the cheapest place to do business. Prices would all be in a computer, and even if the new screen-based brokers committed to trade only with banks at the outset, it was clearly not in their interest to maintain that indefinitely, and it was beyond our capability to prevent them. In fact, any move by a bank to prevent a screenbased broker from opening up to more clients would be regarded as anticompetitive and quite possibly illegal. The banks had only one high card to play. The screen-based systems needed the banks on board at the outset so as to provide enough liquidity to attract other users. Without that, they’d have a screen system with uncompetitive quotes, and new users would quickly lose interest.They needed the banks to get it going, even though the eventual goal was to weaken the dominant market positions the banks currently held. Even an equity stake in the new company wasn’t enough to make it interesting. It was clear to me that such a development would hurt our trading profits and those of the other market makers with whom we traded. We didn’t need to talk to each other—in fact, such discussions would have run the risk of appearing collusive. We knew it wasn’t in the interests of our trading business and therefore most likely not in the interests of the other big banks that looked like us. A development that was almost certainly good for the clients and against the interests of the banks wasn’t likely to move forward because its success required the active participation of the same people likely to lose out.

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Consequently, swaps continued to trade over the phone in a manner not much different from when the market first developed in the 1980s. No disruptive technology was capable of breaking up the current structure, given the relatively small number of banks that dominated the business. Friends of mine often expressed surprise that change was so slow in coming, and for my part, I certainly expected screen-based trading to dominate far sooner than it did. However, ultimately the 2007– 2008 crisis brought about change, by requiring much of the activity between banks to be done on an exchange. The objective was to reduce the mutual credit risk that exists between all the major Wall Street players because of the vast breadth of transactions and exposures they have with one another. Forcing transactions into a clearinghouse greatly reduces the credit risk in the system, which is to everybody’s benefit. An additional unintended consequence is that a clearinghouse facilitates public reporting of trades, which will enhance competition. For the most actively traded areas of the swaps market, it’s about to become more competitive. Much of the bond market retains the characteristics of the swaps market described earlier. While government bonds are highly liquid and competitively priced, once you move into corporate and municipal bonds, retail clients are at an increasing disadvantage. In fact, one of the curious features of the bond market is that generally trades of increasing size get done on more competitive terms, whereas in the equity market it is the opposite. In equities, the lower liquidity afforded large transactions makes perfect sense. A small trade can be absorbed with virtually no visible market impact, whereas larger transactions are more likely to affect pricing. This is how liquidity works—the more of it you need, the more it costs you. However, in bonds, smaller transactions that create no market disruption incur larger transaction costs than big trades. As a result, while institutions are able to obtain reasonably competitive access to markets, individuals are charged more, even though their trades don’t require much liquidity. In fact, for individuals, accessing the bond market is far more expensive than equities. If you measure transaction costs as a percentage of volatility, or the typical daily move in the

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security, retail bond investors pay an enormous amount relative to what they pay to buy stocks.

MUNICIPAL BONDS Munis must be one of the worst deals retail investors face anywhere. Because individuals own around three quarters of the bonds outstanding, there is little incentive for the institutions that make markets to improve transparency. I don’t invest in munis at all myself. I can’t abide the certain knowledge that I’m being exploited by a broker benefitting from the inefficiency of the market. Too many people are just fixated on the tax-exempt yields, although with yields this low it hardly matters. That and the certain knowledge that the market is structured to exploit retail investors who don’t have the time or means to trade on the same terms as the institutions has been enough to keep me away. In stocks, large trades cost more to execute than small ones because they demand more liquidity from the market. Oddly, in bonds it’s the small trades that are at a disadvantage. Research has been done on the extent of the disadvantage to the small bond investor to try and quantify just how bad a deal retail investors are getting. Larry Harris and Michael Piwowar published a paper in 2004 called “Secondary Trading Costs in the Municipal Bond Market” (Harris and Piwowar 2004). They found that for relatively small retail trades of $20,000 the effective spread, or transaction cost, was 2 percent. Even for larger trades of $200,000 likely to be executed by high-net-worth investors, the equivalent cost was 1 percent. Bruno Biais and Richard Green wrote “The Microstructure of the Bond Market in the 20th Century” (Biais and Green, 2007) and found that average transaction costs in the 1920s were less than half of what they are now for retail investors. Part of the reason is that bonds used to be more actively traded on the New York Stock Exchange. However, the bond market gradually drifted away from the exchange model to the OTC model, which generally creates advantages for the biggest firms. When you account for the riskiness of the assets being traded, bonds and munis are even more expensive for the retail investor. Biais

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and Green cite another study, which found that “municipal bond trades are significantly more expensive than equivalent sized equity trades.” Although these papers are several years old, there’s little reason to think things have changed. In fact, The Economist noted in 2013 that inventory of corporate bonds held by primary banks had collapsed from just under $250 billion in 2007 to barely $50 billion today (“The Bond Market: Bit by Bit,” 2013). The requirement to reduce leverage following the crash has had many consequences, and this is one of them. If banks hold less inventory of bonds, it hurts their ability to provide liquidity and on balance further increases the transaction costs incurred by all investors both big and small. The SEC recognizes the poor deal being offered to individual investors. In 2012 they published a report describing the muni market as “illiquid and opaque.” They noted that investors have “very limited access to information,” that “bid and ask quotations are generally unavailable,” and that electronic display of prices was not typical. And, indeed, why should the banks change their ways? Research papers on bond transaction costs are not many people’s idea of a fun read, and investors are rarely even aware of the current high friction costs. Improvements, such as posting prices and trades electronically so everybody can see them, would benefit investors but not the banks that make money from the current inefficient structure. With interest rates as low as they are today and likely to remain, individuals in municipal bonds are receiving a terrible deal. A 2 percent transaction cost can wipe out more than a year’s income! It’s a truly bad deal. Although I went to some length to describe market structure earlier, the problem with municipals is not simply a case of entrenched market interests preventing increased competition. Bonds are many times more numerous than equities. While there are no more than 15,000 quoted stocks in the United States, there are literally millions of different bond issues. A public corporation may have only one class of traded equity but have dozens of different bond issues. The enormous variety of issuers, maturities, and coupon rates creates a far higher cost structure for banks seeking to service their clients.While an equity market maker may well hold inventory that he can sell to a buyer, it’s simply not possible for bond market makers to hold inventory

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in all or even most of the municipal bonds a client may wish to buy. Therefore, they have to be sourced when needed. Or, as is often the case, a dealer may have access to a block of bonds and seek to sell them to clients. However, there’s really no way for the client to judge how much of a bid/ask spread he is being charged. If the bank acts as agent, he will have to disclose the markup he has charged on the confirmation. However, if he’s acted as principal, selling out of inventory, the same information is not required. In fact, the bond dealer has interests that are perfectly opposite to those of the client. The bond dealer wants to sell bonds at a high price, whereas the client wants to buy at a low price. The still prevalent use of the phone to do transactions, as well as the inefficiency of obtaining quotes, work against the client. The enormous number of outstanding bonds is just a fact of the bond market. However, the combination of all these factors results in a bond market that really isn’t designed for individuals. It’s probably fair to say that if an investor doesn’t have a sufficiently large portfolio that he can obtain wholesale pricing on his investments, he shouldn’t own individual bonds at all. Because $100,000 is the minimum size that can be regarded as institutional and transaction costs don’t reach 0.10 percent or so until you’re at $500,000 in size, this is about where any portfolio can truly own bonds that are competitively priced. Since 20 to 30 individual bonds are needed for an appropriately diversified portfolio, the investor in individual bonds should have at least $10 million in order to have any chance of a fair deal. Individual investors buying individual bonds have been paying far more than institutions for decades—often many times more. The brokers that service them have been making easy money off the difficulty retail clients face in obtaining competitive quotes. Perhaps for a buy-and-hold investor this extra profit for the broker hasn’t cost the individual too much of his or her return, although with bond yields generally so unattractive, there’s even less reason to tolerate the status quo. Unless you’re an institution, buying individual bonds is a good way to overpay your broker. The alternative is to own a bond fund, such as a mutual fund or exchange-traded fund. While these will typically charge an annual

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management fee, if you shop around for a passively managed fund that isn’t trying to outperform the market, you can find annual fees as low as 0.15 percent, as in the case of the iShares iBoxx Investment Grade Corporate Bond ETF (LQD), or 0.25 percent in the case of the iShares S&P National AMT-Free Muni Bond ETF, both managed by Blackrock. I generally don’t think bonds are a good investment, but for those investors who insist on fixed income assets, something like this is a better bet than owning individual bonds. In addition, because Blackrock does the actual buying and selling of the bonds that LQD holds, at least you can assume they’re obtaining highly competitive pricing, given their enormous size. I’ve seen many examples of investors who have been poorly treated by brokers putting them into a selection of small individual bonds. In one case, a new client transferring his portfolio over to my business held a couple of dozen individual corporate bonds each around $25,000 in size. He’d undoubtedly been charged a 1 to 2 percent bid/ask spread when the broker bought all these securities on his behalf, and selling them incurred a similar cost. Many advisers promote a “ladder” of individual issues, each maturing in sequential years, as a way to create income for the client, as well as a regular pool of cash from redeeming bonds to be reinvested. They dislike bond funds because, although they own fixed maturity date bonds, the fund itself has no fixed end date. They draw comfort from the fact that if you buy a bond and it falls in price, you only need to wait until it matures to get your money back. This does protect the broker from incurring a realized loss for the client by selling a bond that was evidently a poor purchase, although it doesn’t necessarily favor individual bonds over bond funds. Bonds fall in price because interest rates rise. Although bond funds have no fixed maturity date, they can at least reinvest some of the cash from maturing bonds in new issues with the now higher prevailing rates. The problem with bond funds is that they can be bought and sold relatively cheaply on the stock exchange, and there’s no opportunity for the broker to act as principal by selling bonds directly to the client. Instead, he’s only able to charge a commission on the transaction. It’s better for the client, but far too few brokers recommend taking that course.

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It’s also virtually impossible for clients to benchmark the return on their bond portfolio to see how their broker performed compared with a common benchmark, such as the Barclays Aggregate Index. Whereas an equity portfolio’s return can be compared with an index such as the S&P 500 to see whether active management added any value, bond portfolios are far more problematic. Because they’re typically customized for the individual based on their particular circumstances, the return can likely be higher or lower than a benchmark simply because the client needed, say, a portfolio of shorter-thanaverage bonds that will typically outperform the bond market when interest rates are rising. It is, though, a great source of profits for the banks.

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CHAPTER 5

TRADING DERIVATIVES Before Banks Were Exciting

Banking was a pretty boring business for most of the twentieth century. Taking deposits and lending them to earn a spread isn’t exciting, and there’s a strong case that banking should be boring. My grandfather worked for the National Provincial Bank (a predecessor to NatWest) until he retired in the 1970s, and growing up I developed the strong impression that banking was a pretty serious, stodgy business (although my grandfather, when he wasn’t in his bank manager role, was anything but). Innovation began to creep into banking in the late 1970s/early 1980s, just as the big bull markets in stocks and bonds were beginning and the securities industry was at the start of almost three decades of steady growth.While there were many factors at play that caused this, the development of the personal computer must rank up there as one of the most significant. Banks handle large amounts of data, and the ability to perform analysis across hundreds or thousands of borrowers and account holders added a completely new dimension to risk management.The development of credit cards provides a great example. Conventional loan assessment required a detailed analysis of the borrower’s financial situation, ability to pay, sources of income, and assets.The objective of every bank was to avoid making any loan that would not be repaid. 93

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Bankers have always recognized that default was a risk and that surprises happen, but the basic method of approving a loan required assessing a fairly high probability of repayment. The development of credit cards and in particular the revolving line of credit required a completely different approach. Because the borrowers were all individuals and the amount of credit exposure on any individual credit card was relatively small, it wasn’t economically feasible for a bank to make a detailed assessment of each borrower.To be in the credit card business required the mind-set of a manufacturing organization perfecting mass production. So credit scoring came into use as a way of deriving a single number that reflected the creditworthiness of the borrower. The language of FICO scores, a credit rating for every American, was invented as described in Chapter 2 (Hyman, 2011). Credit card issuers understood that they needed to accept a certain level of defaults on mass-produced loans. By spreading their exposure across thousands of borrowers and relying on statistical measures of risk aided by FICO scores, they could reduce the cost of taking on a new client.This quantitative approach to credit risk acknowledged that there would be bad debts. Where banking for centuries had sought to avoid losing money on any loan, now banks were willing to accept losses of a few percent as the cost of doing mass market lending. They hoped that broadly diversified portfolios of borrowers, combined with low costs of origination, would result in an acceptable return, and by and large they were right. Such an approach wasn’t possible on any kind of scale until computing power became sufficiently available at a competitive cost to allow all the necessary data crunching to be done. Credit cards weren’t the only part of banking that experienced revolutionary change because of the computer. Trading was another. It’s hard to imagine now, but investors needed to know the yield to maturity on a bond before there were machines to figure it out. Calculating the price of a bond if you know the yield can be done with a basic calculator in just a few minutes, if you know how to do it. However, going the other way, from price to yield, is a laborious exercise that requires the use of something called the NewtonRaphson method. No wonder there were yield books that consisted of many pages of yields for different permutations of bond maturity,

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coupon, and price. If you’ve ever tried to figure out the yield on a bond by hand, you can appreciate why so much debt in medieval history was perpetual—if there’s no maturity, the yield is simply coupon divided by price. When I began my career in the U.K. gilt market in 1980, the firm I worked for used a mainframe computer to produce a sheet of yields for bonds we traded, based on current pricing. For relatively small moves in price, you could make an educated guess as to the new yield based on the bond’s price sensitivity (known as duration). Nevertheless, bond math gets complicated very quickly, and, as every bond trader knows, duration changes as yields move. The back-ofthe-envelope calculation of yield when the bond has moved a quarter point becomes increasingly less accurate for larger moves. On days when prices moved a lot, your trading sheet became little more than a rough guide. Those were the days when the jobbers, who made markets in bonds relying on mental acuity while besieged by brokers seeking prices, really earned their stripes. A few years later, when I was an interest rate swaps broker in 1984, we discussed the need to buy a desktop computer. The banks we traded with were already equipped with PCs, but as a brokerage firm we had less need to carry out the type of fixed income math that was necessary for trading. However, commissions were calculated based on the interest rate sensitivity of the swap we had just executed. Figuring out the basis point value (BPV) that drove our revenues required quick and accurate bond price calculations. In the early days without that ability, we simply relied on the trader at the bank to tell us what the number was. My boss at the time, Ira Sobel, had a well-developed distrust of banks and decided we needed to invest in a computer, if for no other reason than to ensure we weren’t being shortchanged on our commissions. Ira assigned me the task of identifying which computer we should buy. My cautious recommendation, since I was not comfortable risking too much of the firm’s money on new and unproven technology, was to buy an IBM PC Jr. It didn’t even have a hard drive—there’s probably more computing power in today’s TV remote control. Although Ira knew nothing about computers, he possessed a little more vision than me and embraced the business risk of buying an IBM AT.

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COMPUTERS AND SWAPS There are few obvious explanations for the launch of the derivatives markets in the early 1980s. There was no great regulatory change or government policy initiative that made that time the moment for a far-reaching form of financial innovation. Rallying markets may have been a factor, and the growing pressure on banks to reduce the size of their balance sheets clearly created an incentive to move assets off balance sheet, which derivatives most definitely do. But the development of the desktop computer was probably the most significant catalyst that was responsible for the enormous growth that followed. Intel’s cofounder, Gordon Moore, famously predicted that the number of transistors on integrated circuits would double every two years, and another Intel executive, David House, made the related prediction of doubling chip performance every 18 months. While the rise of derivatives trading relied on smart people, improving risk appetites, and a benign regulatory approach, computers were probably the most critical component behind their development. Derivatives had been around for centuries. Back in the days of the Dutch tulip bulb craze, options on tulips were bought and sold, and there were also contracts for forward delivery, which is itself a form of derivative. At the peak of “tulipomania” in around 1635 (Mackay, 1932), there is the story of a sailor who had just arrived in Holland with a shipment of valuable tulip bulbs from the Levant (nowadays the countries in the eastern Mediterranean). The merchant, happy to have received this shipment, made a breakfast of fine red herring for the sailor, who then identified a strange looking “onion” sitting out of place among fine silks and deemed it complementary to his herring. The merchant soon missed his prized possession and the sailor was found munching on the last pieces of what could have fed his entire ship for a year. Prison duly followed this illicit feast. Traded options existed long before the invention of the BlackScholes model used to price them, itself a huge chapter in their growth. The Chicago Board Options Exchange (CBOE) started offering markets in listed equity options in 1973, and in the early years, traders made prices in options without the benefit of a program to calculate their correct price.

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Options and other derivatives were a relatively small sideshow on Wall Street until the development of interest rate derivatives in the early 1980s. While the equity markets generally capture the news, the markets for bonds and currencies are far larger. The great inflation of the 1970s and early 1980s had vividly demonstrated the risk in bond portfolios for investors. The arrival of computing power coincided with an urgent search for improved risk management tools. Up until this point, most of the derivatives trading took place on exchanges like the CBOE or the two Chicago futures exchanges—the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT). Trading a small number of generic products resulted in liquid markets, but created basis risk for anyone wishing to hedge a risk that didn’t precisely match the futures and options products on offer. So-called over-the-counter (OTC) derivatives can be customized to suit the user. In effect, each trade is a unique product, and the management of thousands of such transactions, which eventually grew to millions, could never have happened without computers to process the data.

SHOULD BANKS INNOVATE? Former Federal Reserve chairman Paul Volcker once questioned the link between financial innovation and economic growth. He described the automated teller machine (ATM) as the only worthwhile financial innovation in history (Murray, 2009). Finance hadn’t been very innovative for most of its history, and the introduction of computers was the catalyst to alter that. The subsequent growth in the financial services sector that coincided with this innovation really speaks to the issue Paul Volcker raised. It is a valid criticism of banking. New products led to greater employment and an increased share of gross domestic product (GDP) in those countries where banks were most freely able to let their creative abilities run wild.There’s no doubt that for the broader economy, and indeed throughout human history, innovative breakthroughs and steady productivity improvements have made possible the improvement in living standards that modern societies generally reflect.

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At its most fundamental, the purpose of the financial sector is to channel savings efficiently to productive forms of capital formation. In other words, businesses large and small raise capital, either by borrowing money or by issuing equity in order to build profit-generating enterprises. People save, both individually and collectively, in order to pay for future expenses and to preserve the purchasing power of their savings. Perhaps the most important role of a sound banking system is to help savers find the right investments. This can happen indirectly, whereby banks take deposits and make loans, thus standing in between the savers and borrowers. It can happen directly, in that financial advisers and investment managers can make investments on behalf of their clients, the savers. Therefore, the success of banks is inextricably linked with the success of their clients and the broader economy. Measuring their individual success by profitability is as good a measure as any, for clearly banks that do not meet the needs of their customers in a competitive marketplace will not survive. Banks that do a good job will be measurably more profitable. It’s not a perfect gauge—some would argue that Goldman Sachs, in particular, profits from its clients and manages its trading businesses to exploit its clients’ information disadvantage. I’ve never worked at Goldman Sachs and am not their apologist. However, it does seem to me that as long as they continue to have clients trading with them, they must be meeting the needs of the marketplace. We can measure the success of individual financial firms based on their profitability, but that’s an incomplete yardstick for the industry as a whole. Demand for a service is evident in the revenues charged for its delivery. Nevertheless, the financial services industry requires a different measurement tool, since it is a facilitator for capital formation. The better it is at channeling savings to productive places, the faster living standards will grow. This will show up in the form of higher GDP and perhaps a less volatile business cycle. Banking is only as good as the economy it supports. The world is a complex place, to be sure, and for a statistician there’s no satisfactory way to link a growing banking sector with the health of the economy.The view that argues finance has grown without adding commensurate value is not one that can be mathematically proven with an acceptable degree of certainty. It is a qualitative

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assessment that relies on anecdotal evidence selectively supported with quantitative tools. Its critics will inevitably use the same methods to argue their defense of banking. Until 2007, it was a debate that drew little attention and indeed was one of scant importance. Alan Greenspan, chairman of the Federal Reserve after Paul Volcker, embraced a regulatory philosophy built on banks’ self-interest in remaining solvent. Only after this approach was found wanting in 2007–2008 did policy makers start to question such confidently light touch oversight. Similarly, a financial sector that pursued innovation in untold measure before precipitating a collapse that triggered a recession would seem to require defense. Given recent economic history, a more robust view is that the financial services sector can grow too big and that unchecked innovation is wholly more risky for the rest of us. The debate ought to begin at least with that as the position that needs to be defended, rather than the other way around.The economic damage that took place in the world of finance in 2007–2008 seems thoroughly deserving of a debate that considers just how much banking and financial innovation we really need.

GROWTH IN INNOVATION My own experience is that trading, the use of derivatives, and financial innovation evolved over many years and through business cycles. When I first became a swaps trader, the trading philosophy articulated by senior management was one of fee generation, rather than acting as principal. A company or bank wishing to hedge its interest rate risk confronted a trade-off: exchange-traded instruments, such as futures, are highly liquid, transparent, and cheap to trade but offer very limited variation. Protecting against moves in the London Interbank Offered Rate (LIBOR) could be done with eurodollar futures, which settled quarterly, based on three-month LIBOR. If you had exposure to six-month LIBOR, or your borrowings took place on any date other than the quarterly CME settlement, or were linked to commercial paper, you had to reckon on the basis risk, or difference, between the protection futures would provide and your actual economic exposure.

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Alternatively, you could execute an OTC derivative that was designed to meet your obligation precisely, at the cost of less liquidity, transparency and greater execution expense. It was a choice between a cheap but imprecise hedge, and an accurate but expensive one. Our trading business was predicated on helping those clients who wanted a precise hedge, and therefore incurring ourselves the mismatch between the liquid futures markets we used all day and the actual economic exposures we had taken on from the client. It was a perfectly sound and valid approach. If you’ve borrowed money and you want to hedge the interest rate risk, you probably want to do it precisely. However, because we were executing dozens of similar trades, we were in a position to absorb hedging mismatches (known as basis risk) across large numbers of instances and rather like an insurance company, diversify away many similar yet not quite identical types of risk. We quoted prices (or, more accurately, interest rates, since we were trading interest rate swaps) to clients, based on the liquid futures markets where we hedged, plus an additional profit to compensate us for the basis risk we would incur. The difference between “fair value,” or the swap price with no profit, and the price at which we actually traded, came to be called transaction revenue (which we dubbed “T Rev”) in our business. Other banks had a similar measure with different names, such as “profit to mid,” “net present value (NPV),” “markup,” and so on. The goal was to maximize the T Rev. From the moment we closed a trade with a client, the T Rev was at risk. Since it was calculated based on prevailing prices in the futures markets, once the marketer declared the trade was done, we were then exposed to fluctuations in its value. The idea was to immediately hedge away the risk. In the jargon of the day, we were seeking to take risk where we had an advantage, which is to say on the basis risk between futures and interest rate swaps, and avoid taking risk where we had no edge, which was predicting movements in interest rates. Looking back at this time from a vantage point 25 years later, it seems quaint to say that we at a bank were instructed not to take interest rate risk. Naturally, the bank as a whole had plenty of exposure to rate movements, but in our department we were pursuing a more scientific, highly rational approach. Our edge was computing power and accurate risk assessment. Because we were doing new trades all

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the time, we had a very good idea of how much above “theoretical value” or fair value to charge for a transaction. We had an informational advantage about the pricing of our products compared with the clients. We embraced the Efficient Markets Theory that speculation was inherently unprofitable and that no one could possibly know ahead of time where government bond yields and other interest rates were going. Futures prices reflect the aggregate knowledge of all market participants through their buying and selling. If we delayed in, say, selling futures to hedge a transaction with a client, we were in effect gambling with the profitability of that trade. The trader’s job was to accurately price the transaction and then hedge away most of the risk so as to maximize the odds of retaining the T Rev. In time, traders were allowed more flexibility in terms of how risk was hedged. Competitive pressures were such that a truly risk averse trader who immediately hedged out all the risk in a transaction would find that he’d also spent the profit from the trade. In fact, successful market making, the basic business in markets of providing prices to less frequent participants, requires that the trader find a good balance between risk tolerance and risk avoidance.You retain the amount of risk you want based on the cost of hedging it and your assessed probability of a loss. Nowadays, being a profitable “liquidity provider,” as market making has come to be known, requires sophisticated judgments about risk/reward and the costs of changing your risk profile.To use a simple example, suppose a liquidity provider in XYZ stock quotes a price of 31.00 to 31.50 when the market itself is also quoted the same way. If he buys shares at 31.00 and has no tolerance for risk, he’ll immediately sell them, which he’ll have to do at 31.00, the same price he just paid. He’ll gain no advantage from being a liquidity provider—by being risk averse he’ll be completely unprofitable. His goal is to ensure he sees enough “flow,” which is to say buy and sell orders, that he has a decent chance of selling XYZ shares at 31.50 to somebody else. This is the essence of flow trading, to keep moving, to keep changing your position. In this way, you let the slight advantage provided by the bid/ ask spread you quote turn into a profit. The more balanced volume you can do, the shorter the time in between trades, and the less chance there is of the market moving against you before you’ve had an opportunity to lay off the risk through another transaction.

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VOLCKER’S PROBLEM This is why the so-called Volcker Rule, which generally prohibits banks from what it calls “proprietary trading,” will be so hard to implement in businesses where banks operate as flow traders. There’s no clear definition of when a position incurred through market making becomes a proprietary position. If the trader buys XYZ shares and holds them for 10 minutes, that might not be defined as a proprietary position. What about overnight? Or six months? The arbitrariness of such a definition reveals the inherent weakness in the rule, even though it is well intentioned. Given how badly the financial system let us down, it’s hardly surprising that such a proposal has made its way into law. Moreover, implementing it won’t be easy and will probably have unintended consequences. One measure of a flow trader’s ability was if he managed to generate a positive profit and loss (P&L) after adjusting for the profit from all the client trades. Although trading rooms strive to create a team atmosphere, there is the inevitable tension between marketers whose value is measured by the revenue from clients, and traders whose worth can be simply the rest of the P&L after adjusting for the clientrelated value. Since traders set prices, they often have the upper hand in the ongoing back and forth with salespeople. However, generating value from clients is often the more desirable objective. It’s more stable revenue, exploits the “franchise value” of the bank, and leads to a more diverse revenue stream. In addition, good marketers can find clients whose trades will allow the trader to get out of undesirable positions. As the derivatives trading P&Ls I was responsible for increasingly added up to a healthy amount more than the T Rev, it illustrated that our traders were able to judiciously take risk in ways that more often than not added to profitability. Before long, trading profits and risk taking were recognized as an important part of the revenues of the business. Annual budgets would incorporate trading profits on top of client flow, and the original focus on being an arranger of swaps in exchange for a fee evolved into a risk-taking flow business, generating a bid/ask spread on myriad well-understood as well as obscure risks. Many other banks went through the same type of metamorphosis as we did at Manufacturers Hanover Trust (subsequently Chemical

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Bank, then Chase Manhattan, and finally JPMorgan through successive mergers, mentioned in Chapter 1). The trading of increasingly complex products resulted in more retained risk to facilitate the client business. It turned out that a risk-tolerant posture in market making was more profitable than being risk averse, and it’s only a short step from here to a risk-seeking posture. It wasn’t my experience that trades were pushed on clients to benefit the trading desk without regard for the client. Much of Wall Street has been criticized for this and there’s plenty of evidence that it happened. My firsthand experience in derivatives trading concluded in 1999, and perhaps what came next was an evolution of the increasing risk appetite I had witnessed over the prior 15 years. What I saw was marketers and client relationship officers genuinely seeking to provide solid advice. Finance seems to have lost sight of that goal in some areas over the past decade, and there was some evidence of that in the marketplace during the 1990s—but not at JPMorgan and its predecessor banks.

BRING ME CLIENTS WITH A PROBLEM On one occasion we did hire a marketer from Bankers Trust (BT), and perhaps in a precursor to the wrong path that so many made subsequently, listening to him describe their business was a revelation. His name was Jeff Sparks. Jeff was blond, blue-eyed, and good looking. He was very smooth and confident and thoroughly likeable, as is required for any successful marketer. Jeff had left Bankers Trust to join Chemical Bank in 1994, and in doing so he had left one culture to join a completely different one. At Chemical Bank, corporate clients had relationship managers. Their job was to make sure all the bank’s products and services were made available to the client. They also had a vested interest in the long-term success of that client, and as such could act as a gatekeeper, protecting against the recommendation of an inappropriate trade. One of the features that kept banks like JPMorgan and its predecessors out of trouble was a genuine focus on ensuring that whatever advice was suggested was appropriate for the client.

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Jeff Sparks had operated in a totally different environment at Bankers Trust. Client relationship officers did not exist there—in many cases Bankers Trust did not possess a long-term relationship with the chief financial officer (CFO) of the companies with whom they did business. And as Jeff described it during an informal “debriefing” shortly after he joined, he would often cold-call corporate treasurers to pitch them business. In a line that has stayed with me ever since, Jeff would open his conversation with a CFO with the assertion that he didn’t want to do their plain vanilla swaps—he wanted to solve their problems. Plain vanilla swaps (of which we traded more than just about any other bank) were not that profitable on a trade-by-trade basis. Moreover, Jeff and his team at Bankers Trust recognized that if you could identify a strategic risk issue facing that CFO, a solution using derivatives could be customized. Worried about the slope of the U.S. yield curve and the value of the Korean won? A structured derivative could be presented that would hedge against adverse moves in both and would provide an attractive payoff if they moved in the right direction. The beauty of such tailor-made instruments is that, similar to structured notes today, they’re virtually impossible for the client to value accurately. Without access to sophisticated pricing tools and the ability to hedge in the derivatives markets, the client has no way to judge whether the bank’s profit is reasonable or excessive. We listened to Jeff ’s description of this business strategy in growing amazement. Essentially, Bankers Trust would assemble a complex trade using simple instruments that were cheap to trade. They would retain some basis risk between their complex creation and the hedges but would have priced in a healthy “spread” relative to the fair value of the structure. The client really had no reference point against which to judge whether it was a fair deal. All they could do was decide if the overall risk/return of the trade suited them. But there was more. Once the trade was done, there was no way for the client to go back and see if they’d accepted a poor deal. Simply put, Bankers Trust had used a collection of plain derivatives to create a complex one, and taken a spread out of the middle. No matter what the market did, BT would profit. For the client, if they made money, it was still less than they would have by using the simpler

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components themselves, and if they lost money, it would be attributable to an incorrect view on the yield curve (or the Korean won, or both). They’d never really be able to reverse-engineer the pricing of what they did. On top of this, an additional profit opportunity was to restructure the transaction. Suppose it was a two-year maturity. Six months into it, the yield curve view is turning out to be correct but the Korean won is not doing what was expected. At this point the marketer helpfully suggests replacing the Korean won with the Thai bhat, whose future direction appears far clearer and is supported by research from the bank’s economics department. Naturally, restructuring the trade creates an additional profit opportunity for the bank, as something less than the full value of the altered terms is reflected in the pricing of the restructured deal. It’s also quite impossible for the client to comparison shop at this stage— they have an outstanding transaction with Bankers Trust that already has an unrealized gain or loss. Finding another bank to quote on the deal isn’t plausible. And once the new structure is in place, it further muddies the waters for the client in trying to ascertain later whether the entire exercise was worthwhile or not. I felt as if I’d just peered through a window at a parallel universe. Unburdened by client relationship officers standing in between the Bankers Trust derivatives group and corporate CFOs, the full power of derivatives to confuse and separate the unwary from their money was unleashed. Jeff had described a business philosophy developed under Allen Wheat when he ran Bankers Trust’s derivatives business before moving over to run Credit Suisse.

DERIVATIVES MISSTEPS Back in the 1990s, both Procter & Gamble (P&G) (Hansell, 1994) and Gibson Greetings successfully sued Bankers Trust for selling them derivatives products that were inappropriate. In 1994 Gibson Greetings agreed to pay just 30 percent of the actual value of the transaction to cancel it. In 1996 P&G settled their suit on approximately similar terms. Both companies argued that the risks were not

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properly explained by the salespeople at Bankers Trust. If your business is based on a broad banking relationship, there’s far less reason to stuff your clients with overpriced, complex transactions that they really don’t need. However, if you regard your clients as being the occasional counterparty to one-off transactions, it gives the bank far less stake in making sure appropriate recommendations are made. Meanwhile, the technique of using complexity to obscure profits has migrated over to the private banking business. Corporations took note of these two examples and have generally steered clear of such things. But the structured derivative concept has reappeared in recent years in the form of structured notes, sold by many private banks to their high-net-worth clients (as described in Chapter 4). The concept is the same—one of creating a complex risk/return out of simpler instruments and hedging away the risk. The main difference is that nowadays they’re attached to a security issued by the bank. Warnings abound on the Internet about these instruments. The Financial Industry Regulatory Authority (FINRA) even has a website advising investors to, in effect, “read the fine print” on such deals (FINRA, 2011). A typical structure might be a note issued by a bank with a principal guarantee (i.e., worst case, you get your money back) offering “upside participation” in whichever market happens to be receiving a lot of press coverage. For example, the investor received 80 percent of the return on the Standard & Poor’s (S&P) 500 for the year with a cap at 10 percent, and if the market goes down, you earn 0 percent (i.e., no risk of loss). It can sound attractive, although all that’s happened is that the bank has used options and futures to hedge out the risk and pocket some fees. In every case I ever looked at, the investor would have been better off to simply do the derivatives trades themselves. They may not wish to dedicate the time, not understand how to do it, or have other legitimate reasons for selecting the structured note instead. However, clients who do go ahead and invest in structured notes should recognize that this is a great business for the banks, and they rarely, if ever, disclose the fees they are charging. A friend of mine recently launched a business to source competitive pricing on structured notes, which at least provides the potential to compare pricing and reduce the overall cost to the client. He’s

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certainly operating in a market that could benefit from increased competition and transparency. Trading derivatives in the early years felt like being on the frontier of new financial products and new risks. One of the businesses we developed was making markets in interest rate caps. Most adjustable rate mortgages have a cap on how much the rate can adjust up in any one year and over its lifetime. Many corporations that borrow shortterm money based on LIBOR may wish to ensure that their total cost won’t go above a certain level, and they might buy a cap for this purpose. For example, a $100 million five-year cap on three-month LIBOR set at 4 percent would protect the buyer against ever paying more than 4 percent on their $100 million loan. Whenever the company had to pay more than 4 percent, the cap would pay the excess and so provide protection. Variations can include floors (a downside limit on rates) or swaptions (an option to do a particular interest rate swap), and there could also be trades done on other indices, such as commercial paper or Treasury yields, although LIBOR is by far the most common.

TRADING BY THE BOOK At one point in my career, I was running the interest rate option book, which consisted of options on all these instruments and other more exotic ones.The basic idea behind running any derivatives portfolio is to quote prices on new transactions that build in some profit margin versus the theoretical value (or “theo,” as we called it). By using exchange-traded, liquid instruments, as well as offsetting trades with other banks, the trader maintains many different types of mismatch or “basis” risk within acceptable boundaries, while earning a spread on new transactions. It’s a bit like riding a bicycle, in that you need to keep moving forward with a fairly steady flow of transactions to maintain profitability and provide the opportunity to position the portfolio for the risks that you want while finding ways to get out of what you don’t like. Trades take place with clients, with the liquid exchange-traded markets, and with other banks in the interbank market. In many ways,

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trading with other banks was the most interesting. Sometimes we knew the other traders, and we usually had an opinion about which banks were smart traders identifying an opportunity versus just offsetting risk from some highly profitable trade with a client. Goldman Sachs was usually doing something big and carefully thought out. So was Salomon Brothers (subsequently acquired by Citigroup). Generally, U.S. and U.K. banks knew what they were doing. Others were less sophisticated, although French banks were often staffed by highly numerate traders, reflecting the strength of the universities there. This was a time when we were learning many of the subtleties of trading and risk management of interest rate derivatives. And sometimes those lessons came the hard way, through one trader benefitting from a greater understanding of a subtle feature than his counterpart. When mistakes cost money, you learn quickly, and good traders took their lumps, moved on, and incorporated their expensively acquired knowledge on the next trade. I kept a copy of Cox and Rubenstein’s option pricing book, our bible, on the desk. It was full of formulas and graphs illustrating the math underlying option pricing, which we then took and applied to real-world situations. I used to joke that we were trying to stay one chapter ahead of the market in making sure every page was properly understood. In those days I worked for Manufacturers Hanover Trust (“Manny Hanny”). Eventually, we would become JPMorgan, but at that time Manny Hanny was one of several decent-sized U.S. banks trading derivatives. Chemical Bank (with whom we eventually merged) had a similar profile. We traded caps and swaptions with Chemical Bank on a fairly regular basis. Generally, the trades held out no particular profit for either of us; we were just laying off risk incurred through our dealing with corporate clients. Then Chemical Bank began trading very aggressively in the market for caps on commercial paper (CP). Most big, investment-grade companies issue CP to fund their day-to-day operations and for working capital. Much of it is held by money market funds. CP is liquid, very short maturity, and low risk. CP rates tend to move with LIBOR but are usually lower due to technical features around how the rates are calculated.

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A five-year 4 percent cap on CP had a similar value to a fiveyear 4 percent cap on LIBOR. Their prices would move together pretty reliably, and since the market for LIBOR caps was far more liquid, we based our pricing on that and used an adjustment to come up with CP cap prices. Based on the price our model generated for LIBOR caps, we could come up with a “theo” for CP caps. Chemical Bank was selling CP caps below our theoretical value. At first, we bought some and took them into our complex portfolio. The pricing was such that at least in theory we had executed a trade that would ultimately result in a profit. It had a positive NPV. The problem was that day after day Chemical Bank kept selling. Although we had carefully booked trades at prices that showed a profit in our model, the reality was that if we wanted to sell those trades out in the market we would have to realize a loss. In one year Chemical Bank’s options portfolio doubled, with written options exceeding purchased by almost two-to-one (Guenther, 1989). Markets are untidy places, and many times securities prices can deviate from fair value. Sometimes there’s an opportunity to buy and sell similar securities in different markets and lock in a profit, through arbitrage, but in this case, although the prices of LIBOR and CP caps were linked through sound math, the linkage wasn’t so strong as to guarantee us a profit as we built up a long position in CP caps, which we increasingly hedged by selling LIBOR caps. We were building up a big mismatch between LIBOR and CP caps. I went to the research department. Like all banks trading derivatives, we had our department of PhDs and rocket scientists who would use the math of engineering to solve the more difficult elements of pricing financial derivatives. I had sat through one-on-one classes with the head of research before I took over the options business, learning about the application of Brownian motion (the process that describes how particles move in a liquid) and Ito’s Lemma (both components of option math). Now I went back and challenged my teachers. How sure were they that our models were right? Which assumptions in commonly used option pricing models such as BlackScholes were most vulnerable to being incorrect? What if their quants were better than our quants?

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Our research guys expressed confidence in the math, but nevertheless declined to sign the memo I suggested guaranteeing their work. At the end of the day the right model is a necessary tool, but you also need to use judgment and not follow it blindly.

AN OPTIONS BOOK BLOWS UP I was very worried. We had been booking profits for several weeks based on our model valuation. However, I knew the trades weren’t money good, at least not yet. I didn’t want to be accused of manipulating what might be a weakness in our valuation models, so I put together a reasoned argument for holding the profit in reserve. Essentially, I said that although our models suggested we would ultimately make a profit, based on current market prices we would not. I recommended we hold an accounting reserve equal to the theoretical profit on these trades and release it either when we got out of them or when market prices returned to levels we thought were normal. To the credit of the managers for whom I worked (Jeff Larsen and his boss, Don Layton), there wasn’t any opposition to this. Although bankers have in recent years earned a widespread reputation for booking profits as soon as possible so as to maximize their year-end bonuses, it wasn’t always that way, and I’ve been fortunate in my career to work for bankers who possessed the integrity and intellectual honesty that should always have been prevalent in the industry. They satisfied themselves with the analysis we had done and accepted the conservative accounting adjustment that I wanted. Meanwhile, we still couldn’t figure out what was persuading Chemical Bank to keep selling CP caps. It seemed as if every day they were in the market. Whatever size position we had bought from them, I’m sure at least another five banks had done the same. The market had one very big and motivated seller, who was in effect challenging the other traders to bet with their models. The size and apparent confidence with which Chemical Bank’s traders sat on the offered side day after day consumed me. What could they know that we didn’t?

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We decided to try a different approach. We’d gone through the math and there wasn’t anything more to be done there. So we invited two of the traders out to dinner. I went with a colleague who worked with me on the options book, and we set out to see what a couple of bottles of wine might reveal that Cox and Rubinstein could not. We had a good dinner, and later my colleague Dan Ho and I compared notes. In the course of the evening, we’d had a four-way conversation across the dinner table and at times two parallel chats, as sometimes happens. Although we’d been careful not to behave as if CP caps were all we wanted to talk about, Dan and I had both asked about the source of all this CP business at different points during the dinner, and we had each received a totally different response from our respective diner. One had confided that they had a “secret” model, while the other had attributed all this activity to a big client.We pretty much knew there wasn’t a client in the world big enough to execute $10 billion or more in CP caps. No one company or investor had that much exposure to CP. And their vague answers about the model combined with our assessment that these guys were definitely not rocket scientists led us to wonder just how good this secret model really was. Not many weeks after that dinner, Chemical Bank stopped selling CP caps. There was no explanation provided to the brokers through whom they traded, simply that they had no price to show today. And then, one day, the news flashed across the wires that Chemical Bank was taking a write-down on its cap book. It turned out that head trader Steve Edelson had mistakenly thought that the conventional pricing of CP caps used by most market participants was flawed. Their “secret” model was based on their conviction that everybody else’s model was wrong. They had been executing vast numbers of trades in the belief that they were smarter than most of the market. Chemical Bank took a $33 million write-down (Guenther, 1989), the price for discovering they weren’t smarter than everybody else. History is littered with the corpses of traders whose ego exceeded their ability. They’d also been valuing their trades as if they were already profitable. Finally, internal auditors had caught up and recognized the flaw in their approach. Because the impact on earnings was material to Chemical Bank’s quarterly results, they had to make a public disclosure of the loss.

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The good news was that we now knew we had been pricing our CP caps correctly when we did all those trades. There was no big weakness in our models, just a market distortion whose cause had now gone. However, while this vindication was great, we still retained a large imbalance between the CP caps that we’d bought and the LIBOR caps we’d sold as a volatility hedge. The accounting reserve we had taken would eventually be released into trading profits, but only as the trades we had done rolled off, which would take many years. Although Chemical Bank was no longer in the market, their activity had left everybody else with an “inventory” of CP caps, so prices remained depressed. Eighteen months later the unexpected happened, when Manufacturers Hanover Trust merged with Chemical Bank. Two big U.S. banks with considerable overlap agreed to become a behemoth, another step on the long road to what would ultimately become JPMorgan Chase. In mergers like that, both banks typically have similar departments doing similar things. The objective is to find “synergies,” which means in practice keeping the best people from both former departments and building a new version better than the prior two, with revenues more than the aggregate but lower costs. Layoffs and cross-sell opportunities follow. Our cap book was scarcely on the radar screen of John McGillicuddy and Walter Shipley, respective CEOs, when they agreed on this merger. However, our new derivatives department incorporated the old Chemical Bank cap book as well as my own. Like two halves of a broken plate, the two cap books fitted together. The CP caps we had bought were canceled out by the CP caps Chemical Bank had sold. Combining the two books reduced the risk in both, as so many trades wound up being paired with their natural other side and collapsing into nothing. After more than a year of challenging, questioning, and worrying about our approach, our accounting reserve was released and one chapter in the history of derivatives reached a happy conclusion. Although the growth in finance over three decades took place without the support of a specific public policy objective, debt growth has clearly been consistent with federal government policies. From promoting home ownership to student debt and the tax-exemption

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of municipal bond interest, Washington has clearly found little to dislike about borrowing money, and the banking system has played its role in finding willing lenders. Now that we’ve reached a point where excessive debt is the problem, public policy will need to respond.The most urgent task is bringing the federal government’s debt under control. It represents an enormous political challenge.

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CHAPTER 6

POLITICS Government-Controlled Investing

If you’re a bond investor, you have to consider politics and the actions of the federal government.This is not only because they’re the biggest issuer of bonds. It is also because they have a huge impact on market conditions. The federal government sets market interest rates both for short maturities (through the federal funds rate) and in recent years for long maturities (through bond buying programs designed to depress yields, dubbed quantitative easing). Today, the biggest issuer is also the biggest buyer. Bond yields are heavily influenced by the yield on debt issued by the U.S. federal government because the United States is still the most creditworthy issuer despite a downgrade of one notch from the highest triple-A rating by the rating agency Standard & Poor’s in August 2011. However, as all rates are tethered to the U.S. government’s, successful bond investing requires considering the likely course of government fiscal policy. Discussing government finances, the deficit, tax, and spending policies can quickly become very political. It’s relatively easy to agree on the size of the fiscal challenges facing America. Moving on to how to confront them soon leads to disagreement. This book isn’t going to take a stand on the right and wrong policies to be pursued. Our focus is on investing and assessing in a dispassionate way the range of plausible outcomes. It takes no view on the relative merits of big government versus small or appropriate tax and spending policies. It certainly 115

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doesn’t express an opinion on which political party got us here and who’s most responsible for the unpleasant choices we face. We’re not on the side of Republicans or Democrats; we’re on the side of investors.What are the most likely outcomes for fiscal and monetary policy, and for gross domestic product (GDP) growth and inflation? That is what bond investors care about. How likely am I to get back my principal plus inflation plus a return above inflation? Many millions of words have been written about the looming U.S. debt crisis. Virtually every political leader has expressed a view that we’ve been borrowing too much for too long and that present policies are unsustainable. The problem is recognized; agreement on the solutions has generally been found wanting. Total government debt at the federal, state, and local levels including unfunded state pension obligations is around 144 percent of GDP, as shown in Chapter 2. Because the United States operates a federal system with debt at multiple levels of government, simply measuring debt owed by Washington fails to show the whole picture. State and local governments owe substantial amounts as well. If you include student loans (6 percent of GDP), since they are largely government guaranteed (i.e., taxpayer supported) you get to 150 percent of GDP. Adding it all up, we already look a lot like Greece, and on current policies it’s likely to continue increasing. The cost of providing health care under Medicare and Medicaid will be the main driver of increased borrowing. Even at today’s levels, it works out to $75,000 per U.S. citizen. It’s a lot of money, and how it gets repaid is going to substantially determine the long-term returns earned by today’s bond investors.

WHY SHOULD WE WORRY? First, let’s assess the likelihood of the federal government’s passing legislation that will solve the problem. Most observers outside of Washington, D.C., concur with the idea that both sides will need to compromise their principles in order to reach an agreement. As long as neither party has complete control of the White House and Congress, including a filibuster-proof 60 seats in the Senate, it will be

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necessary for whichever party is in power to find some accommodation with its opponents. Congress has become more partisan in recent years. There is research that measures this and shows how it’s become steadily less likely for politicians to break ranks and vote with the other side. Senators and congressmen often lament the long lost ability to craft bipartisan solutions. A major reason the House of Representatives is more polarized in this way is that there is less turnover. The vast majority of seats are safe seats, and 90 percent or more of congressmen are returned to Washington every two years. Although opinion polls consistently report that the public’s approval rating of Congress could scarcely be lower, it’s a little bit of a simplification. In reality, most voters like their congressman—they just dislike the other 434. That’s why the strong disapproval doesn’t result in any change, because you only get to vote once. Every 10 years following the decennial census, congressional districts are redrawn to reflect the shifting population. States that gain or lose seats in the House of Representatives because of population changes have to alter their districts accordingly. In many states the governing party controls the redistricting process, and by designing districts that pack together as many as possible of their opponents’ voters they can consolidate their electoral advantage.The odd-shaped districts that result draw their name (gerrymandered) from Boston in 1812 when Governor Elbridge Gerry redrew a district that some felt resembled a salamander (“Gerrymandering,” n.d.). Redistricting in Texas in 2003 was contentious and eventually reached the U.S. Supreme Court in 2006. Republicans in Texas argued that their redrawn districts were intended to create a congressional representation whose makeup reflected the overall mix of both parties in the state. Once you do that, it’s the start of a journey toward less competitive elections, since the intent is to reach a more predictable mix of both parties from that state. The U.S. Supreme Court affirmed the Texas plan, but the justices issued several different opinions both in support of and in opposition to the case. Five of the nine justices were unable to agree on the definition of an unconstitutional gerrymander (Lane, 2006). Many observers felt that by failing to emphatically reject demographically

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based redistricting, they provided support for other states to follow the same course. The unfortunate result has been congressional districts drawn by committees, creating highly convoluted shapes based on the groups they wish to lump together. This is why there’s so little turnover in seats for the House of Representatives. Both parties have used the redistricting process to create safe seats for themselves. While there may have been an initial intent to improve democracy, the outcome has in many ways served democracy poorly. In addition, because so few seats change hands between political parties, it means that often the primary process, during which each party selects its general election candidate, is more important than the election itself. If you live in a congressional district that is, say, 60 percent Republican, there’s not much doubt that the Republican candidate will win in November. The real election for that seat takes place during the primary, in the spring or summer. Nevertheless, far fewer people bother voting in the primary.Those that do usually have to be registered with the party whose primary they’re voting in, and they invariably hold more extreme views than the electorate as a whole. So, active members of the dominant party choose the congressman for virtually every district. By the time the general election comes around, the majority predictably sides with the candidate from their party even if a more centrist candidate would have been more popular as a whole. This is why during the presidential primaries candidates articulate more extreme views in order to gain the votes of the party “activists,” and then during the general election their views become more centrist, so as to appeal to the moderate voters in the middle who tend to decide the outcome. Because congressional districts are increasingly designed to not look like the average, there’s less reason to run toward the middle. What it means in practice is that the United States has adopted certain features of proportional representation, a practice followed in many European countries such as Germany and Italy. This may come as a surprise to many—one of the hallmarks of proportional representation is that voters choose a political party but not a candidate. The elected officials are chosen by the party, and the number

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of seats awarded corresponds roughly to the percentage of the vote each party wins. The United States has slid into a system of letting party activists select congressmen, as so few districts have competitive elections. There’s also evidence to show that Americans are on balance migrating internally to communities and states whose views they share (Gimpel, 1999). This is exacerbating the problems of gerrymandering, and has probably contributed to increased partisanship in the Senate as well. Because the issue of congressional districts doesn’t apply to the Senate (since each state elects two senators who represent the entire state), the committee-designed districts described earlier don’t present the same problem. However, partisanship is increasing in the Senate as well, and the trend is toward less competitive elections at the state level, too. These are bad developments in many ways. More extreme political views are clearly not conducive to a smoothly functioning democracy or to finding the types of compromise so badly needed to confront our fiscal challenges. California recently adopted a type of open primary in which the top two vote winners regardless of party engage in a runoff during the general election (known as “Top Two”). Washington State has done the same (Fair Vote). This may be a good solution. Instead of each party holding its own primary, there is just one big primary, and anybody can vote for candidates from either party. In many states, you can only vote in the primary for the party with which you’re registered. Under California’s new rules, the top two finishers in the primary go head to head in the general election. The ingenious feature of this system is that it draws candidates toward the center, toward more moderate positions. The reason is that in a district designed to heavily favor one party or the other (which applies to the vast majority), the second place candidate in the dominant party’s primary may in fact be more appealing to that district’s overall electorate. However, under the first past the post system, this more moderate candidate doesn’t make it to the general election because each party fields only one candidate. In California, a district that is heavily Democrat could have two general election candidates that are both Democrats themselves, if they were the top two finishers in the primary. Republican voters, although

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in the minority, will most likely favor the less strident of the two Democrats running, and this will have the effect of favoring the more moderate of the two. It’s an innovative solution and one that just may result in a Congress that looks a little more like the people who elect it. Lawmakers tend to hold more extreme views than their constituents. While there’s some reason for long-term optimism, the “Top Two” type of primary is still used in only two states: California and Washington (Fair Vote). It’ll be some years before their usefulness has been demonstrated and probably sometime longer before the idea is tried in other states. It’s also likely to be unpopular with both parties, since people who care enough to be active in politics tend to hold strong views on how to solve many of the problems we face. Open primaries may be part of the solution that brings democracy back to the people. Nevertheless, it’ll be a long struggle to get there. What it means for bond investors, though, is that compromise around a grand fiscal bargain is unlikely under most plausible scenarios. As Congress has become increasingly partisan, it’s become ever harder to find areas of common agreement. Because fiscal policy is an area of such huge philosophical differences in approach, legislators who express willingness to compromise run the risk of a primary challenge from someone in their own party hewing more closely to the orthodox line. An unfortunate result is that our government looks less and less like the people it represents. Congress reflects the more extreme views of each party because of gerrymandering and the decline in the number of competitive congressional races. American politics has a history of self-correcting moves to the extreme. While identifying the catalyst that will lead to improved legislating is hard, eventually Americans will probably just run out of patience and force change.

WHO SAYS THERE IS A PROBLEM? Another enormous challenge confronting those who sincerely want to improve the long-term fiscal outlook is that there’s no actual evidence that we have a problem. Most thoughtful observers, investors,

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regulators, bankers, and economists are all consistently voicing the same concerns. However, interest rates are low and likely to remain low. Inflation remains well behaved. Although, intellectually, voters can appreciate that current policies are unsustainable, there’s very little evidence of support for the belt-tightening necessary to improve the outlook. Polls reveal support for deficit reduction as long as it doesn’t involve higher taxes or reduced entitlements. Such an incoherent view is barely worth recording, so implausible is its implementation. It’s exacerbated by the absence of visible deficit-linked economic pain today. When President Clinton adopted policies that ultimately balanced the budget in 1998, the economy had the tailwind of falling interest rates to soften the blow.Yields on government bonds reflected a “deficit premium.” In countless testimonies before Congress, Alan Greenspan opined that constructive moves to reduce the deficit would be rewarded by lower interest rates on government bonds, which would provide an economic boost to offset the fiscal drag of higher taxes and reduced government spending. Greenspan as good as promised that the Fed would lower short-term interest rates as a reward for fiscal prudence. There was a visible carrot for a Congress that could be persuaded to act responsibly. Today, no such carrot is available because interest rates are already so low. It’s unclear whether bond yields incorporate any “deficit premium” because whatever message they might be communicating is distorted by the Fed’s steady buying of bonds to maintain low interest rates. The patient’s thermometer is unable to record his correct temperature because it’s being constantly dipped in a glass of cool water. Although few serious analysts question the orthodoxy that the deficit requires attention, the opinion polls reflecting such weak and heavily qualified support for dealing with it clearly reveal public ambiguity. For the majority of voters who don’t think about these things every day, one can understand the absence of unequivocal demand for action given the absence of warning signs and the certain pain such steps will require. Politicians promoting specific measures to improve the outlook have little they can point to by way of compensating benefit. A puritanical commitment to current sacrifice in order to save tomorrow is all they can call for. It’s hardly surprising

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that a generation nurtured on “consume today and sacrifice tomorrow” is unenthusiastic about a 180-degree shift. Long-term deficits have been caused by one generation choosing consumption today to be paid for by tomorrow’s taxpayers. It is a generational wealth transfer. The majority of today’s voters have shown themselves to be quite comfortable with their side of this economic shift. It should therefore not be surprising that, when presented with the opposite (foregone consumption today in order to benefit tomorrow’s taxpayers), they lose enthusiasm. Although there’s no bright line that separates the cohort of takers from the unfortunate younger Americans who have received the short end of the stick, what has taken place in the course of about a single generation is the largest intergenerational wealth transfer in history. This is why Reinhart and Rogoff raise the possibility that younger voters may choose policies that better reflect their status as the unwilling funders of the older generation’s retirement, as noted in Chapter 2. We are setting the stage for an intergenerational political struggle. It’s such an obvious question that it will inevitably gain political traction in the years ahead. The bond linking commitments made by an earlier generation to obligations of a later one is gradually fraying. Those who invest in 30-year long-term government bonds at today’s rates are recklessly betting against this likely fiscal awakening of younger taxpayers. In re-reading A History of Interest Rates (Homer and Sylla, 2005) recently, one of the themes that became clear to me was that throughout human history governments have borrowed money for generally two objectives: to fight wars and to build public infrastructure. This pattern is very clear over the past few centuries during which sufficiently detailed records exist. Even going back to Roman times and beyond, though the written records are increasingly sparse, the general picture is the same. The commitment to repay borrowed money has always been regarded as a solemn pledge, carrying with it a heavy moral obligation, insensitive to altered circumstances. Lenders might finance a war that lasted many years and required many more to ultimately repay. In practice, the citizens and taxpayers fulfilling the obligation might be the descendants of those who incurred it. A later generation might pay the bill incurred by the

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previous one. Given the existential risks presented by war between neighboring states, the moral duty to repay lenders can be equated with properly honoring the sacrifice of those who fought and died or were wounded. The investment in physical infrastructure, whether it’s a Roman aqueduct or a new airport, can similarly justify repayment by later generations given the typically long useful lives of such improvements. Roads, power distribution networks, water systems, and so on last for several decades if not a century or more. London’s sewer system dates back to nineteenth-century Victorian times. Today’s federal deficits have a wholly different moral standing. Whereas past obligations transferred to subsequent generations carried with them some tangible benefit, such as a successful war intended to preserve their freedom or infrastructure-aided improved living standards, today’s debts are quite different. A generation of Americans has promised themselves pensions and retirement health care, but neglected to put aside the money to fund them. Promises have been made. Many will claim they have paid in so they have “earned” these entitlements.Two expensive wars have been fought. Even discussing changes to Medicare and Social Security is fraught with political risk. Voters just don’t want to hear about changes to promises made. However, the problem is, these promises were made by approximately the same people now demanding payment. In a form of collective cognitive dissonance, the typical voter won’t accept that the commitments made needed to be funded. The fact that insufficient funding was made is self-evident; if it had been sufficient, we wouldn’t be facing a fiscal crisis. People live longer, and medical science is forever discovering new ways to cure diseases. These are all wonderful developments and should be celebrated. However, they carry with them financial consequences that people really don’t want to confront. The result is that an enormous obligation is being transferred by today’s retirees and the Baby Boomers on future generations. It is a most extraordinary moral failing. Blame can be affixed on any number of political leaders, but America is a democracy and the choices that have been made over 20 or more years were not the result of an undemocratic process. Politicians have done what they’ve been

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elected to do, which, as far as the deficit is concerned, has generally been inadequate. One way to look at this is to compare how the net worth of different age groups has been changing. Using data from the Federal Reserve’s Survey of Consumer Finances, the chart in Figure 6.1 shows median household net worth for various age groups. Older households have always been wealthier than younger ones. The disparity has been increasing steadily since 1989 (when the Fed began the survey) and has shot up in recent years. No doubt the 2007–2008 recession hurt younger households more, probably because they have more debt and are more leveraged. In the past decade, $1 trillion of student debt has appeared and that is borne mostly by households 45 years and younger. The Medicare Prescription Drug Benefit passed under President Bush in 2004, though not funded through tax increases, added $395 billion in future expenses over the subsequent 10 years, all to be funded with debt and only later paid for by taxpayers (Congressional Budget Office, 2004). Funding major commitments like these with debt avoids the scrutiny that would be received if current taxpayers had to pay for them. This was an intergenerational wealth transfer. What is also interesting about Figure 6.1 is what’s happening to the 55–64 age group, which is generally approaching retirement. A typical life-cycle approach to retirement savings would see net worth grow until retirement, at which point savings are gradually withdrawn to fund living expenses. In recent years, this pre-retirement age group of 55- to 64-year-olds has seen a sharp drop in net worth down to the same as the older groups, even though they have an additional 20 to 30 years or so of living expenses ahead of them. A study by the Urban Institute in 2011 (Steuerle, 2011) showed just how badly future generations are being treated compared with the present. Workers retiring over the past 50 years largely received more in Social Security than they paid in. This is adjusting for inflation and assuming a 2 percent real return on the premiums they paid, so it’s a pretty fair accounting. A single female retiring at age 65 in 2010 and earning the average wage ($43,500 in 2011 dollars) can expect to receive $185,000 in lifetime Medicare benefits after having contributed only $58,000 in

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45–54

65–74 55–64 75 or more 350

300 250 200 150 100 50 0

1989

FIGURE 6.1

1992

1995

1998

2001

2004

2007

2010

Median Household Net Worth by Age, 1989–2010

Source: Federal Reserve Survey of Consumer Finances.

Medicare taxes. A 2020 retiree can expect $275,000 versus $87,000 paid in (Steuerle, 2011). A one-earner couple at average wage retiring in 2010 can expect to receive $351,000 in lifetime Medicare benefits after having contributed $58,000. This is the scheme being perpetrated on future generations by today’s system. The shortfall will obviously have to be met by higher taxes on those still in the workforce, who therefore won’t enjoy the same gap between benefits versus what they paid in. It used to be that Social Security represented the biggest mismatch between taxes paid versus benefits received. However, reforms made under the 1983 Greenspan Commission on Social Security Reform created a much better balance. Health care inflation and greater longevity have caused Medicare to be substantially underfunded in the future. The chart in Figure 6.2 is simply based on existing law—it

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Soc Sec Net

Medicare Net

1980

2010

$200,000

$150,000

$100,000

$50,000

$0 1960

2030

($50,000)

FIGURE 6.2

Net Lifetime Benefits of Taxes, Typical Single Female

Source: Urban Institute.

doesn’t mean it’ll actually happen; in fact, the projected imbalance probably can’t happen because there won’t be the tax revenues to support it. The chart in Figure 6.2 shows how this has changed over the years. Each bar represents the net lifetime benefit for the typical individual (if positive) or cost (if negative). If the bar is positive, the typical retiree is getting more benefits than they paid for. If it’s negative, they’re getting less. Everything’s inflation adjusted, and taxes paid during a career are assumed to have been invested so as to earn 2 percent return over inflation. The chart in Figure 6.3 shows the same information for a typical married couple. I hear people say that they paid their taxes all these years and therefore they’re entitled to receive what they paid for. The problem is they didn’t pay enough. People live longer, and health care inflation has been faster than was budgeted, so the numbers don’t add up.

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Medicare Net

1980

2010

127

$400,000 $350,000 $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 $0 ($50,000)

1960

2030

($100,000) ($150,000)

FIGURE 6.3

Net Lifetime Benefits of Taxes, Typical Married Couple

Source: Urban Institute.

Today’s retirees may believe they’re simply receiving entitlements. In fact, they’re borrowing from future generations because collectively they failed to save enough money. It’s not the fault of just one political party. The problem’s been developing for a long time, but voters don’t want to hear about higher taxes and, sadly for today’s young people, they didn’t have an opportunity to vote when the needed decisions were not being made. The Economist published an article called “Sponging Boomers” (2012) to highlight this problem. This is what will weaken the moral obligation of Americans to honor past debts. They’ve been incurred through moral failure. Perhaps democracies are singularly ill-suited to handling the transfer of intergenerational obligations. How does an elected official ever make the case for sacrifice today in exchange for benefits much later? While parents make enormous sacrifices to secure a better future for their children, the same biological imperative doesn’t exist when the future isn’t genetically connected.

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LOOK TO THE FUTURE This discussion is not taking sides. Readers of many different political persuasions can hopefully find common ground with the assessment I have provided. It’s so often true that consensus on the cause of the problem is more easily found than agreement on the solution. The purpose of highlighting the inter-generational wealth transfer that is taking place is to present its risks to the bond investor, for that is to whom this book is aimed. Today’s investors in long-term bonds planning to hold securities for 10 years or longer must consider the fact that as time goes by and the composition of the taxpaying electorate shifts, they’ll increasingly be relying for repayment on people who didn’t choose to incur the indebtedness in the first place. Because the tangible benefits of today’s borrowing will not be apparent to tomorrow’s taxpayers, resulting as it is from retirement benefits that were unfunded, the moral obligation to honor them may well be far weaker. In fact, it should be weaker. To take a simple example, my children are growing up to inherit a far worse fiscal outlook than the one I inherited. They didn’t have an opportunity to express a point of view on deficit-funded retirement benefits. In the early years of this debt creation, they weren’t even alive. So when important public policy choices of the future are increasingly limited by the cost of servicing this debt, how do we suppose the next generation will react? How should they react? How strong an obligation will they feel to repay those that funded that for which provision should already have been made by the beneficiaries? Of course we don’t know. My personal advice to them is that their generation has been shafted by the previous one. Although it’s not a big political issue today, I think as time passes and interest expense on existing debt consumes a bigger share of government expenditures, it will become one. Remember the debt buildup has taken place to fund retirement benefits for which sufficient provision was never made. Approximately the same people promised themselves something, didn’t save for it, and so borrowed the money instead. For this reason the moral obligation to repay the debt isn’t nearly as great as it might be. In fact, its imposition on later generations is itself immoral.

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If the politicization of debt repayment doesn’t seem plausible, consider for a moment how the voting taxpayers of the past 20 to 30 years, who to a large degree caused this problem, would have reacted to different circumstances. Suppose a generation that happily borrowed to provide for its retirement had instead faced constraints on its ability to collectively spend as it chose because of poor decisions by earlier generations. I imagine there would have been considerable dissatisfaction and much debate about what to do about it. Or take a look at southern Europe, where austerity is already a highly unpopular consequence of poor fiscal management. Greece’s debt ultimately had to be restructured (i.e., partially written off) because politically the country was unwilling to divert an increasing portion of its economic output to servicing it. So far, not a single Eurozone country faced with debt-induced cutbacks has voted in favor of such policies (although Irish voters have been remarkably cooperative). Will American voters quietly accept a smaller federal government when faced with an increasing budgetary burden from interest payments on debt? Providing lenders with a return above inflation would certainly seem like a needless waste of money.

LOOKING AHEAD So now let’s look ahead another five, or ten years, and consider some plausible outcomes. Assume that nothing dramatic has been done to improve the fiscal outlook for the reasons noted above. Meanwhile, interest expense has continued to crowd out other discretionary forms of expenditure, and entitlements remain largely unreformed (because the recipients still vote). An increasingly large group of taxpayers will be facing a future of repaying debt incurred to fund entitlements even while their own prospects of receiving the same retirement benefits are receding. What are some relatively painless ways to mitigate the burden? A default can be largely ruled out. While a plausible case can be made by those who didn’t borrow to refuse repayment, a failure by the U.S. government to meet its obligations would most certainly create enormous financial chaos, provoke a recession or worse in the

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United States and around the world, and would not be in anybody’s interests. Expecting or advocating such an outcome is a fringe view, and, while nothing in life is certain, I think this one has about as low a probability as any outcome you might consider in investing. However, a stealth default aided by inflation is a far different and more likely outcome. First of all, negative real bond returns, which is what happens when interest rates are below inflation, isn’t a widely accepted event of default. It results in the lender receiving back less than the amount they are owed when adjusted for purchasing power, and they are clearly worse off. It’s been a time-honored way for governments to ease the pain of debt repayment for centuries. Allowing inflation to erode away the real value of borrowed money is a form of wealth transfer from savers to borrowers. And, in fact, the United States has been doing just that since 2008. The Federal Reserve has maintained interest rates close to 0 percent for short maturities through their management of the federal funds rate, and they’ve pushed bond yields down to levels below inflation through their buying programs known as quantitative easing. One can debate whether these policies have been good or not—I’ll leave that for others. For the bond investor, the question is: how long will they continue? The relatively light public opposition to this steady transfer of real wealth from savers to borrowers is not entirely surprising. Lenders seeking safety in government bonds have been helping those who borrowed too much by allowing the real cost of debt service to be low or even negative. Buyers of high-grade corporate bonds, whose yields are tethered to governments, are scarcely better off. In fact, it’s likely that the beneficiaries of this low-interest-rate policy are far more numerous than the benefactors. The typical American household owns an inflation-sensitive asset (a house), and many of those have an inflation-insensitive liability (a fixed-rate mortgage). House prices will rise in step with modest inflation while the amount they owe will remain fixed in dollars that are worth less.The household balance sheet holding a house financed with fixed-rate debt would prefer 3 percent inflation to 2 percent.With most American households in this position, isn’t a little more inflation an appealing policy? In fact, aren’t persistent negative real yields good for this borrower? There are many

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dangers to high inflation, and no one benefits from hyperinflation that distorts prices and paralyzes decision making. However, would a little more really hurt? A 2011 research paper by Carmen Reinhart and M. Belen Sbrancia made the case for financial repression as a time-tested way for a government to pay down its debt. They show that paying interest rates below inflation has been used in the past to steadily reduce the real value of money owed. In fact, real rates were low in the United States from 1945 to 1980. This made repaying the debt from World War II less painful than might otherwise have been the case. Maintaining low interest rates is a form of tax, what Reinhart and Sbrancia refer to as a “financial repression tax” (Reinhart and Sbrancia, 2011). At times during this 35-year period, real rates averaged negative 3.5 percent, a substantial penalty forced on savers who had few equivalent investment choices at their disposal. The savings for the government were substantial, amounting to 2 to 3 percent of GDP. Great for the taxpayers, but equally poor for the bond investor receiving back currency worth less while receiving inadequate coupons—on which additional taxes were paid. As a bond investor, it creates a big incentive to find alternative ways to invest your money. This wasn’t just a strategy pursued in fairly recent economic history. Following the Napoleonic Wars, Britain had debt outstanding of 260 percent of GDP. Forty years of “financial repression tax” reduced it to just 100 percent. Today, developed government bond markets are increasingly dominated by nonmarket players with motives often at odds with those of traditional lenders. It is creating substantial distortions. Critics will argue the Federal Reserve is independent, that they will decide on their own when interest rates ought to rise at which point “normal” conditions of nominal rates 1 to 2 percent above inflation will prevail. Perhaps this will be so, although in reality the Fed’s independence is more conditional. Congress has set a twin mandate of maximum sustainable unemployment consistent with stable prices. It’s a reasonable objective and has served us well for many decades. But the key is that Congress sets the objectives and Congress monitors them. Administrations rarely applaud a rise in interest rates, and the increasingly more populist direction in which the country is moving

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helps feed the cheap credit addiction. Individual U.S. borrowers are far more numerous than individual lenders in America. A political acceptance of the need to raise interest rates would require the majority to accept the need to reverse the transfer of real wealth back in the direction of the lenders. It’s happened many times in the past and will certainly happen again, though perhaps next time it will be slowly and with much reluctance. As a bond investor, you’re making the bet that inflation will be diligently held in check. And yet, the equanimity with which low returns are received is telling. Congressmen focus on unemployment, Chinese currency manipulation, or the bank bailouts during the Fed chairman’s appearances, and not about how he’s harming bond investors through the erosion of their purchasing power caused by low rates.That’s because there aren’t many votes in that line of questioning. High interest rates are perceived to benefit banks—for good reason since traditional banking seeks a wide spread between deposit rates and loans. Helping banks or wealthy savers is not something any congressman with an eye toward reelection will want to be seen doing. So the test will come when the Fed finally decides it’s time to begin “normalizing” interest rates. Clearly, given the size of the Fed’s holdings, financial markets will be highly sensitive to their exit strategy. The potential exists for rates to move higher, faster than anybody wants. At that time, the response of Congress and the administration will be important. Depending on the circumstances, including the level of unemployment and the overall strength of the economy, the criticism of this change in Fed policy might be quite severe. As well as harming the majority of voters (whose household balance sheets are biased toward inflation as discussed above), it will also increase the government’s own cost of borrowing and therefore increase pressure on other forms of discretionary spending or lead to higher taxes. Given the absence of any popular opposition to low interest rates, we may anticipate the outcry over rising rates may be quite vocal. And while the Fed is independent of Congress, they’re not immune to congressional feedback. Nor should they be—we do, after all, live in a democracy. In fact, if negative real rates benefit the majority, isn’t it entirely reasonable for that condition to persist? The future is uncertain, although the bond investor betting against such forces and assuming that the next rate cycle will unfold as they have in the

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past three decades does so at his peril. There are many reasons to expect that interest rates will stay close to or below inflation for some time to come. Inflation may rise, and interest rates will follow them. However, investors are not likely to escape negative real returns. For many centuries, inflation was less of a potential problem than deflation, other than during times of war (Homer and Sylla, 2005). The 1970s was a rare case of peacetime inflation. However, the United States has maintained a war-ready military capability more or less since World War II, with a brief hiatus between the collapse of Communism in the early 1990s, which ushered in a “Peace Dividend,” and the 2001 attack on New York’s World Trade Center. So a return to nominal rates above inflation that offer a fair return to lenders appears more hopeful than likely. A society that has borrowed excessively has an incentive to allow inflation and low rates until the point at which they’re clearly negative for overall economic growth. Such a condition may prevail for many more years.

MONETIZATION—A THOUGHT EXPERIMENT The Fed holds around $3 trillion of U.S. government debt (Treasury securities and agency-issued mortgage backed securities) on its balance sheet (U.S. Federal Reserve, 2013). Stabilizing the financial system and pursuing low interest rates through quantitative easing has resulted in the Fed buying a lot of bonds. Many economists predicted this would be inflationary, and it may be, but so far inflation has been well behaved. The Fed’s credit creation has not translated into debt monetization, as some had feared. Whether or not you like the Fed’s policies, the overall criticism of them is muted. The bond investor need only concern himself with various outcomes and assess the probability of those taking place. The emergence of the Federal Reserve as the largest holder of U.S. government debt has occurred with very little political opposition. Although the Fed is nominally independent, its ownership of large amounts of government bonds makes possible an intriguing thought. When the Fed buys bonds, what’s really happening is that the U.S. Treasury issues debt through the primary dealers, who then

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turn around and sell it on to the Fed. In effect, the Treasury has issued bonds to the Fed. It’s no different than if they did the transaction directly with one another. The Federal Reserve is a government agency. They remit all of their profits back to the U.S. Treasury annually. The transaction whereby the Treasury sells bonds to the Fed is really just a bookkeeping entry. Assets and money simply move from one pocket to another. Indeed, on a consolidated U.S. government balance sheet that combined all government agencies including the Treasury and the Fed, these debts would disappear. Since the Federal Reserve remits all its profits back to the Treasury, in effect the federal government is funding a substantial portion of its needs at 0.25 percent. This is the interest rate the Fed pays on reserves that it uses to fund its own holdings of government debt acquired through quantitative easing. Since the profit between the interest rate the Fed receives on bonds and its own cost of funding belongs ultimately to the Treasury, it means that the Fed’s cost of funding is the government’s. Assuming an average spread of 1.5 percent on the Fed’s $3 trillion balance sheet produces a “profit” of $45 billion. “Seignorage” (which includes profits from issuing currency although that’s a relatively smaller item) was worth $89 billion annually in profits returned to the U.S. Treasury (“The Other Side of QE,” 2013). Currently, this money goes toward reducing the deficit by lowering the Treasury’s overall cost of borrowing. At some point when the Fed begins to unwind its huge portfolio of bonds and allows rates to rise, the Treasury’s cost of funding will move up sharply. It’s likely the Fed will seek to ensure rates rise only slowly. The risk of triggering another crisis probably ensures a cautious approach in which the risks of falling behind inflation outweigh any benefits from being preemptive. In fact, if the Fed raised short-term rates too fast, they would quickly begin running at a loss, when the average rate on their borrowings rose above the yield on the bonds they still hold. The budget support the Fed’s activities have provided would cease. There would obviously be political consequences if Congress found that the budget deficit was wider because of the Fed’s financial results. Although Congress wouldn’t have to actually fund operating losses (since the

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Fed can in effect print money to fund its losses), it’s likely that the then–Fed chairman would spend more time testifying in front of Congress than in the past. Since the losses would be exacerbated by higher rates, it’s implausible that the Fed could be indifferent to the politics and the optics when deliberating on interest rate policy. This illustrates that the Fed is less politically independent than they’d like to believe, and pretty much assures that they could not raise interest rates sharply, even if economic and inflationary conditions warranted it. It’s another reason why negative real rates will be here for a long time. The mischievous bond analyst therefore wonders what would happen if the Treasury didn’t repay the bonds. Suppose $10 billion of old five-year notes yielding 1 percent matured, and the Fed told the Treasury it didn’t need to repay them? At this point most economists will throw up their hands at the impossibility of such an outcome. They’ll warn of the market chaos that would ensue and the immediate collapse of confidence in the U.S. dollar. Such an outcome is fanciful and utterly implausible. Of course, it probably is. I don’t expect it. Consider for a moment, though: such an outcome would not require any movement of funds; would be voluntary by the investor (the Fed), and therefore not imposed on any private investor in government bonds; and would create no injured party. In fact, if the government published only a consolidated balance sheet that aggregated all its assets and liabilities, there would be no way of seeing this transaction take place! What if debt forgiveness was altogether milder than the total writeoff of an issue just described. What if the $10 billion of old five-year notes yielding 1 percent just described are maturing and prevailing rates on new five-year notes are 2 percent. Suppose the Fed agreed to simply roll over the maturing notes at the same 1 percent yield? Given that prevailing rates are higher, the Fed would in effect have paid par, or 100, for a security that ought to cost around 95. Would this be a big deal? Many expected quantitative easing to lead to high inflation, which it hasn’t. Given that the Fed remits all its profits to the Treasury anyway, does it really matter if the Fed invests in Treasury debt yielding less than market rates? Who is the injured party? Done gently in this way, a very modest form of debt monetization might well be politically acceptable if the economic

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consequences were not severe. Saving 1 percent on $10 billion in debt would represent $0.5 billion in reduced interest expense over five years. This could be very appealing to a Congress grappling with the challenges of balancing a budget. Who’s to say it couldn’t happen? It hasn’t received much attention, but for the bond investor the risk is that it may. If the political process finds negative real rates useful and is willing to tolerate some risk of higher inflation, these are stark warnings to the bond investor that he should take his money elsewhere. The government continues to be a substantial buyer of bonds in pursuit of their objective to maintain low interest rates. Interest rates would probably be higher if the government had adopted a passive approach. Again, the bond investor shouldn’t get hung up on whether it’s enlightened policy or destructive, but should focus on its continuation and the likely outcomes. Frankly, if the government purchases bonds in such size to distort interest rates through their actions, the disciplined bond investor should step aside. If the Fed likes bonds so much, let them own the lot!

IMPERIAL OVERSTRETCH Paul Kennedy’s 1987 book The Rise and Fall of the Powers (mentioned in Chapter 2) was a seminal work, tracing the history of many great empires throughout history as they reached the pinnacle of their success through economic and military dominance only to lose influence through competition and excessive commitments. Great Britain, where I grew up, was the last great power before ceding the role to the United States. World War II was the defining event that exposed Britain’s imbalance of commitments versus resources and highlighted America’s rise as a dominant power— ultimately, the sole superpower. Re-reading Kennedy’s book some 25 years after its publication reveals some now quaint assumptions. In the 1980s Japan was the rising power, and their growing economic influence, powered by a relentless export-driven economy, led many to fear that they’d eventually dominate every market. It didn’t turn out that way as the Japanese stock market peaked not long after Kennedy’s book

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(in 1989), and two decades of lost growth ensued. The weaknesses in Japan’s highly leveraged banks, as well as its poor demographics, had been missed by most observers, including Mr. Kennedy. Funnily enough, the U.S. deficit was of great concern back then, too, with many dire warnings about the perils of inaction. What followed were the strong economy of the 1990s and the budget-balancing policies of President Clinton. Long-term forecasting isn’t easy. Paul Kennedy identified some big themes in his book that are still valid today. He coined the phrase “imperial overstretch” (Kennedy, 1987) to describe what happens when a great power’s commitments to its empire exceed its resources. Time after time, history has shown that maintaining a large military empire consumes an increasing share of economic resources. In fact, President Reagan’s insight was that the Soviet Union’s sclerotic, centrally planned economy wouldn’t be able to match the growth in U.S. military capability without sharply reduced domestic nonmilitary consumption. The United States outspent the Soviet Union because its economy was so much more dynamic. Even though Kennedy’s book is more than a quarter century old, the insights he draws about great powers in history whose relative ascendancy lasted a century or more, are still highly relevant today. He compares America’s situation with those of Spain around 1600 and Britain around 1900. Both countries had taken on “a vast array of strategical commitments . . . made decades earlier, when the nation’s political, economic and military capacity to influence world affairs seemed so much more assured.” Kennedy goes on to warn that U.S. leaders “must face the awkward and enduring fact that the sum total of the United States’ global interests and obligations is nowadays far larger than the country’s power to defend them all simultaneously.” Kennedy’s words highlight the inevitability of the choices the United States will have to make. Many may criticize the characterization of the United States as possessing an empire. America constantly promotes key values such as human rights, liberal democracy, and free markets. In this regard I believe it is a truly great country, a shining light for so many people around the world not fortunate enough to enjoy those same freedoms in their own country.

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Promoting American values has turned out to be not just morally right, but in America’s interests, too. Unfortunately, though, as admirable and almost romantic as this vision is, the inexorable truth of the math is that it will ultimately not support the military capability to project it globally forever. In 2011 the United States spent 4.7 percent of its GDP on defense (World Bank, n.d.). During the Cold War it was above 5 percent (Chantrill, 2013) and in World War II reached as high as 10 percent. It’s far more than other developed countries. The United Kingdom (2.6 percent) and France (2.2 percent) are also threatened by terrorism, which is probably today’s foremost challenge, and nevertheless manage spending levels less than half of the United States. Germany and Japan are lower still, but their defeat in World War II still acts as a restraint on the development of an assertive military.Very few countries devote more of their output to their military than the United States. Exceptions include Israel (6.8 percent). That is hardly surprising, given their neighbors and history. Even Afghanistan is 4.4 percent in spite of the ongoing civil war, and Pakistan is at 3 percent, although it, too, faces substantial threats within its own borders. Because the U.S. economy is so large, when you compare our military expenditure in absolute terms with the rest of the world, the difference is remarkable. The Peter G. Peterson Foundation calculates that in 2011 U.S. defense spending at $711 billion was more than the next 13 defense budgets combined (Peter G. Peterson Foundation, 2012). This group consists of China, Russia, United Kingdom, France, Japan, India, Saudi Arabia, Germany, Brazil, Italy, South Korea, Australia, and Canada. The U.S. military capability is admirable and completely in a class of its own. Is this enough to justify outspending others by such an enormous margin? Is the world really such a dangerous place? Is the United States truly that threatened? The 2001 attack on the World Trade Center in New York altered our strategic compass appropriately and dramatically. Terrorist threats will never fully disappear, and no country can assume it is ever totally safe. However, the numbers are unsustainable, because the U.S. percentage of global GDP is shrinking (Data 360, 2007). U.S. economic leadership following World War II provided the foundation for several decades of military

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leadership. Growth in the developing world, notably China and India, but also in Brazil and many other smaller countries, is inevitably reducing the economic dominance of the United States. As America’s share of GDP falls, the capacity of other countries to spend relatively more on their military increases. So, although the United States doesn’t control a vast empire in the way that Spain or Britain did in the past, it spends on its military as if it does. Britain’s challenges culminated in military victory in World War II, which was accomplished at the cost of virtual bankruptcy. Defending Britain’s far-flung empire was beyond her economic resources because other countries had grown their economies and therefore their military capabilities and also because Britain’s commitments were too big. Paul Kennedy notes the strain imposed on the British Army by maintaining the ability “to fight on the Northwest Frontier of India or in Belgium” (Kennedy, 1987). U.S. military doctrine has long maintained the need to fight two wars simultaneously, reasoning that engagement in one major conflict could invite an aggressor to provoke one elsewhere. The parallels are similar. The world has seen this movie before. Inevitably, the United States will have to accept a world of multiple powers where we have less ability to control events. Regrettably, bad things will happen that violate our moral values, and we will not have the resources to tackle them alone. Campaigning on constraints to American power is not a popular political message and sounds a lot like accepting America’s decline. Few politicians spend much time on it. Even so, America isn’t in decline—at least not yet. Many economic policies in China and India that for decades robbed those countries of their potential have been reversed over the past 20 years. Communism’s fall in the 1990s freed up tens of millions of additional workers to be more productive. In fact, America’s falling percentage of global GDP is due to the adoption of Western capitalism in so much more of the world. American values are prevailing. The fact that China’s economy will be bigger than America’s within the lifetime of most people reading this book is the inevitability of their far larger population. Nevertheless, GDP per capita, or average incomes, will be greater in the United States for far longer. It’ll be generations before living standards in developing

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countries converge with Western ones. However, total economic output is what matters in terms of the size of military a country can support. Over time, those constraints will impose themselves just as assuredly as they have on other countries in the past. It’s unclear whether as a nation we’ll have the good judgment to recognize and adapt to them in time or will bankrupt ourselves as we exceed them. But the direction seems pretty clear. The United States today is probably the most benign empire the world has ever seen. Even Britain’s enlightened dominion forced trade flows from its far-flung charges through Britain. Historians debate whether India’s physical infrastructure, legal system, and democracy, all benefits of British rule, sufficiently offset the vast wealth transfer that took place through the forced trade of raw materials to the United Kingdom at controlled prices. By the standards of the day, Britain ruled its empire fairly, but its history is not without blemishes. Some may even question the notion that the United States possesses an empire, citing lack of sovereign control over large areas of the world or population centers. The United States has not annexed territory since the Mexican War (1846–1848), which brought California and the vast territory from there to Texas including New Mexico, Nevada, and Utah within its borders. In terms of global influence and military power, the United States is clearly an empire. It projects its democratic values and free-market capitalism as broadly as possible, for which the world is undoubtedly a better place. America is the world’s moral leader, perhaps more ready to go to war over values than any other country in the world. When Iraq invaded Kuwait in 1990 and the United States led an allied force to repel them in 1991, U.S. popular opinion at the time, with overwhelming support from the United Nations, backed a war of right versus wrong to free the Kuwaiti people from an oppressive foreign dictator. Clearly, Iraq posed no direct military threat to the United States, and while, no doubt, geopolitical objectives played an important role in George H. W. Bush’s decision to eject Iraq’s military, popular opinion fell in behind the moral rectitude of Desert Shield, which became Desert Storm. Only America and Britain have led others to fight a war on such terms.

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MORE DEBT MEANS MORE BANKING America’s debts grew in tandem with the size of banking on Wall Street and in “The City,” as London’s financial district is known. Financial innovation aided by desktop computers led to increasingly complex securities and risk, as loans were bundled together and then sliced up in order to meet the needs of every conceivable investor around the world.The origination, trading, and management of more complex products led to more sophisticated forms of market making. Banks built businesses that bought and sold risks rather than assets. Derivatives allow for the easy separation of the asset from its economic outcome, and a new generation of markets, traders, and risk concepts was born.

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CHAPTER 7

MANAGING RISK 1990–1998 Risk-Oriented Market Making

During the approximate quarter century from the 1980 peak in global interest rates to the 2007–2008 mortgage bubble, financial services and investment banks were transformed enormously. Banking evolved from the staid activity of deposit taking and lending to handling unrecognizable financial complexity. The business of channeling savings to productive forms of capital formation, the fundamental purpose of banks, became steadily removed from dayto-day activity. The interest spread—what banks earn on the difference between deposit and loan rates—gradually lost importance. Fee income, whose generation often used very little capital, gained in importance. Market making revenues are analogous to fee income; they tend to be stable, and because the business of making markets involves constant turnover of inventory, the risks are usually handsomely compensated. However, because market making requires some appetite for risk, it blurs the line between providing a service of liquidity to clients and taking proprietary positions. Indeed, I don’t believe it’s possible to define a discrete difference between them. A riskaverse market maker will do no business because his prices will never be competitive if he has to ensure that every trade can be 143

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profitably offset. A proprietary trader indifferent to meeting the liquidity needs of clients will do little or no business, since he’ll only trade with clients where it suits him, which most clients will find unsatisfactory. Successful market making—and by successful, I mean generating an acceptable return on capital while also providing generally competitive pricing to clients—requires a risk tolerance large enough to facilitate trades, although not so large as to dominate the activity. It’s impossible to define precisely. While risk-averse market making and client-insensitive proprietary trading would be easily recognizable to the informed observer, the vast gray area in between is open to substantial judgment. Reasonable people could easily disagree over how much money a trader was making from client flow versus maintaining profitable risk positions. In my own experience, as managers of market-making businesses in fixed income and foreign exchange, we couldn’t even figure it out precisely ourselves. We could only estimate it. We knew, for instance, that the market-making trader in, say, the dollar/yen foreign exchange (FX) market should make $5 million in trading revenue because of the client flow. It came from a mix of being able to lay off client trades profitably and being able to hold selected positions to profit from advantageous market moves. You can’t separate the two completely; the activities are to a large degree symbiotic. A $15 million year might be accompanied by increased client flow, but that flow might also increase risk-taking opportunities. This is why historically traders in market-making positions have received a smaller percentage of trading revenues in compensation, because they are to some degree monetizing the client franchise of the bank. Wall Street gravitated toward increased risk taking in support of its market making as securitization became an increasingly important way of distributing risk. The carving up of mortgage pools into tranches of declining seniority often requires finding a buyer for the most junior, most risky piece. Imagine selling a year’s insurance that pays off for each foot of a house’s wall that floodwaters reach, in a neighborhood that doesn’t often flood, though it is not actually in the desert. The premium required to protect against the 10th

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foot being reached is pretty low because it’s never happened. The first foot is obviously the most expensive insurance because in any flood it’s getting wet. This junior tranche in any pool of securities that’s being carved up into tranches is the piece the bank wants to be sure to sell. In a mortgage pool, it’s the place that any losses on the underlying mortgages will go first, until it’s used up. The problem in 2007–2008 really was the 1,000-year flood, in that all the buildings turned out to be in similar neighborhoods. Moreover, there were many other problems, such as underpriced insurance and excessive complexity. The blame goes further than the homeowners and these flood insurance underwriters for 2007–2008 crisis. Public policy of increasing home ownership through lower mortgage standards was pursued by both political parties. Combined with low interest rates, poor regulatory oversight by the Federal Reserve, relaxed mortgage standards, and animal spirits of increasing home prices, the stage was set for a housing bubble and its burst. Popular opinion blames Wall Street, and while it’s not blameless, this is far too simple a narrative. Today’s investor cares about the explanation only to the degree that it affects future investment returns. A populist backlash against banks is under way, and regardless of its justification, our focus is on assessing its likely consequences for public policy toward interest rates.

TRADERS AND RISK Complicated financial instruments are simply more profitable for the people that manufacture them. Because they tend to be illiquid, they’re hard to price. Breaking them down into components is not easily done without access to price information on all the bits, something banks possess far more readily than their clients. The shift into ever more complicated financial instruments often left the banks with residual risks that they judged too expensive to lay off, so they would choose to retain them. These risks can often be extremely obscure, exposures to financial variables unrecognizable outside the world of derivatives traders at banks

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and hedge funds. They are secondary risks, basis risks between related instruments. Exposure to the basic building blocks of interest rate, FX, and commodity and equity prices is easily hedged, so banks routinely lay that off. Many other quantifiable, though less easily observable, risks remain. The swaps business at Manufacturers Hanover Trust in the 1980s was very focused on generating arbitrage profits with as low risk as possible. When a swap was traded, we’d hedge it with eurodollar futures quickly and precisely, to lock in the profit on the transaction and avoid any unnecessary market exposure. Traders all spend so much time watching markets tick up and down second by second that it’s almost unavoidable to develop views on where prices will move over the next few minutes, as well as days and weeks. Some are very good at it, although few are as good as they think they are. I’ve known many traders over the years who believed that their profits from market making were largely attributable to their own markettiming skill and that the client flow was inconsequential. Because trader compensation is a lower percentage of revenues for market making than for traders who are purely proprietary (i.e., don’t trade with clients at all), traders usually have an incentive to downplay the value of the client business. Sometimes they’ll decide to leave it altogether and become a proprietary trader, where they’ll receive 100 percent credit for their revenues without having to share any with salespeople. They may do this at the bank or at a hedge fund (although the recent Dodd-Frank legislation pretty much precludes being a proprietary trader at a bank). One trader complained to me so consistently and bitterly about clients forcing him into risk positions he didn’t want that I offered to make his life simpler by removing him entirely from talking to salespeople. Although I thought I was solving his problem, he quickly rejected such a simplification of his life, claiming that he “needed to see the client flow” in order to be profitable. More often than not, the successful market-making trader discovers that the client flow was rather more valuable than he had conceded, even to himself. Another trader who often generated very good profits making markets to clients through the recurring FX volatility that preceded the euro in the late 1990s became a proprietary trader

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(i.e., gave up trading with clients) because he wanted to demonstrate how his profit-and-loss (P&L) was fully the result of his own skill. He was never profitable again and eventually left to try and start a hedge fund (which was a failure). Successful proprietary trading is one of the rarest skills in finance, which is why those who are good at it run hedge funds where they can truly maximize their compensation. Many more traders claim skill than actually possess it. The use of leverage (inevitable if you’re to earn an acceptable return on capital) magnifies the impact of timing. An unleveraged investor in an unleveraged company can be early committing his capital but, assuming he’s invested in a sound business that doesn’t actually go bankrupt, time will ultimately bail him out. As the investor adds leverage, he forfeits patience and becomes a trader; the path the company’s stock price takes now assumes importance. This analogy applies to any investment in traded securities or futures.Traders care about timing because poor timing will cause leverage to wipe them out. Although I traded with leverage for years, we don’t use it to invest, nor do we invest in companies with more than modest leverage. Selecting good investments is hard enough without having to get the timing precisely right as well. While low-risk market making in which we hedged away risks so as to lock in an arbitrage profit characterized our early years in derivatives trading, as time went by our risk tolerance increased. This was driven by declining margins—in any new market, arbitrage profits are soon whittled away through competition, and the interest rate derivatives business was no exception. Arbitrage spreads came in as volumes increased, but the result was more risk for the same profit. We found that we could add value through more flexible risk taking. The numbers showed this, and the bank first tolerated more risk and over time embraced it as an additional source of revenue.

WHY TRADERS ARE BAD AT BUDGETING Before long, annual budgets for trading businesses incorporated an assumption of profitable risk taking on top of the value added

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from client trading. Managing traders through this budgetary process is quite challenging. The annual bonus cycle dictates that toward year’s end whatever results a trader has generated are characterized as obtained in a very difficult market. This theoretically makes them more valuable in the back-and-forth over year-end bonuses. When it comes to budgeting for next year, the prior year’s trading outcomes are suddenly the result of fortunate circumstances (once the relevant bonus has been paid), and future conditions cannot be expected to be nearly as cooperative. I can’t even count how many times I had a trader who’d just generated, say, $10 million in annual trading revenues tell me sincerely why we should budget for him to make only $2 million the following year. The problem is that adding up 25 conservative forecasts for trading profits from 25 traders seeking to manage expectations results in a budget that is about one third of the prior year’s actual results. Few businesses, in finance or any other industry, will find that an acceptable way to plan for next year. However, in this regard, trading is somewhat analogous to returns on individual equities in that you’ll always get some outliers or extreme results. In my experience managing traders, results had positive skew, meaning the average is greater than the median. While the average trader in this example might make $5 million in profit, a few traders generating $20 million each will pull that up and the typical (or median) trader might only generate $3 million. In managing a portfolio of traders or securities, you need to expect some outliers. In the trading case, we solved the problem by developing budgets that were individually somewhat high (at least as viewed by each trader) but that in aggregate reflected the expectation of a few positive surprises somewhere across our portfolio. Steadily, our risk-oriented market making grew and provided generally reliable profits. The interest rate derivatives business of Manufacturers Hanover Trust merged with Chemical Bank in 1991, when those two banks combined, and then with Chase in 1995. Interest rate products included bonds, swaps, FX, and futures and options on all of them. These trading businesses came to be known as the “rates business.” Essentially, they included most of what banks

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traded, excluding equities. Because equities are largely exchange traded, the market-making function is far less profitable for banks than in the rates business. Equity markets—and the U.S. public equity markets in particular—provide some of the most accurate price information and cheapest access of any securities market. Bonds are far more biased against any but the largest investor, as discussed in Chapter 4. Structured notes are orders of magnitude worse. So many large investment banks put all the products in which they could profitably act as market maker within the same division. In the stock market, once a desired stock has been selected, the investor, big or small, gets a pretty fair shake when it comes to the cost of committing his money. Users of bonds would benefit immeasurably from similar levels of price transparency. As nominal yields fall, these transaction costs take an increasing share of the potential return. Because bonds are so unappealing on their relative return prospects, improving their transparency and reducing the costs of execution would seem more important now than ever.

THE GROWTH OF GLOBAL TRADING During the 1990s and beyond, JPMorgan and its predecessors saw their rates business reliably grow in profitability and volumes. When you’re in the midst of it, nothing seems routine. Every year’s different, every major market development is challenging. Hedging techniques become more sophisticated, as ever more subtle risks are identified, sought, managed for profit, or eliminated. Looking back, there were many great years as we participated in the steady growth of financial services. Broadly speaking, twin bull markets in bonds and stocks were increasing investor appetite for returns. The search for returns increased risk appetites: more leverage, more illiquidity risk, more credit risk in order to meet performance objectives. The movement of savings to productive forms of capital formation was increasingly accomplished through active money managers driven by asset gathering and short-term performance measurement. This exacerbated a principal-agent problem that is prevalent in finance, in that success

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for the agent (money manager, investment bank) is not as closely aligned with success for the principal (client) as it might be. Much of the growth in hedge funds has been assisted by agents (consultants, funds of hedge funds) whose business models rely on asset growth driving their fees far more than the appropriateness of hedge funds for an investor. I pointed this out in my previous book, The Hedge Fund Mirage (Lack, 2011), and it continues to be true today. While the overall history of the 1982–2007 period was one of trading successes and wealth creation for financial services firms, the anecdotes that reveal minor setbacks are often far more revealing. In the years leading up to the creation of the euro, there were many more European currencies to trade, and we had traders specializing in most of them. Interest-rate-sensitive products were grouped together, so the deutsche mark trader, for example, would trade deutsche mark swaps, forward rate agreements, FX, futures, and government bonds. Identifying trading opportunities across these similar though not identical markets was a huge money maker for many years. Until the currency relationships of the Eurozone were fixed in 1999, the central banks of each country managed the value of their currencies against their neighbors so that they remained within an agreed-upon band. The convergence trade was a bet that Italian bond yields would eventually fall to meet those of triple-A-rated Germany once they had dropped the lira and the deutsche mark to both use the euro. And this happened, although as subsequent events have shown, the assumption of credit risk equivalency across the Eurozone (the idea that Greek debt is as creditworthy as German) is deeply flawed. Our traders specialized in a specific currency (deutsche mark, lira, French franc, etc.) but retained some flexibility to take on limited risk in currencies outside their specialization. Periodically, downward pressure on a currency might force the central bank to defend it through raising short-term interest rates with the intention of making it prohibitively expensive for speculators to finance their bearish bets. Such an approach generally hasn’t worked, because the shock of a sudden hike in short-term interest rates impacts the real economy far more adversely than the speculators betting against the currency. If you think a currency will drop 10 percent, even if it costs you

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20 percent a year to bet against it, you can wait six months to see if you’re right before the interest costs start to eliminate your expected profit. No economy can tolerate 20 percent rates for long. George Soros’s famous bet against the British pound in 1992 was based in part on this insight. Speculative currency attacks were not uncommon during the 1990s as the markets tested the conviction of governments to see the European project, and indeed the euro, to a successful launch. On one occasion the French franc came under pressure in its price relative to the deutsche mark. There was a view that France wouldn’t be able to sustain high interest rates for long, the traditional tactic to defend one’s currency, and consequently we had many traders who had taken interest rate positions betting on a fall in short-term French franc rates. Unfortunately for our traders, the Banque de France, the French central bank, proved surprisingly assertive, and as they showed no signs of weakening the markets began pricing in further rate hikes rather than a French surrender to the “Anglo-Saxon speculators.” As losses grew for many of our traders, they began selling out positions at a loss. Such was our relative size in the market that in some cases traders wishing to limit losses were selling to other traders within the same division newly attracted to the falling futures prices. When the dust settled and positions were largely closed out, we had lost a good month’s trading revenues on that one trade. It was a very bad result, but not catastrophic. In our postmortem, we calculated that our traders’ positions had added up to 40 percent of all the French franc interest rate futures positions. We had held such a large position that we were the market. Virtually every trader had taken on the same bet, the unfortunate consequence of having people exchange views regularly on good trading opportunities. Ironically, the one trader who’d made money was the French franc trader himself. He nonchalantly commented that the losing interest rate bet had “seemed a bit crowded” and so he’d decided to go the other way. Naturally, greater attention to liquidity and our own market share of specific futures quickly followed, and we never suffered a repeat. In fact, results for that year turned out fine.

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Don Wilson, the head of Global Trading at the time, shrewdly noted the large number of English traders, both in New York and London, who had found it so compelling to, in effect, bet on a quick French central bank surrender. Perhaps many of our English traders were motivated by France’s almost 200 years of less than glorious military history since Napoleon, and anticipated another French setback to contrast with Anglo-Saxon success. Don issued an edict asserting that traders who held British passports would no longer be allowed to trade French franc instruments. It was probably as effective a risk management rule as anything else.

MANAGING OBSCURE BASIC RISKS Derivatives trading increasingly required that traders hold residual, basis risk positions for many months if not years. Some of them can be very obscure. Hedging interest rate swaps with eurodollar futures is a very mild form of basis risk. The combination is by no means riskless, although the two instruments are very similar and generally won’t cause much trouble. In the commercial paper (CP) cap episode described in Chapter 5, we took on a fairly substantial basis risk between the CP cap market where we were long and the Libor cap market where we were short. Because we had options positions, we cared about interest rate volatility but also about the correlation between the CP index and the London InterBank Offered Rate (LIBOR).You can rarely assume precise relationships will hold, so it’s necessary to build in a margin of safety in accumulating such a risk in case you’re wrong. As described, we did that, and our assessment of value turned out to be vindicated. However, trading history is littered with the corpses of traders who were insufficiently skeptical of the valuations their models pumped out. On one occasion during a merger-related reorganization, I inherited a trader called Jim (not his real name). Jim had once served in the military and, like others I’ve met with his background, was unfailingly professional, always following orders. Jim managed an interest rate swap book that specialized in long-dated interest rate swaps. Quite often, swap books would focus on a particular

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set of maturities (zero to two years, for example, or five-plus years). Specialization allows traders to develop a deep understanding of the subtleties involved in their particular sector, and therefore allows for a more profitable overall business. Jim focused on long-maturity swaps but with a forward start date. So a typical transaction might be a two-year swap that begins three years forward (colloquially referred to as a 3 × 5). Jim priced and valued his swaps using eurodollar futures, which was how short-term swaps such as two years normally traded. The calculations weren’t that complicated, relying largely on the math of compound interest applied to the appropriate futures contracts. Eurodollar futures are almost interest rate swaps, though the properties of the two instruments aren’t identical. Their behavior starts to deviate at longer maturities due to convexity. Fixed income traders generally understand convexity very well—for the reader whose life has spared them the need to understand it, the relevant knowledge is that at longer maturities swaps and eurodollar futures have a less reliable pricing relationship. While you could price a two-year swap pretty much with a Hewlett Packard 12C (the handheld workhorse of the 50-something derivatives crowd), pricing a two-year swap that begins some years in the future is more complicated. Jim wasn’t using a 12C, but he was using a pricing model on his computer that was indifferent to convexity. One day shortly after he had become my responsibility, I sat beside him for the morning to learn in detail what he did. To that point I knew I had inherited a solidly reliable trader who was profitable virtually every month. I looked forward to finding out more about his consistent profits and was quietly pleased that my overall revenue responsibilities had expanded in such a trouble-free manner. Jim patiently explained to me how on each trade he did he sought to “lock in” a profit of around 15 basis points (0.15 percent). This was substantially more than we made in our other swaps businesses, where competition for arbitrage profits had driven margins down to 2 to 3 basis points, some 80 percent lower than Jim was able to achieve. His steady profits were based on his ability to pick up such wide arbitrage profits day after day. I watched as he did a

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trade. A broker asked him for a price on a particular structure (a 5 × 7 year swap, a two-year swap beginning in five years). Jim made a price based on where he could buy the appropriate eurodollar futures needed to hedge, and after a brief moment the broker said he was done. Jim had “paid fixed” on a swap and so needed to buy futures. His pricing model registered a 12-basis-point profit, a very nice return. Jim turned to me proudly, having just demonstrated the method behind his profitability to his new boss. I took a look at Jim’s portfolio of swaps and futures, and I saw that all his futures positions were long positions. It looked as if he had been paying fixed and buying futures more than the other way around (“receiving fixed” and selling futures), which could be fine over a period of weeks or so, but generally trading on both sides of the market is preferred. So I asked Jim, “If you can make 12-basis-point profit on the trade you’ve just done, what sort of profit do you think you can generate when you reverse the trade out?” And Jim solemnly replied that he never did trades on the other side. If he wanted to receive fixed on the 5 × 7 structure he’d just done, he would register a loss of at least 10 basis points. His previous boss had simply told Jim to keep doing trades that made 10 to 15 basis points in profit. Jim, with his military respect for the chain of command, had not questioned this order. His commanding officer had sent him into battle, and it was his job to take the fight to the enemy until new orders were issued. Jim only did trades that showed a profit according to his pricing model. He unquestioningly accepted that the model must be right. It was not. There’s no reason why traders with a military background can’t be successful, and many are. However, in Jim’s case, he had too faithfully followed a straightforward instruction without considering reasons why it might be too simplistic. Jim had been trading in this way for a couple of years, and the consequent restating of his past profits wasn’t well received through my chain of command that had been completely unaware of the pricing error. Jim’s trading career was over. Nevertheless, Jim wasn’t a bad guy; he was just in the wrong job. We retooled him as a marketer, where he set out to sell swaps to many of the banks with whom he had traded in the past. His

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military bearing and professionalism stood him well. Few people hang up on an ex-soldier, and Jim went vigorously at his new task. Military guys don’t show up for work feeling depressed or whine about trivia. I had asked (ordered) Jim to double our market share with a particular client segment. I might as well have told him to take out that machine gun nest on the hill. He never wavered; he relentlessly went after his goal, and happily his career moved on to a legitimately successful path.

WHAT’S THE SOCIAL PURPOSE? I imagine doctors rarely need to stop and ask themselves if there’s any social benefit to their work. My friends who are doctors are disillusioned at the growing administrative burden that insurance companies and the government have pushed on them. In fact, if you want to ruin a perfectly pleasant dinner with a doctor, just bring up the topic of insurance companies and it will dominate the discussion for the rest of the evening. Even so, healing people is pretty self-evidently doing good. Most jobs don’t provide such obvious proof of their social utility, and so we rely on capitalism to channel resources appropriately. If society values a product or service, its market price reflects that value. I believe this works almost completely, although I have agreed to concede to my wife, who teaches preschool, that teachers’ pay has somehow bypassed the market forces that their social value should impart. However, my clients don’t send me cute hand-drawn Christmas cards saying they love me, so pay can come in many forms. Nobody should expect traders, or even the banks they work for, to establish society’s benefit from their actions. Banks are owned by profit-seeking shareholders, as with so many other industries. But it is fair for society overall, and for the government, to ask that question— most especially since banks occupy such a crucial role in the working of the economy. Channeling savings to where they can be profitably deployed and operating a reliable payment system are two functions whose benefits show up throughout the rest of the economy. While capitalism generally works better than any other method at

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allocating resources efficiently, an increasing share of gross domestic product (GDP) from financial services does not, in hindsight, appear to create substantial benefits beyond the industry itself. The anecdotes just recounted are intended to portray a flavor of how banking has evolved over the past 30 years.What we did was highly profitable, although I can’t really point to much benefit beyond employees and stockholders. It’s hard to connect derivatives trading with efficient capital formation. Finance would better serve the broader economy if every clientfacing business examined its activities from the perspective of moving capital efficiently from where it is to where it’s needed.

WALL STREET FUELS THE DEBT GROWTH The 2012 Greenwood and Scharfstein paper referred to in Chapter 1 highlights the increasing share of economic growth represented by the financial services sector. Using data on GDP value added from the Bureau of Economic Analysis from 1977 (as far back as data are available) shows the steady increase in financial services as a percentage of GDP. Public policy did not overtly drive this growth, although it certainly fueled it inadvertently. Securitization, which was developed in the 1980s, was a factor. The desktop PC brought computing power in support of ever more complex financial instruments. The market for asset-backed securities, which began with mortgages but eventually came to encompass other forms of consumer debt, including credit card and auto loan receivables, could scarcely have been created without desktop computing power allowing underwriters and investors to value the instruments.The entire derivatives industry emerged approximately at the same time, and there’s little doubt that computing power played a big role here, too. Where public policy did get involved, such as in promoting home ownership, it supported the financial sector by increasing the volume of loans to be originated, securitized, and distributed. Increasing home ownership aside, seemingly unrelated developments combined to make debt far more accessible to so many borrowers.

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There are clear signs that the buildup of consumer debt began at approximately the same time as the growth of finance. The household savings rate had been broadly steady since the end of World War II. If anything, it had been trending slightly upward. However, in the early 1980s, it began to decline steadily from 8 percent to as low as 1 percent in 2006 (Hunkar, 2009).This was the tangible manifestation of all the credit card and other debt we all read about. Homeowners using their house as an automated teller machine through home equity loans further added to outstanding debt. Household debt as a percentage of GDP had been fairly stable at around 80 percent until 1993, at which point it began rising and approached 130 percent by 2006 (Reinhart and Rogoff, 2009). Government debt at all levels grew during this time as well. Collectively, an electorate that was increasingly comfortable using debt financing themselves showed greater tolerance for the public sector to do the same. Greenwood and Scharfstein further question whether the growth in financial services has been good for society. They draw their conclusions tentatively, which is understandable because the world is a complicated place and many variables are at play here. They do suggest that the growing use of active money management has been a positive, through increasing the diversification of so many investor portfolios. Interestingly, they hold this view while acknowledging the failure of active managers in aggregate to outperform passive investing. They find that even though active managers don’t add value to investors, they do help provide cheaper capital to companies as their more diversified portfolios compared to self-directed investors have a lower return requirement which benefits society overall. It’s a somewhat tenuous assertion, although probably as hard to disprove as to advocate. They go on to question the value of much of the money that is spent to gain an advantage in a zero-sum game. Perhaps controversially, they suggest that a hedge fund spending $20,000 to obtain a more accurate forecast of a company’s quarterly earnings is presumably only going to benefit at someone else’s expense. Society is not $20,000 better off. This view suggests seeking an information

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advantage has no value which isn’t true, but the focus on short-term results pursued by so many is deserving of criticism. Today, the pursuit by high-frequency trading (HFT) firms of computer servers physically in the New York Stock Exchange (NYSE), so as to shave milliseconds off the transmission time of trading orders, surely warns that something is wrong. HFT is simply high-tech front-running. Their activities are designed to figure out what other market participants are trying to buy and get there first, profiting from the resulting higher price paid by the investor. When a human broker buys stock for his personal account because he knows an imminent order from a client will boost the price, this is called frontrunning and is illegal. For some reason we allow computers to do what humans may not. Technology often outpaces regulations, and hopefully policy makers will examine more deeply whether HFT has any function in today’s marketplace. Thomas Philippon has written several papers examining the financial services industry. In “Has the U.S. Finance Industry Become Less Efficient?,” published in November 2011, he develops a theoretical model to suggest that productivity in banking has seen very little improvement in spite of huge increases in volumes of assets managed and traded, as well as vast investments in information technology (IT). Wall Street has certainly increased its share of GDP and compensation, which supports the idea that information asymmetries and other barriers to entry are in effect allowing financial firms to earn excess profits precompensation. In fact, the large percentage of profits that’s commanded by employee compensation, rather than returned to stockholders, is why I’ve long felt that banks were better places to provide labor than capital. It’s often been far better to work for one than invest in one. In “Wages and Human Capital in the U.S. Financial Industry: 1909– 2006,” Philippon and Reshef in 2012 find that financial sector wages move out of equilibrium with the rest of the economy when credit risk and corporate activity around capital raising such as initial public offerings increases.They find that the 1920s and the 25 years after 1980 were two periods when financial compensation was excessive, relative to jobs in the rest of the economy. In “The Evolution of the U.S. Financial Industry from 1860 to 2007: Theory and Evidence”

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(Philippon and Reshef, 2012), they link variations in the size of the financial economy with demand for venture capital, finding that the 1920s and the Internet bubble in the 1990s had this in common.The period following the collapse of the dot-com bubble in 2000–2002 is notable, in that small company financing slowed down sharply, though compensation did not. Philippon and Reshef have thought and written as much as anybody about the value of financial services to the rest of the economy. Ultimately, Wall Street has to show its value through improved economic performance. Changes in GDP don’t really offer much insight to whether the U.S. economy has benefitted from more banking. GDP swings are not obviously greater since 1980 than in earlier decades. The 1970s were tumultuous for reasons that can scarcely be blamed on traders, and there’s not enough data to form a clear view. The 2007–2008 real estate crash clearly had its origins in finance, although misguided public policy played a role, too. Finding that finance has hurt GDP growth overall relies heavily on whether you regard 2007–2008 as a 1,000 year-flood or as part of the new world we live in. Greenwood and Scharfstein (2012) note Paul Samuelson’s view that while markets are very “micro-efficient,” they can be far less “macro-efficient.” Price discovery works pretty well. Nevertheless, in the past 15 years, two entire asset classes (technology stocks in 1998– 2000 and real estate in 2005–2007) were for a time substantially mispriced. Both events relied on the securities industry to help inflate the bubble. GDP figures by definition reflect the aggregate economic result. However, increasing attention in recent years has focused on the growing disparity in incomes. Real income growth for the median household has been far slower than for those in the top 10 percent. A large disparity in earnings need not be a problem if the composition of the top decile is constantly changing. If a different group of people are at the top of the income heap every year, economic mobility can compensate for big differences in income. While there’s lots of academic research on income distribution, it’s harder to find conclusive evidence that income mobility is falling, although there is growing evidence that this is the case (Levine, 2012). A growing gap between rich and poor is a bigger problem when who’s rich and

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who’s poor isn’t changing as much as it used to. It is likely to increase political support for policies that seek to moderate or reverse these combined trends. Net worth of the median household in 2010 was lower in real terms than 21 years earlier, in 1989 (Levine, 2012). The issues are complex and clearly beyond the growth in financial services. Globalization and China’s emergence as a huge manufacturing exporter are part of the explanation. Public policy will focus more on the median, because that’s where the votes are. Growing average incomes through huge increases for a small minority is never going to command the same popular appeal as growing the median, especially if it looks as if economic mobility is falling at the same time. Americans have long tolerated large disparities in income because surveys show that substantial numbers of people hope and expect to move up themselves. Given the increasingly long history of stagnant middle-class incomes and net worth, and now less movement between income groups, it shouldn’t be surprising to see the democratic process react. What’s also interesting is that real income growth is increasingly differentiated by age. Since 2000, every age bracket up to 54 years old has seen their real incomes shrink. Only retired households 65 and older have experienced any appreciable growth (U.S. Federal Reserve, 2012). The reasons for this are complex and probably include lower real estate exposure and also more investments in fixed income versus equity by older people. In other words, they held more of their savings in the assets that had the best decade. It also reflects the generational wealth transfer that underfunded entitlements and excessive government debt are causing, at the expense of younger people. Regardless of whether the reasons include high bond returns and low equity/real estate returns affecting age groups differently, as the gap between rich and poor increases, it’s likely that public policy will respond to seek to correct it. Today, the United States is a highly indebted society whose politics are increasingly populist. There’s a growing sense that the typical household hasn’t shared fairly in the wealth creation that has taken place, and that typical household has demonstrably more debt. Moreover, their share of public sector debt is as big as ever in history

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as well. As the years go by, the realization that so much of what is owed by our government is a burden left to us by the self-interested choices of the previous generation will become more apparent. This is likely to make its ultimate repayment in dollars that have retained their real value unlikely. The Federal Reserve’s response to a debt-induced financial crisis has been to reduce the cost of debt. So far it has worked better than many expected, and inflation remains low in spite of the Fed’s growing $3 trillion balance sheet, as Fed Chairman Bernanke predicted (Torres, Zumbrun, and Gage, 2012). Investing requires considering many possible outcomes and their probabilities. Interest rates in 2013 are low and may stay low for a long time. Or inflation may roar back and push rates higher. Nobody really knows. However, history suggests it’s likely that real interest rates, the difference between actual yields and inflation, will remain low or negative in virtually any scenario. For the bond investor, the excess return above inflation is the only meaningful return. Anything less and their repayment buys less than what they lent. For the borrower, a negative real cost of borrowing reduces what is owed. The assertion that real rates will be paltry for many years rests on recognizing that the borrowers are solidly in control. The Federal Reserve’s independence will be surely challenged if it concludes that real rates of 2 to 3 percent are what’s required. The budgetary impact will be huge. The political response is likely to be severe. Given the muted complaints from savers over the poor returns they’ve been earning, we can surmise that far more voters like low rates over high ones. A country that is drifting in a populist direction is likely to elect politicians that will reflect the typical household’s position of being in debt and holding an inflation-sensitive asset. In fact, real rates of 2 to 3 percent are not the norm, in spite of a widespread belief that this is so. Real rates were unusually high during the 1980s and 1990s but averaged 0.7 percent in the 1950s and were negative during the 1940s. Much of the fluctuation in real rates has derived from swings in inflation more than nominal rates themselves (Homer and Sylla, 2005). Moreover, the path we are on—at least at the government level— is for debt to keep growing.The cost of financing the growing mountain of obligations will render the economy less able to withstand

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higher rates in any case. Inflation and interest rates may move up, and they could even jump dramatically if the bond crash that so many forecast occurs. In any case, the bond investor need not attempt to accurately forecast whether such turmoil will happen. Simply assessing the likely political response to our past fiscal profligacy is sufficient to render fixed income investments among the poorest choices one can make. Negative real rates benefit more people than positive real rates. Fundamentally, negative real rates suit the borrower more than the lender. America is the world’s biggest borrower by far: $36 trillion of debt owed by government at all levels, households, students, and underfunded public pensions. Quite simply, low interest rates are in America’s interest. As the Federal Reserve has shown so clearly since 2008, they can influence the Treasury’s borrowing rates at every maturity, from short-term Treasury bills to 30-year Treasury bonds. There is no conspiracy. America is acting in its national interest. A three-decade boom in financial services helped fuel an excessive buildup in debt. The political reaction to the economic catastrophe has been multifaceted, although the backlash against banks and desire for less disparate income distribution are both important elements. The investor in you should discard any political views you may have on the appropriateness of these policies and simply focus on assessing how they will impact bond returns. Ultimately, the United States may find that it can no longer set its own interest rates, in which case they will move higher, perhaps much higher, inflicting severe losses on bond investors. Or the United States may find that it can maintain negative real rates indefinitely, which, given our enormous collective liabilities, would be no bad thing for taxpayers. It would ensure lost purchasing power for bond investors. You don’t even need to correctly predict which of these outcomes occurs. The only scenario in which bond investors will win is one of rates 3 percent or more above inflation, under which inflation drops to 0 percent or goes negative. An extended period of deflation would be fought by all the tools in the government’s arsenal. The defining economic event of the past 100 years was the Depression, and the huge increase in the Federal Reserve’s balance sheet was informed by the policy mistakes of the 1930s. Deflation is still possible, but

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given the likely overwhelming policy response to avoid it, this is not an outcome that rates a high probability. And higher real rates without falling inflation mean higher nominal rates. Investors can most plausibly earn a fair return only after suffering substantial losses on existing holdings. Better to wait for that outcome on the sidelines, rather than participate by staying invested. Achieving an acceptable real return requires a comfortable margin over inflation, and it turns out that the way inflation itself is measured contains many surprises for the average investor.

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CHAPTER 8

INFLATION A Brief History

Inflation is the hidden tax that eats away at the value of money. High inflation distorts decision making in numerous ways, and because it’s less stable than low inflation, it adds uncertainty to most economic decisions about money. Low and stable inflation is uniformly regarded as conducive to economic growth. Since the very beginning of the use of money as a medium of exchange, governments have been aware of the potential for inflation to slowly, or sometimes spectacularly, destroy savings. There exist numerous examples throughout financial history of currency debasement—often, this was to the perceived benefit of the government through a reduced real value of debt owed to private lenders. Eventually, investors demanded adequate compensation for inflation and federal revenues and outlays began to be indexed for inflation. Even so, prior to that, inflation usually hurt just about everybody. Although accurate data are obviously difficult to obtain farther back than three or four centuries, history going back to Roman times contains examples of currency debasement during which coins issued by the government were minted with ever decreasing percentages of the precious metal from which their value was derived. In other cases, older coins would gradually lose weight and metal content through wear and tear; as new coins were issued with a metal content that conformed to the original, they would 165

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be hoarded by consumers and not used because of their greater perceived value, reflecting Gresham’s Law (Selgin, 2010) that “bad money chases out good.” In fourth-century B.C. Greece, Dionysius demanded that all his subjects turn over money in circulation to the government on penalty of death. All the one drachma coins collected were thereupon stamped with a two-drachma mark and used for repayment (Reinhart and Rogoff, 2009). Records of the subsequent inflation do not exist, although one can suppose that it was at least 100 percent. There is reason to believe that the Romans experienced inflation during the third and fourth centuries A.D. under Emperor Septimus Severus and his successors, as the silver content of their money, the denarius, steadily fell. The sharp rise in prices took the rulers of Ancient Rome by surprise, and price controls were introduced on hundreds of goods and services. Simple human greed was blamed for the inflation, and the penalty for charging higher prices than allowed by law was the death penalty (Bernholz, 2003). In seventeenth-century Spain, the Kingdom of Castile gradually reduced the silver content of its local currency, the maravedi, because of fiscal pressure on the government, which caused a rise in inflation (Bernholz, 2003). Carmen Reinhart and Ken Rogoff have created a database of inflation, going back in some cases to 1500, in their masterful work This Time Is Different: Eight Centuries of Financial Folly.They examined inflation in different countries from 1500 to 1799 and uncovered some interesting facts. For instance, surprisingly perhaps given the United Kingdom’s long history of issuing government bonds, the United Kingdom experienced inflation above 20 percent fully 5 percent of the time over these 300 years.Who would have guessed that from 1743 to 1799 Korea’s inflation rate exceeded 40 percent almost a third of the time (Reinhart and Rogoff, 2009)? By contrast, in Latin America, commonly regarded as perennially vulnerable to hyperinflation, prices during the last half of the eighteenth century were comparatively well behaved, with bouts of more than 20 percent inflation occurring less frequently in Argentina or Chile than in Denmark or Portugal. Many may be surprised to learn that from 1886 to 1920 wholesale price inflation in the United States averaged over 5 percent following

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a collapse in prices that began during the Civil War in the 1860s (Homer and Sylla, 2005). During the 10-year period from 1910 to 1920, inflation was over 8 percent, the fastest rate of price increase the country had witnessed in its history up until that point. Looking at approximately the past 200 years or so since 1800 until the early twenty-first century, it’s also quite sobering to see how many countries have endured inflation rates of 20 percent for substantial periods of time. Although the United Kingdom exceeded this level less than 3 percent of the time, many European countries spent 20 years or more over the past two centuries with inflation rates above 20 percent, including Austria, Greece, Hungary, Poland, Russia, and Turkey. Who knew the U.S. dollar value of the French franc fell by 99 percent from 1900 to 1958 (Homer and Sylla, 2005), an annual inflation rate of 7 percent? This number even understates the actual inflation France experienced since the U.S. dollar lost substantial purchasing power during this time. Even allowing for Latin America’s extremely poor track record in recent decades, some of their statistics are still breathtaking. Mexico holds the record, with 85 of the past 208 years of inflation above 20 percent and fully a third of the time above 40 percent. Bonds denominated in fiat currencies have caused huge real losses all over the world throughout history, particularly during the most uncertain of times—wars.

GERMANY’S DEFINING ECONOMIC EXPERIENCE A vivid example of the societal destruction inflation can cause is the Weimar Republic, Germany’s government in between the two world wars of the first half of the twentieth century. Following its defeat in World War I, the victorious countries imposed punitive reparations on Germany under the Treaty of Versailles, which had the result of accelerating the decline of the German mark against other currencies. The inflation that resulted from the rapidly falling German currency reached such a staggering rate that prices for basic needs such as bread would change in the course of a single day. Photos of German citizens transporting cash in a wheelbarrow to buy food

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provide a vivid record of the result. The consequent destruction of the country’s productive capacity and societal upheaval led to totalitarianism. In his book Monetary Regimes and Inflation – History, Economic and Political Relationships, Peter Bernholz (2003) produces some striking examples of German diary entries written contemporaneously in 1923. A postage stamp costing 2 million marks is expected to cost 5 million tomorrow. An employee received 870 billion marks in salary on Monday, and on Wednesday received double the amount, reflecting the newly depreciated value of the currency. Exchange rates into gold moved during the day, and one writer described rushing breathlessly from the cashier’s to make purchases before his money lost all its value. Some towns and villages in Austria issued their own currency, which had little value in neighboring towns, and increasingly people moved to a barter system. Overnight call money rates on the Berlin Stock Exchange reached 30 percent a day (Homer and Sylla, 2005). Alexander Jung recounted poignant tales in Der Spiegel (Jung, 2009). One family sold its house and set out for Hamburg, where they planned to board a ship to America.They were emigrating, leaving the madness behind. And yet they found upon their arrival at the north German port city that the proceeds from the sale of their house were insufficient to pay for the journey by boat to the New World. Even worse, daily inflation had so ravaged their savings that they couldn’t even afford to travel back to their old home town. A man who ordered a coffee for 5,000 marks then asked for a second and was ultimately asked for 14,000 marks because a cup of coffee had risen in price while he was still drinking the first one. The hyperinflation of this time had devastating political consequences for Germany and for the whole world, as subsequent events led to the rise of Adolf Hitler. It is hardly surprising that the searing experience on a generation of Germans led to the Bundesbank, Germany’s central bank, being created with a single-minded focus on controlling inflation. This uncompromising DNA was later transferred to the European Central Bank (ECB) when it was created to oversee Europe’s common currency, the euro. Germany’s defining economic experience had a long-lasting impact. By contrast,

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America’s collective memory of the Depression in the 1930s and the coincident widespread unemployment is why the U.S. Federal Reserve has a dual mandate, of seeking maximum employment consistent with price stability. Neither the Bundesbank nor their successors, the ECB, have any explicit responsibility to promote full employment, which is one reason why Europe’s solutions to the euro debt crisis have been so focused on austerity. In spite of their different mandates, the Fed and the ECB have achieved similar inflation results. Some argue that the Fed’s dual mandate is in fact a single inflation mandate and that the unemployment goal is merely an intermediate step to thinking about the long-run inflation goal, for those who believe that economic slack is a predictor of future inflation. Bernholz argues that governments have an inherent bias toward inflation, since they benefit from the resulting reduced real value of their debt. Because the negative impact of rising inflation can take years to inflict harm on an economy, whereas the benefits of interest rates below inflation can occur immediately, one could even make the case that an absolute ruler secure in his position might care more about these long-term effects than a democratically elected government whose planning needn’t extend beyond the next election. Although it’s an interesting thought, the track record of dictators in this regard hardly supports such a conclusion. What this review of economic history says to me is that high inflation has occurred far more frequently than is popularly believed. In the developed world, the majority of people alive today don’t possess any personal experience of managing a household budget during such times. Intellectually, inflation is understood to be a bad thing, and economic policy makers rarely deviate from this view. There’s little reason to disagree. However, in a world of stagnant real incomes, in which so many people owe debt on assets (such as houses) that seem to have stopped appreciating, a little bit of inflation could seem quite attractive.The trade-off for the average household with a fixedrate mortgage that protects them against rising inflation and a house whose value would surely benefit from it could quite possibly result in a subtle political bias that is at least tolerant of higher inflation, if not even seeking it.

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INFLATION TODAY The typical household lost almost 30 years of progress through the 2007–2008 collapse, and as a result is back to where they were in 1983. The Federal Reserve publishes a Survey of Consumer Finances every three years, and median household net worth adjusted for inflation is back where it was in the mid-1980s (see Figure 8.1). And that’s measuring inflation the way the Bureau of Labor Statistics does, which strips out any improvements in average standards of living. A higher estimate of past inflation would show an even worse change in median household real net worth. Average net worth has increased quite substantially, but from a political standpoint the median is more important, because it’s more reflective of the typical voter’s experience.The plunge in household net worth was clearly triggered by the Great Recession. Nonetheless, there’s little real improvement over almost 30 years. We are where we are. Many households own an inflation-sensitive asset (their home), which is financed with a fixed (i.e., inflation insensitive) liability. Looked at purely from the point of view of the household balance sheet, a pickup in inflation would, over time, drive up the value of the house, while the cost of financing it would not change.This is the precise opposite of the balance sheet exposure savings-and-loans (S&Ls) 130 120 110 100 90 80 70 60 1983

FIGURE 8.1

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Median Household Net Worth—Constant 2010 Dollars

Source: The Federal Reserve, Survey of Consumer Finances.

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had in the early 1990s, which led so many of them to default. Banks traditionally lend long (i.e., make long-term loans at fixed rates) and borrow short (through holding consumer checking accounts). Rising interest rates exposed S&Ls to a negative interest spread between what they earned on their loans (whose rates were fixed) and what they had to pay on checking accounts in order to retain their customers. Many went bankrupt as a result. I’m not suggesting that the government should target 10 percent inflation. The point here is that popular opposition to a gentle rise in inflation is probably going to be muted. A rise in inflation to 3 percent could well help households whose net worth in real terms has remained stagnant, because their cost of borrowing is fixed. Or, put another way, when the Federal Reserve does eventually see the need to raise interest rates to head off inflation, expect far greater outcry about the harm of rising rates on the economy than from those arguing against higher inflation. The Fed’s independence may well be tested, and as they navigate the politics of their dual mandate (maximum employment consistent with stable prices), expect them to move cautiously. There’s very little political opposition to interest rates below inflation.We’ve become used to it. Although today’s savers would benefit from higher rates, their interests have consistently taken a back seat to borrowers in recent years, and stagnant real net worth will likely cause that to continue. Banks generally benefit from rising rates and a steeper yield curve because the rates they pay on deposits don’t rise as fast as the rates at which they lend. JPMorgan expects to make $5 billion in additional pretax profit if interest rates rise rapidly by 3 percent (JPMorgan Chase 2012). The optics of the Fed raising rates to the benefit of banks will be exceptionally poor given the still-fresh memories of Wall Street receiving government support in 2008. Inflation statistics affect virtually every aspect of economic decision making. Savers understandably seek a return on their money that is above inflation, so as to preserve its purchasing power. Companies making long-term investments in factories, oil exploration, or drug research need to consider how their costs will rise during the lifetime of the project, in evaluating its ultimate profitability. It’s as fundamental as knowing with some tolerable certainty what a dollar will buy in the future. Countless big and small decisions about how to allocate

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resources hinge on this knowledge. It is perhaps the most vital input to any financial forecast, from an individual planning retirement and whether to buy or rent a home to selecting in which country a multinational company should build a new plant. The U.S. Bureau of Labor Statistics (BLS), an agency of the U.S. Department of Labor, calculates the indices from which measures of inflation are drawn. The Consumer Price Index for All Urban Consumers (CPI-U) is most commonly referred to as the CPI, and this is the most widely used measure.∗ However, the BLS also publishes other measures of inflation, including Producer Price Indices (PPIs) and measures of import and export prices. Given how important inflation estimates are and how actual inflation affects so many people, it’s interesting to discover some of the subtle features that, while well known to statisticians, are not otherwise widely understood. For most households, housing represents the biggest expense in their discretionary budget (i.e., after taxes). The cost of shelter (as the BLS terms it) is consequently just over 30 percent of the CPI. The respective weights of hundreds of items are set based on periodic surveys carried out by the BLS to determine spending habits (as of November 2012, the most recent survey was carried out in 2008). The BLS focuses on the cost of shelter, and not the cost of owning a home, because the CPI is designed to measure the cost of a basket of goods and services. Shelter is a service, whereas owning a house involves investing in an asset. So you wind up with the curious situation that although over two thirds of Americans live in homes they own, the BLS doesn’t directly measure the cost of owning anything, ∗The inflation measure of record used by the Federal Open Market Committee (FOMC) now is the chain price index for Personal Consumption Expenditures (PCE), published by the U.S. Department of Commerce. This is the inflation benchmark the FOMC refers to when communicating its goals for inflation. The key differences are that the chain PCE measure reflects better the idea that consumers substitute like items when relative prices change and includes all purchases of medical care (those paid for by consumers, those paid for by private health insurers, and those paid for by the public system) just to give a few examples. At the same time, the expenditure weights reflect what people do, not what they say they do. The CPI expenditure weights are based on surveys, what people say they do. The issues with calculated inflation are not unique to the CPI.

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only the cost of renting it (which in theory reflects all of the costs of ownership). They use something called owners’ equivalent rent of primary residence (OER). Simply put, they measure what the home you own and live in would rent for if it were rented, and they construct an index out of that. Perhaps even more surprising, they measure this by asking homeowners how much they think their home would rent for if it were to be rented out. The results of this question drive almost one quarter of the CPI (the rest of the housing component is based on actual rents). It may be a simple enough question if you own an apartment and there are other units in the building that are rented at rates you know. Nevertheless, how many people really give much thought to the rental market for their home? How often have you had a discussion about how estimated rental rates in your neighborhood are ticking up? It’s a completely theoretical concept that has little relationship to how people find a place to live. The actual cost of shelter for most families is the cost of owning a home, driven by such obvious factors as house prices, mortgage rates, property taxes, insurance, maintenance, and utility bills. Of these, the BLS measures only utilities. The other costs are all deemed to be the cost of holding an asset and therefore not applicable to the CPI and its objective of reflecting the cost of goods and services. It relies on the idea that these costs are implicitly in the shelter component because they presumably are reflected in the rent that you would charge yourself or someone else to live in your house. As strange as this sounds, there is a sensible theoretical basis for their approach. Households don’t have to own the place they call home; they could choose to rent (and many people do). Every household faces the choice between renting and buying, and people are free to choose one over the other. The home ownership component is meant to measure the user cost of owning a home and does not include any offsets from capital gains that represent the investment aspect of a home. Theoretically, if the cost of owning a home moves too far away from the cost of renting that same home, more people will begin renting and house prices will fall. In this way, the price of an asset (houses) will move back toward the long-term value of what it provides (monthly shelter, as measured by rents).

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It’s a reasonable theory. The problem is, it doesn’t reflect the actual world in which most people buy the home they live in. Home prices, property taxes and insurance are real items for millions of people, and they affect their standard of living and their ability to spend money on other items. Although home ownership has been part of the American Dream for generations, its cost isn’t picked up directly in the inflation statistics. The BLS argues that rents and home prices can only diverge for so long before market forces bring them back together. This is true, although the real estate crash that began in 2007 shows that such a mean reversion is far from painless. What it means is that the BLS is measuring what they’ve set out to measure. However, it also means that what they’re measuring is less relevant to everyday life than most people think. OER, what you think you could get for renting your home, is a concept that only economists and statisticians could love. During the 10 years prior to the real estate crash in 2007, consumers were dealing with the reality of rampant inflation in the cost of shelter, while the BLS was not recording any such pressure because estimates of imputed rent (meaning the rent surveys said you could get from moving out of your home and renting it out) were stable. Asset prices such as houses and stocks are often more volatile than the cost of goods and services. Stock prices in particular readily adjust by many multiples of the difference between expected and actual earnings for a company, and their tendency to overshoot news in both directions is well known. House prices are less volatile than stocks, which in recent years have certainly experienced their own overshoot. There is an argument that the CPI should reflect the cost of owning a home, since the majority of people choose to obtain shelter in that way. However, it doesn’t, and the BLS makes very plain that the CPI isn’t designed to do that.

THE FED’S HUGE MISTAKE The Federal Reserve clearly missed the housing bubble, and the thenchairman Greenspan’s oft-repeated defense that they can’t manage asset prices fails to stand up against some of their own practices. The

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Fed wasn’t just wrong in hindsight to ignore rising house prices; they were inconsistent with their own custom of paying close attention to market indicators of future inflation. Although history will associate Alan Greenspan’s chairmanship with a real estate bubble that should have been checked long before it burst, he did at least acknowledge his mistakes in subsequent comments. The Federal Reserve issues minutes from the discussions of the Federal Open Market Committee (FOMC) shortly after they meet, which is generally every six weeks or so. More often than not, they’ll comment on inflation expectations, which they measure through surveys as well as directly from the yields on long-term bonds. In fact, in recent years the issuance of Treasury Inflation Protected Securities (TIPS) that pay a yield that is added to inflation has allowed for a more precise estimate of what investors expect future inflation will be. If the nominal yield on 10-year Treasury notes is 3 percent and the yield on same maturity TIPS is 1 percent, one can infer that investors expect inflation over the next ten years to be 2 percent. Investors who thought inflation would be higher than 2 percent would buy TIPS at the expense of nominal Treasury notes, until their yield differential moved to reflect the collective inflation expectation. So the Fed has tools they can look at to see what the collective inflation forecast is.To return to house prices, economic theory holds that any asset is ultimately worth the cash flows that it will generate, adjusted for the time value of money. A company’s stock is worth the present value of the cash an owner can extract throughout its life. Looking at house prices in the same way, which is to say the way a BLS economist would, the price of a house reflects the sum of all the “imputed” rent that could be earned from it. So if house prices rise, but rents don’t, the economist must conclude that expectations of future rent are rising. They would regard market participants as expecting rent inflation to rise in the future.They should interpret an expected rise among consumers in OER over the horizon. The Fed pays close attention to bond yields because of the information they reflect about market expectations. Bond investors know that if long-term yields were to rise even without rising inflation today, the Fed might conclude that expectations were for higher inflation in the future, and they may feel compelled to act, by raising

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interest rates today so as to cool economic growth and head off the threat of rising inflation. Observers describe this type of preemptive move as the Fed “asserting their inflation fighting credentials.” Sometimes it’s felt that mere words in support of sound money are insufficient and action is needed. And yet the Fed had a clear warning sign flashing yellow that inflation was heading higher. Just as a high price/earnings ratio on stocks implies that investors anticipate strong growth in future earnings, the high ratio of home prices to rents in 2005–2006 should have been interpreted by the Fed as homebuyers expecting sharply higher rents, or OER, to use the government’s term for it. Rising home prices surely portended an expectation of rising rents. Although it’s doubtful many homeowners are familiar with OER, the collective bidding up of real estate should have been interpreted by the Fed as an important signal about price expectations. The Fed deserves its share of blame for failing to make this connection. The classic argument to justify stable inflation is that it avoids a misallocation of resources into areas that won’t provide an acceptable return. Eventually, the excess capital drives returns below what investors need, and what follows is usually a crash.And, in fact, that’s exactly what happened; too much capital was invested in real estate because the Fed chose not to interpret rising house prices as an expectation of future inflation, and so the bubble was allowed to grow and burst. Their defense is that it’s not their job to burst bubbles, and supporters frequently note that the Internet bubble of the late 1990s burst on its own with fairly mild economic consequences for the broader economy. Following a drop in 2001, corporate profits (as defined by earnings on the Standard & Poor’s [S&P] 500) increased at double digits for several more years, vindicating the previous high earnings multiples. However, a 50 percent success rate for a strategy of letting bubbles grow and deflate by themselves doesn’t count as a win. There are many sources of responsibility for the housing bubble, not least of which is government policy, which provides extensive subsidies for housing through tax breaks and subsidized interest rates. However, the Fed deserves a share of the blame, because they even possessed the analytical structure that would have allowed them to identify rising inflation expectations in one important sector of the

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economy—and yet they chose to ignore it. They claim to look at expectations in setting monetary policy. In this case they weren’t looking at all the information at their disposal. A fair apportionment of the blame extends far beyond the Fed. Investors globally lowered their standards and for a time suspended disbelief. Underwriting standards deteriorated. Congress promoted home ownership and created misaligned incentives for Fannie Mae and Freddie Mac, which contributed substantially to the financial crisis. The Fed was arguably the “adult in the room,” capable of influencing behavior through more assertive regulatory oversight and even moral suasion. They missed the opportunity. It turns out that OER and house prices do tend to track each other over long periods of time. So markets do correct, and house prices, like any asset, eventually wind up where the income they generate dictates. However, they can behave differently for long periods of time (years) before correcting back toward one another. The focus on OER shows not just that measured inflation doesn’t reflect typical consumer experience, but also that its use as the biggest single component of CPI has led to important policy errors.

YOU CAN’T SPEND QUALITY IMPROVEMENTS A second problem with measured inflation concerns quality adjustments, what the BLS refers to as “The Hedonic Quality Adjustment in the CPI” (BLS, 2012). The statisticians are frequently faced with the problem that the things they are comparing from month to month change. Most simply, suppose a jar of peanuts rises in price from $2.50 to $3, but the size of the jar also increases from 15 ounces to 18. Clearly, the price of peanuts hasn’t risen by 20 percent because the unit size has altered, and quite properly peanuts in this case would be found to have not changed in price. So far, so good. It becomes less clear when this month’s product is not directly comparable with last month’s. It happens all the time, because companies are constantly revising their offerings. The BLS has a well-developed procedure for making the necessary adjustments so that this month’s basket of goods from which the CPI is calculated

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can be compared with last month’s. Many of the items that require adjusting are clothing. Fashions, fabrics, and seasons change, and the consequent shifting mix of dresses and shoes to reflect current tastes and temperature constitute much of the work directed toward quality adjustment in the index. It becomes trickier where a product changes because of improved quality.The way the BLS deals with this reveals an important concept behind the way the government measures price changes. Technology products are a good example. Consumers are perfectly attuned to regular new releases of cell phones, laptops, and iPods that are better than the previous model. Take iPads; the latest version is released to great fanfare, and reviewers laud the faster speed, greater connectivity, and enhanced screen resolution compared to the prior version. It goes on sale at $500, the same price as the old one. Now the BLS statisticians start to work on the data, and they note a new and improved iPad in this month’s basket, which they compare with last month’s old iPad. The new iPad is a higherquality model, and so the commodity analysts (as they’re called at the BLS) need to make a price adjustment. In the same way that a bigger peanut jar shows that peanuts haven’t gone up in price, a new and faster iPad that costs what the old one used to, reveals that iPads have in fact fallen in price. What the consumer pays for an iPad is unchanged. However, because they’re getting a better iPad than they used to, the BLS records this as a price drop. So improved iPads serve to reduce the stated inflation rate below what it would otherwise be. To see why this makes perfect sense within the context of what the BLS is seeking to measure, it’s important to understand that the CPI measures a basket of goods and services of constant utility. Utility is an economic term that basically measures how much you get out of anything you buy. Although we can’t measure utility directly, the theory is that whenever you buy anything, it’s because you get more utility out of your purchased item than the money you handed over in exchange. Utility can vary widely from one person to another. I may assign little utility to ballet tickets, which is why I don’t go to the ballet, while ballet fans clearly assign more. And we all (hopefully) assign less utility to the second donut than to the first—hence the

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expression diminishing marginal utility. Economic theory holds that economic agents, or consumers, all seek to maximize their utility. Basically, we all try and spend our money in a way that gives us the greatest possible benefit. The CPI is designed to measure things that have measurable utility, which means they have an identifiable cost. So the pleasure you get from living in an area of many parks or a low crime rate has no place in the CPI (although the imputed rent from the home you own in that neighborhood reflects your idyllic surroundings). In an important yet subtle way, the CPI is not measuring what many people think it is measuring. Routinely, comment is made on the cost of living, by which people generally mean the cost of a constant standard of living. This isn’t the same as constant utility. What we need to maintain our living standard changes as society changes and as living standards improve. If your standard of living includes being able to afford the latest iPad, and the latest iPad costs what the older version did, you don’t feel as if your standard of living has improved. The BLS would record an increase in your utility (because you bought more iPad for $500 than used to be possible), but you’ve simply bought the latest iPad. Increases in GDP are broken down into “real” and inflation. Nominal GDP might grow by 3 percent, of which 1 percent was an increase in real GDP (and therefore 2 percent was the inflation adjustment). Per capita GDP breaks down the same way, simply adjusted for population. One way to think about it is, if you want to maintain your standard of living relative to others, it’s the increase in nominal per capita GDP of 3 percent that is important, not just the 2 percent inflation. This example highlights the difference between what the BLS is measuring and what we all care about. Tastes can change and the satisfaction (or utility) you derive from tickets to the opera versus a rock concert might change as you get older. The CPI is designed to measure and adjust for the many small improvements in quality of life that happen all the time. Cars used to be sold without airbags; now they have airbags. When the new model included airbags for the first time, the BLS made a quality adjustment to its price to reflect the greater value provided by improved safety. If the car

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cost the same as before, the CPI would record a fall in price. Is the car really cheaper? It does provide greater utility to the extent that safety is desirable. Nevertheless, you don’t have any money left over to buy something else. Your standard of living now includes a car with an airbag, in an example of one small yet important improvement in living. Health care inflation is an especially difficult area. Making hedonic quality adjustments to the cost of medical services would be highly subjective. How do you adjust for a less painful procedure or increased life expectancy? It’s not currently done. Furthermore, medical care receives only a 6.5 percent weight in the CPI∗ (BLS, 2012), whereas health care represents 18 percent of United States GDP (World Bank, n.d.). The Federal government picks up much of the difference through Medicare and Medicaid, and inflation in this category results in more debt and ultimately higher taxes to repay it. The BLS is measuring what it costs to live at a standard that’s in the past. They strip out quality improvements, even though they’re an integral part of living in a capitalist economy. This notion of constant utility means that whatever satisfaction you received in the past from a given basket of goods and services is the same one you should expect today. For the government, time stands still and progress is factored out of the result. Someone living life today at the average standard that prevailed 50 or 100 years ago would feel very poor indeed. Foregoing the millions of improvements in quality that progress creates makes the job of measuring inflation easier. However, it also results in a measure that isn’t all that useful. The BLS takes the view that buying last year’s iPad today when it’s old will give you as much satisfaction (“utility”) as if you’d bought it a year ago when it was new. In the community of experts on price statistics, there is no controversy over the effort to quality adjust price indexes. Most nonstatisticians probably wouldn’t agree. It means that the BLS is measuring prices one way while we’re experiencing them differently. The third area of difference involves substitution bias. This takes account of the fact that if apples rise in price compared with pears, ∗Medical care is a bigger percentage of the PCE.

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consumers will buy fewer apples and more pears. They will substitute to some degree the product that rose in price with the cheaper alternative. This technique allows the fixed weights of each product and service within the index to vary somewhat as a better reflection of what people are actually buying. Although this element also has its critics, substitution probably doesn’t create much of a distortion, because it reflects something people do every day—compare prices of similar products and buy based on better value.The assumption that consumers buy the same basket of goods and services every month will inevitably drift away from reality over time, and so there seems little choice except to make adjustments based on substitution and shifting patterns of consumption. These quirks or shortcomings in the CPI are freely acknowledged by government statisticians, and the CPI is the source of many academic articles on its construction. Nevertheless, the cost of a constant standard of living, which is what most consumers care about, typically rises faster than the cost of a basket of goods and services with constant utility. If your income rises at the rate of inflation, you will feel poorer over time because inflation isn’t designed to reflect the quality improvements in many things we buy. This is one reason why it’s popularly believed that inflation is understated. It’s not that there’s a government conspiracy to manipulate the data; it’s that they’re not measuring what we think they’re measuring.

WHAT CRITICS SAY For many years, some observers have speculated on the existence of a U.S. government conspiracy to understate inflation. There’s no doubt that the government would derive a benefit in the short run from artificially low inflation, since entitlements and welfare payments are adjusted upward by inflation every year. The interest rates at which they borrow are also affected by inflation, at least to the extent that investors consider future inflation when choosing whether to buy bonds at prevailing yields. The conspiracy theorists are an eclectic bunch. Former congressman Ron Paul is perhaps the best known. He used to routinely lambaste Fed chairman Bernanke about the

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Fed’s inflationary policies and has argued for some time that actual inflation is understated. On February 29, 2012, Ron Paul stated during a congressional appearance by Bernanke, that actual inflation was really 9 percent, rather than the 2 percent figure commonly used and published by the BLS (Paul, 2012). Ron Paul’s views are far from mainstream, and included among the many radical moves he has advocated is the abolition of the Federal Reserve and a return to the gold standard. While his belief that inflation is overstated isn’t widely shared, he does make the case that savers on fixed incomes relying on bond investments to fund their living expenses are getting a poor deal. In this he’s clearly on solid ground. Niall Ferguson is a noted author and economic history professor at Harvard University. He has also argued that the inflation data don’t reflect reality, such as in a column he wrote for Newsweek magazine on May 1, 2012 (Ferguson, 2012). Ferguson makes the case that the methodological changes implemented over the years by the BLS have caused an increasing discrepancy between inflation calculated the old way and the current method. Other critics of the inflation methodology agree. John Williams, who runs a website called Shadow Government Statistics (www .shadowstats.com), publishes an inflation series using old BLS methodology that shows much higher inflation than is currently reported. Williams contends that adjustments to the calculation of inflation were implemented in the early 1990s so as to reduce the cost-ofliving adjustments made to Social Security recipients. He focuses on the quality adjustments as described earlier, particularly the “hedonic quality,” as the BLS calls it. The bigger jar of peanuts is an example of a simple quality adjustment that everybody would acknowledge is appropriate. The hedonic version relates to the improved quality that results from a faster computer, and is certainly worth questioning. Williams goes on to point out that declining quality in things such as air travel (longer security lines since the 9/11 attack, more delays, and less legroom) haven’t shown up as upward adjustments. Just as a faster computer for the same price is a quality improvement, a less pleasant flying experience for the same price is a decline in quality. This strikes me as a valid argument. The same theory that assumed a consumer gets some benefit from faster chip speeds in a laptop ought

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to reflect the steady deterioration in flying coach toward the equivalent of a Greyhound bus. The BLS doesn’t make quality adjustments to airline fares other than to reflect easier cancellation terms. Since 2000, domestic airfare inflation has been 5 percent. To say flying domestically in the United States on an economy fare has become steadily worse could scarcely draw any dispute except perhaps from airlines. A statistician would require something a little more quantitative before concluding that quality had declined. According to IndependentTraveler.com, a web site that covers such things, the gap between seats has shrunk from 33–34 inches to 31 inches in recent years, although airlines counter that airline seats are thinner so legroom has not changed much. (My business partner Henry Hoffman counters that the flying experience has actually improved in recent years and cites the elimination of a smoking section on planes representing an immeasurable quality improvement that also didn’t make it into the CPI statistics. However, Henry is both a glass half-full guy and a sympathizer with the challenges faced by BLS statisticians.) For most passengers the entire experience is far less pleasurable. If we assume an annual 5 percent drop in quality, which the BLS does not pick up, that translates into a price index 0.5 percent higher in 2012 versus 2000 than reported. And air travel is less than 1 percent of the index. Although the conspiracy theory requires a fairly dark view of government to be credible, as I dug into figures such as the airline example, I did begin to wonder whether there wasn’t, in fact, some desire to ensure a downward bias to reported inflation. Jim Bianco, president of his eponymous research firm, told Bloomberg in April 2012 that he agreed with John Williams (“CPI Conspiracy Theories,” 2012).

MEASURING WHAT THEY CAN, NOT WHAT COUNTS Although the group of inflation critics is small, it includes some thoughtful individuals. However, most economists and financial market analysts reject the idea of even a benign misstating of inflation. As for the conspiracy theory that the federal government is

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actively manipulating the figures, there are few serious observers who really believe that. It’s simply not credible because there’s no evidence of any data manipulation, and people who understand the process the BLS follows note how hard it would be to orchestrate such a fabrication. Even so, there remains the nagging perception that individuals experience inflation at a higher rate than the stated figures. One explanation for this is that consumers are more sensitive to the prices of smaller, frequent purchases than less frequent, but larger ones. Paying more for gasoline, food, or movie tickets is a regular experience whereas the lower price of, say, flat-panel TVs doesn’t resonate very often. It’s a “recency” issue, to use a phrase that behavioral scientists attach to the human brain’s tendency to attach greater importance to more recent experiences. It’s more likely your last purchase was for an everyday item that may well have gone up, than for an electronic appliance. This is one explanation for why inflation feels higher than it is. However, an overlooked possibility is that people don’t really grasp what the BLS is measuring. They’re focused on constant utility, the abstract notion that you’re purchasing a basket of goods and services for which you get the same benefit as before. Most people care about a constant standard of living, and measuring this is more subjective. Because society’s quality of life generally improves in many ways, some of which can’t be measured, the constant standard of living that many people care about is a relative measure. Advances in technology and productivity have been raising living standards for generations, whether you include electricity, indoor plumbing, or the Internet. The average standard of living has improved enormously compared with 100 years ago. This is in large part due to quality improvements in so many of the goods and services we consume.When we think in terms of a constant standard of living, we really mean constant relative to our peers and neighbors, that is, improving at the same rate as the average. The BLS seeks to remove the effect of improvements in quality. Basically, the utility we might derive from whatever we could purchase in the nineteenth century is the same utility demand we’re

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seeking to satisfy today. In economic terms, however, we expect a little more utility every year to the extent that living standards increase every year. This is the disconnect between the inflation statistics and the daily experience of consumers.The government is measuring something, but not what most people think they’re measuring. In some ways the CPI is just not as useful as we are led to believe. The common phrase that “the cost of living is rising” refers to the cost of maintaining a constant standard of living, and that standard is itself a relative one where we compare our situation with others. We don’t want yesterday’s utility, we want today’s. The BLS defines cost of living in absolute terms. In theory, you get the same use, or utility, out of a basket of goods this year as last year or 10 years ago. I think most people think about it somewhat differently. What does it cost to achieve this year’s median standard of living compared with last year’s? Improvements in productivity or living standard quality, to the extent that they can be measured, count to the average person, not to the BLS. There’s no conspiracy. The BLS is just not measuring what we care about. Even so, measuring the cost of living is a far more difficult task, with greater subjectivity. So they don’t measure what we care about because it’s too hard; they measure what they can, and we mistakenly think they’re counting what counts to us. It is in some ways a fairly benign misunderstanding in that there’s no intention to create any financial harm and the BLS is totally open about their process. It does reinforce, though, that if you simply keep up with inflation, you will experience a steadily declining standard of living.You’ll have last year’s utility when you really want this year’s to maintain your relative standard of living. So if this year’s iPad is faster than last year’s version yet priced the same, you don’t perceive an improvement in your standard of living, because you’re simply buying the latest iPad for what it cost a year ago. Although the new iPad is faster and better, it’s not clear that the time saved through improved processing and downloading speeds can actually be put to good use. It’s a better product at the same price to be sure, yet using that as the basis for an effective price reduction would strike most people outside the BLS

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as counterintuitive. In the statistician’s world, you have gained greater utility, because this is an improvement in the quality of the product. Because they want to assume the world has stood still, they measure the cost of the same utility, which means a downward adjustment to the price of an iPad going into the CPI basket. It’s a subtle issue but also an important difference between the BLS view of inflation and the average person’s. These differences I’ve described here don’t amount to anything noticeable from month to month. The short-term effects are imperceptible. For savers planning their retirement many years ahead and for investors making long-term assumptions about inflation, the impact can be significant. If, as a saver, you simply compound your retirement pot at inflation, you might expect to enjoy today’s standard of living at that point in the future. That won’t preserve your relative standard. You’ll be living somewhat farther down the economic pecking order than you may have expected. It means that for people making long-term saving and investing decisions, simply keeping up with inflation isn’t enough. To preserve the same relative quality of life you need to do better, maybe an additional 1 to 2 percent better. Clearly, the world of low interest rates that appears never ending is not going to help at all. Even interest rates equal to inflation still expose savings to erosion through taxes. The financial repression that such policies represent will force a lower standard of living on people trying to save for retirement. It’s a stealth tax, a form of wealth transfer away from the prudent and to the profligate, to those who already have borrowed too much and can’t afford to service it at normal rates. It’s not an unpopular policy, either. The typical household benefits from some modest inflation, which over time boosts the value of their home, which is likely financed with a fixed-rate mortgage. While nobody wants a return to the inflation of the 1970s, most people would probably tolerate a somewhat higher rate. Assuming the question could be asked in a way that was understandable, a popular vote on whether an inflation rate of 2 percent or 3 percent was preferred would probably choose the higher figure. Savers looking for steady income from bonds are increasingly looking like the late Rodney Dangerfield—they get no respect.

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Investors need to assess how this set of policies, which is likely to continue for a long time, will affect them—and act accordingly. Whether or not government policy is enlightened is not as important as deciding how to protect your savings, given the available options. Government policy is biased against fixed income investors. There’s little upside in hoping that will change. A successful investment strategy will acknowledge our excessive debt, partisan government that is leaning populist, and the inadequacy of simply keeping up with measured inflation.

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CHAPTER 9

BONDS ARE NOT FOREVER Putting It All Together

In 2011 I wrote The Hedge Fund Mirage:The Illusion of Big Money and Why It’s Too Good to Be True. I explained how hedge fund investors had done quite poorly out of their hedge fund investments—not all investors, but in aggregate and certainly most of them. The early success of hedge funds drew in more capital than they could manage, and so the returns went down. Investors would have been better off owning Treasury bills. The returns for clients had been a mirage, although enormous wealth was created for hedge fund managers and those who guided the investors to them. Calling this book “The Bond Mirage” would be wrong. Bond investors really have done very well. Bonds outperformed stocks during the first decade of the millennium, and the buyer of a 30-Year Treasury bond at the peak in yields in 1981 also outperformed equities during the subsequent 30 years. Bonds have largely done what they’re supposed to do, and following the equity market collapse of 2007– 2008, it’s hardly surprising that their popularity has never been higher. Past performance is no guarantee of future returns, as the familiar disclaimer on investment products warns. Buying what’s been going up, which is called momentum investing, feels more comfortable than buying what few others want. Humans are social creatures, and most would 189

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rather find reasons to agree than hold a minority view. Successful investing requires looking forward. History is relevant, though positive real returns can come only from investing on terms that provide a reasonable probability of beating inflation. The math of yields and of the amount of debt as well as the politics are all increasingly biased against today’s bond investor. Much of the return of recent years has been fueled by capital gains through falling yields on long-term bonds. Today’s yields are close to, if not at, the point where further capital gain is not possible. Returns will simply be the interest rate on the bonds and nothing more. The long bull market has pretty much run its course.Yields may move higher, inflicting actual losses on investors, or they may remain tethered by the Federal Reserve to 0 percent short-term rates. It’s time for bondholders to begin looking elsewhere, for three reasons. First, transaction costs for the retail buyer have always been too high. Investors have paid far more in markup to brokers than they should have. Incredibly, the bond market of the 1920s and 1930s offered clients a better deal than today. A bull market and the absence of accurate price information have prevented this from being as apparent as it should be. Clients don’t know and brokers won’t tell them, but the data are clear in that retail buyers pay far too much for relatively safe securities. Perhaps the buy-and-hold investor need not care, yet when yields are pegged between 0 percent and approximately 3 percent, the 1 percent or more markup that’s common represents an unacceptably big chunk of the possible return. Second, nominal yields that are close to and below inflation ensure that the investor will get back less purchasing power than he gave up when he bought the bonds. Figure in taxes and it’s worse. Moreover, real rates on government and investment-grade credit are unlikely to provide the 2 to 3 percent cushion above inflation that ought to be the minimum requirement of lenders. Government policy of maintaining a cost of borrowing that’s negative after inflation will remain successful, as it has been at other times of high public indebtedness. Lenders are increasingly a minority, and their interests clearly don’t figure as highly as those of the far more numerous debtors. Debt owed by federal, state, and local governments; households; and students, as well as other substantial obligations such as unfunded public sector pensions and entitlements, create an enormous public interest in the lowest possible cost

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of borrowing. As a society we want low rates, and the Federal Reserve is pursuing policies that are clearly in the public interest. Short-term interest rates that are most easily controlled by the Fed are likely to remain low for years. When the Fed begins raising rates, their ability to push them above inflation will be constrained by their dual mandate, which includes maximum sustainable employment. They will likely raise rates cautiously, lagging inflation, although it’s entirely possible that they may have to raise rates quickly. Neither outcome will be pleasant for fixed income investors. Furthermore, they will have to give attention to the $36 trillion of debt throughout the economy whose servicing costs will rise, slowing growth and raising unemployment and political pressure. Long-term rates may remain tethered to short-term rates and stay low, or they may drift higher as private investors impose a higher inflation premium. A steepening yield curve with negative real rates for short maturities is hardly the place for investors to find attractive returns. Third, even earning a return on bonds that beats inflation after taxes doesn’t ensure a secure future for those planning their retirement. Inflation measures a standard of living that stands still, based on a basket of goods and services whose utility, or value, is fixed. Merely keeping up with inflation results in a steadily falling relative standard of living.The downward price adjustments for quality improvements, as everything from electronic goods to automobiles gets a little better, is not intuitive to most people. The government’s treatment of housing costs is frankly bizarre and exists to suit the statisticians and their theories while having little to do with the real world, where consumers wrestle with housing costs not directly measured by the CPI at all. Many analysts forecast that if America doesn’t deal with its deficit, rates will eventually move sharply higher, reflecting increasing risk of default through inflation. They worry that China may start dumping some of the $1.2 trillion in U.S. government debt that it holds, stopping the economy in its tracks (U.S. Treasury, 2013). It’s worthwhile to consider this possibility. The range of possible outcomes is wide, and this is a real one. However, you don’t need to believe such an outcome is the most likely one to avoid bonds. Rates that remain where they are will turn out to be confiscatory. Rising rates and higher inflation will simply make it worse.

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I think that America’s foreign creditors are in too deep to be much of a threat. They hold so much of our debt because there’s no other market sufficiently big and liquid to absorb the reserves they wish to hold. If China held, say, $50 to $100 billion in bonds, maybe over time they could exit without driving rates up in the process. However, at their current size, they simply can’t sell. They are in for the duration. When you owe somebody a trillion dollars, it’s as much their problem as yours. China will get back what we want them to get back. Frankly, I like our position better than theirs. It’s a negotiation that will take place through America’s fiscal policies and the foreign exchange value of the U.S. dollar over many years. That view may be wrong, but being wrong needn’t cost the investor who recognizes that yields are in any case too low to compensate for the risks. As our domestic expenditures increasingly shift toward paying for unfunded entitlements such as Medicare and interest to foreign holders of our debt, consider how the political mood may start to move against the foreign lenders, who so readily provided finance and therefore muffled the warning that higher rates could have provided. Foreign governments have seen it in their interests to facilitate a transfer of wealth from one generation to another and have confidently assumed that a younger generation of taxpayers would willingly accept the moral obligation to repay what their forebears failed to save. Today’s buyers of 30-year debt assume no culpability in helping one group take from another. Will subsequent taxpayers and voters accept their unwanted obligations willingly? Or will they reason that the buyer of long-term bonds deserves to bear some of the cost of their actions? Negative real returns and a depreciating currency will be the most obvious way to modify repayment terms, yet if our children ultimately decided on more severe forms of debt modification, who could blame them? Bonds have been great for a very long time, but today Bonds Are Not Forever.

WALL STREET BUILT IT The debt that’s built up has been inextricably linked with a robust financial services sector. Financial innovation, from the use of the

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personal computer to securitization, has vastly increased the forms of debt available, so as to suit every possible taste. It’s inconceivable that one could have grown without the other, in a symbiotic relationship that fed on itself until the music stopped in 2008. It wasn’t a public policy objective to create huge banks, though cheap financing for wars, home ownership, consumption, and education was. The banking system enabled easy access to borrowing, helped by pro-debt tax policies and yields comfortably above inflation.The growth in government and household debt since World War II shows unmistakably where it took off in the early 1980s, around the peak in interest rates (see Figure 9.1). The growth in finance since 1947 is shown in Figure 9.2. There were ups and down through the 1950s and 1960s, but pretty clearly a sustained increase in its share of GDP began in the late 1970s, approximately when we began our climb into the debt stratosphere. Some may find alternative explanations for the apparent connection between the two. It’s a rich subject and clearly worth further research. When you combine the first two charts with how the median household has fared, you can see why many people might ask if all the borrowed money was worth it? The typical family is no better off

Household % GDP Govt Debt % GDP 250% 200% 150% 100% 50%

FIGURE 9.1

2011

2008

2005

2002

1999

1996

1993

1990

1987

1984

1981

1978

1975

1972

1969

1966

1963

1960

1957

1954

1951

1948

1945

0%

Government and Household Debt Share of U.S. GDP

Source: www.usgovernmentspending.com/federal_state_local_debt_chart.html.

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0.3%

1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

1952

0.3% 0.2% 0.2% 0.1% 0.1% 0.0% –0.1% –0.1% –0.2% –0.2%

FIGURE 9.2

Finance Five-Year Average Growth in Share of U.S. GDP

Source: Bureau of Economic Analysis. www.bea.gov/iTable/iTable.cfm?ReqID=5&step=1#reqid=5& step=4&isuri=1&411=1947&412=1&401=1&402=1&403=1&413=GDPVA,52VA,521CIVA,523V A,524VA,525VA. 130 120 110 100 90 80 70 60 1989

FIGURE 9.3

1992

1995

1998

2001

2004

2007

2010

Median Family Net Worth, Thousands of 2010 Dollars

Source: Federal Reserve Survey of Consumer Finances.

than 25 years ago. Of course, we’re just coming out of the worst recession since the 1930s, but the prior 25 years of improvement in household net worth coincided with, and was supported by, a huge run-up in debt (see Figure 9.3). The debt buildup was enabled by a growing financial sector. More debt, bigger banks, and stagnant net worth are inextricably linked. A bigger financial system has not obviously created many benefits for nonfinanciers. Today’s huge banks routinely produce outcomes that lead many to question the value of such large institutions. It’s certainly been true that providing labor to the banking system (i.e., working for one) has been a far better proposition than providing capital by investing in the sector. Banks today, while holding more capital to support their activities than in the past, are

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still highly leveraged companies. JPMorgan, one of the best-run banks in the world, operates with almost 10-to-1 assets to tangible common equity. While their record is supportive of today’s banking system, the industry’s overall is not. Although capital as a percentage of assets has been rising, suggesting a safer banking system, more sophisticated measures of risk are clearly needed. The Fed’s annual stress testing of the largest banks’ balance sheets to simulate their ability to withstand a deep recession is certainly a positive development. For a great many Americans debt has gone up and net worth hasn’t. For the bond investor, it should be enough to assume a shift toward more populist monetary policies with their corresponding effect on bond returns. Some people made a lot of money from the debt buildup, but clearly most did not.

MAKE YOUR OWN BOND So where should investors go in their search for more reliable ways to preserve the purchasing power of their savings? The answer is equities. U.S. common stocks come in many flavors, provide growth opportunities, and also offer an extremely fair deal to investors in terms of transaction costs. Many small and large investors are still reeling from the credit crisis and a poor decade of performance from stocks. This feeling is understandable, yet looking back is rarely the best way to assess investment opportunities. The concern that stocks can fall, perhaps a long way—eviscerating savings in the process—can be handled by holding some cash as well. Moving fully from bonds to equities is too radical a move. Nevertheless, cash, even yielding close to 0 percent, can be used as a risk enabler. In fact, the Fed’s successful manipulation of interest rates below where they would otherwise be has rendered an entire asset class devoid of an acceptable return. It’s their response to a crisis that was induced by excessive debt, but there’s no reason for investors to help the process along.The Fed is a noneconomic buyer.They don’t seek to earn a positive real return on their investments—in fact, if sufficiently robust economic growth drives rates higher and causes the Fed to lose money on their leveraged holdings, they might well regard their policies as having been successful. Clearly, the private investor in bonds would not.

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The Federal Reserve has become increasingly open about their objectives and expectations in recent years. They publish their own forecasts for interest rates, gross domestic product (GDP), employment, and inflation (U.S. Federal Reserve, 2012). Ben Bernanke holds regular press conferences following each meeting of the Federal Open Market Committee (FOMC), which meets every six weeks or so to set interest rate policy. It’s worth noting that the Fed’s own equilibrium forecast for short-term interest rates is 4 percent (U.S. Federal Reserve, 2012). They’ve long been buying securities at all maturities at yields well below this. While it’s not clear when they’ll raise rates to 4 percent, the startling implication of this is that they don’t think bonds are a particularly good investment for private savers. To anybody who will listen, the Fed is plainly saying, “We don’t recommend that you do what we’re doing.” If bond investors turn around and discover with dismay that their holdings have lost substantial value, they really can’t blame the Fed for not communicating its objectives clearly. They don’t think you should own bonds. It’s really as simple as that. The yields on stocks and bonds are surprisingly close nowadays. The big difference is that stock dividends grow, whereas bond payouts are fixed. The dividend growth on stocks represents a significant form of inflation protection. If consumer prices start rising, many big companies will respond by raising the prices of the goods and services they sell. Some will possess more pricing power than others, and it will be an uneven process, to be sure, but far better than owning securities whose payouts are fixed no matter what the future holds. The dividend growth potential in stocks means that a small portion of what you hold in bonds can be put in stocks and achieve a similar return. In effect, you can create your own bond, by selling the bonds you own and dividing the proceeds between stocks and cash. Table 9.1 illustrates how you would replace a 10-year bond with this combination. It shows what portion of the proceeds from selling your bonds you’d need to invest in stocks to achieve the same after-tax return. The amount of stocks you’d need to hold depends on where bond yields are, compared with the dividend yield on the Standard & Poor’s (S&P) 500. As you can see in Table 9.1, it doesn’t require much of an equity holding to beat bonds.

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Percentage of Stocks Needed to Earn an Equivalent Treasury Bond Return

Yield on 10-Year Treasury Note Dividend Yield on S&P 500 1.5% 2.0% 2.5%

1.5% 19% 17% 15%

2.0% 25% 23% 20%

2.5% 32% 29% 26%

3.0% 39% 35% 32%

The two key assumptions are: 1. 2.

Dividends will grow at 4 percent annually, which compares with a 50-year average of 5 percent. Valuations in terms of price/earnings ratio (P/E) or dividend yield are broadly unchanged in 10 years.

This second assumption may strike some as unrealistic. There’s never agreement on whether stocks are cheap or expensive. So consider a couple of additional points: dividends have grown at 5 percent annually, even while companies have paid out successively less of their profits each year. Over 50 years the payout ratio (the percentage of profits paid out in dividends) has dropped from two thirds to one third. Companies are buying back more of their stock as a way to return value to shareholders. The other consideration is risk. Suppose stocks fall in value 50 percent. Look at Table 9.2 and see what happens to your synthetic bond portfolio in such an outcome. Holding cash provides some valuable stability and greatly reduces the overall loss of value experienced by the investor. Table 9.2 applies various falls in equities on the barbell of stocks and cash that you’ve constructed to replace bonds. Assuming 25 percent in stocks, a 10 percent fall will cause your barbell to lose 2.5 percent. The next column over shows how much 10-year Treasury yields would need to increase in order to create the same 2.5 percent loss. A 50 percent drop in the S&P 500 would cause a portfolio loss of 12.5 percent; 10-year Treasury yields moving from 2 percent to 3.5 percent would do the same. Which is more likely? If you think the 50 percent fall in stocks is, then you should own bonds. Over the

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TABLE 9.2

Drawdown Comparison, Cash and Stocks versus Bonds

Fall in Stocks 10% 20% 30% 40% 50%

Loss on Synthetic Bond 2.5% 5.0% 7.5% 10.0% 12.5%

Increase in Interest Rates for Equivalent Loss 0.28% 0.57% 0.87% 1.17% 1.49%

next 10 years, that will sometimes look like a smart move. My bet is that at the end of 10 years, bonds will turn out to have been far worse than some combination of stocks and cash. It’s important to know your own risk tolerance. For many people, the trade-off is attractive. However, for those who maintain that bonds are still a preferable investment, in Chapter 2 we identified $36 trillion of debt in the United States across all levels of government, households, and students. If lending is your thing, there’s no reason to rush.You can be assured of healthy demand for a very long time yet.

HIGH DIVIDEND, LOW BETA If you’re going to rely on dividend-paying stocks as a substitute for bonds, you obviously need to select reliable dividend payers.There are many big companies with decades of history of paying and increasing their dividends. Often, they own broadly diversified businesses that are not highly cyclical or vulnerable to swings in the economic outlook. The best of them reliably generate more cash than they can usefully reinvest back in their business, which provides the ability to continue raising dividends and to return additional cash to their owners through share buybacks. Many of the companies who fit the preceding description are less volatile than the overall market.To use a term from financial theory, they are low beta names. Beta is a measure of a stock’s returns compared with the market.The market overall has a beta of 1.0, so a stock with a beta of less than 1 is generally less volatile than the market and above 1 is more

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volatile.∗ It comes from the Capital Asset Pricing Model (CAPM), which holds that the more risky (i.e., volatile) a security is, the higher should be its return.Taking more risk gets you more return, a fairly uncontroversial statement.The implication is that if you think the market will rise, you’ll do better holding stocks with a beta of, say, 1.5 than 0.5. The low-beta names won’t keep up with the overall market because they’re less risky. As reasonable as this sounds, the real world doesn’t actually work that way.There’s considerable academic research going back 40 years or more that shows that CAPM, a cornerstone of financial theory, doesn’t reflect how stocks really behave. In fact, low-beta stocks have been shown to outperform high-beta stocks on numerous occasions, not just after adjusting for the lower risk, but even in nominal terms. Time and time again, the tortoise beats the hare. It’s called the Low-Beta Anomaly. There are several possible explanations for this, and some have refined CAPM to come up with an “adjusted” CAPM so that the old model can still be shown to explain how the world works, with suitable modifications. One theory is that high-beta stocks are owned by investors who want to use leverage to boost their equity exposure, yet are prevented by their investment charter or other reasons from doing so. This is quite plausible. The problem is that any explanation of the weakness in CAPM is hard to prove, because there’s only one record of history to examine.You can’t go back and relax the leverage constraints faced by certain investors and then observe their behavior to see if it changes in a way that supports this explanation for the Low-Beta Anomaly. I like another possible source of this inefficiency. Studies have shown that active managers of equities, whether they’re running hedge funds or mutual funds, tend to have a little more risk than the market as a whole. The reason for this can be traced back to the principalagent problem that is present in so much of finance.The investor (who is the principal in this case) seeks an attractive return on his portfolio for a given level of risk. The agent (who is the money manager) ∗A stock’s correlation with the market also affects its beta, so a stock can be more volatile than the market but have a low beta if its correlation with the index is sufficiently low. It’s important to distinguish between low beta stocks that genuinely move less than the market, and those whose low beta derives from a low correlation which might make them appear less risky than they are.

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generally seeks to grow his assets under management (AUM), a goal that is most readily achieved through simple outperformance of the relevant benchmark. Both want good returns, but the investor’s definition of good is subtly different than the manager’s. It’s no secret that it’s easier to gain new clients in a rising market. When markets are falling, asset growth slows. When recent returns have been good, investors naturally seek to achieve the best returns available, and their willingness to try new managers is higher. Holding a portfolio of stocks with more risk than the market makes it more likely than not that the manager will outperform the benchmark in raw terms when it goes up. He should because, according to CAPM, he’s taking more risk than the market (“higher risk = higher reward”), although often the simple outperformance of his portfolio will be what draws attention. Many low-beta stocks are widely owned, but not widely owned by active managers. If you’re bullish, grabbing that high-flying financial services stock is far more appealing than the stodgy, predictable, consumer staples name. In addition, accurately calculating risk is far more complicated than calculating return, and people will more readily agree on the latter than the former. The result is that outperforming a rising market is one of the most reliable ways for a money manager to increase the size of his business. The obvious corollary is that in a falling market the active manager holding a portfolio that’s more risky than the market should lose more than the benchmark. For the investor, a portfolio that makes 5 percent more than the market after it’s gone up, yet loses 5 percent more when it’s fallen, is no better than simply holding an index fund. However, the “agent” or money manager faces quite different outcomes. In a rising market, he’s competing with other money managers to raise AUM. In a falling market, relative underperformance is less likely to hurt because he’s facing fewer opportunities to attract new clients, like his competitors. A further consideration is operating leverage. Money management can be a highly scalable business. The cost of managing $1 billion is rarely 10 times the cost of managing $100 million. Growing the business drives up profits at an ever faster rate. The payoff for the money manager looks rather like a call option. Good returns can be hugely profitable, whereas poor returns, especially if they can be partially explained away, may not hurt that much.

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The investor’s payoff is linear. Good returns help him as much as poor returns hurt. The money manager’s payoff is asymmetric. He has far more to gain from good returns than he has to lose from bad returns. The simple solution is to ensure that a substantial portion of the money manager’s personal wealth is invested alongside that of the investors whose money he is managing. This can create a far better alignment of interests and neutralize the principal-agent problem just described. Personally, I like this explanation of the Low-Beta Anomaly rather more than the leveraged one. They can both be correct, but the principal-agent issue fits with the world as we see it. Some money managers take the business asymmetry they face and push some of that risk onto their clients.

HEDGED DIVIDEND CAPTURE High-dividend, low-beta stocks can be an appealing way to build a diversified portfolio of equities for the long-term investor. A correctly constructed portfolio is unlikely to create many sleepless nights. Companies with decades of steady earnings and dividend growth rarely blow up overnight, although it’s important to hold a diversified portfolio and review their appropriateness regularly. There are many ways to use equities to create different risk/return profiles, and combining the low-beta portfolio with an equity market hedge results in a quite different result.The Low-Beta Anomaly doesn’t rely on predicting the market’s direction. The asymmetry noted earlier exists in both up and down markets. Although it’s impossible to predict on which day, month, or even year low-beta names will do better than CAPM expects, over sufficiently long periods of time it’s a fairly reliable phenomenon. In addition, whether the leverage explanation or the principal-agent one described above turns out to be correct, the result is likely to be enduring. Leverage constraints and business model optionality will remain in finance for the foreseeable future.The current focus on immediate returns is also unlikely to change any time soon. If you own a portfolio of low-beta stocks, you won’t often find them the subject of the excited Fast Money crowd on CNBC.What you own will be too boring. Day-to-day investing should appear boring to the outsider. For most people, there are far safer sources of excitement than stocks.

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Illustrating the flexibility of equities, a portfolio of low-beta names correctly hedged with a short position in the S&P 500 will largely eliminate the impact of stock market moves on returns while still extracting the profits from the inefficiency. The returns will probably be lower than owning equities, though the volatility will also be lower and the short-term correlation to the stock market eliminated. In fact, the overall result will look more like a corporate bond portfolio than an equity portfolio. It’s not a hedge fund, but it is a long-short portfolio which is what many hedge fund managers run. However, by avoiding the higher beta names that many active managers (including hedge fund managers) often own, you’ll have an opportunity to profit from the collective futility of so many managers trying to outperform the market over the short run.

MASTER LIMITED PARTNERSHIPS (MLPs) MLPs focus on energy infrastructure such as pipelines, refineries, oil and gas storage, and transportation. They tend to be involved in businesses that generate predictable cash flows, and as a result their distributions to investors are similarly consistent. Although MLPs operate in the energy sector, a substantial portion of them more resemble a “toll” business model, in that their results are dependent on the volumes of product gathered/shipped/ stored/refined, so the price of the oil or natural gas they’re handling is of secondary importance. They’re referred to as “midstream” because they don’t get involved in exploration and production (E&P) or refining, both of which can generate more volatile results. MLPs are most appropriate for income-seeking investors willing to tolerate risk similar to high-yield bonds. The risks can be worth it, though—MLPs have outperformed major asset classes over most time frames, as Figure 9.4 shows.They’ve also beaten diversified hedge funds, but then so have most investments. The asset class was created through the 1986 Tax Reform Act under President Reagan. The intention was to attract capital to energy infrastructure, and in that regard it was a successful piece of legislation. The market cap of MLPs is around $300 billion.

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Corporate Bonds

S&P 500

Hedge Funds

203

20%

15%

10%

5%

0%

–5%

1 Year

FIGURE 9.4

2 Years

3 Years

5 Years

7 Years

10 Years

MLP Performance versus Other Asset Classes

Source: SL Advisors.

Distribution yields on MLPs are currently 5 to 6 percent, and historically they have grown their distributions by a further 6 percent through price increases and improved operating efficiency. If you assume 5 percent current distribution yields and 4 to 5 percent growth, that adds up to a 9 to 10 percent long-term return. That’s much more attractive than high-grade bonds, although MLPs are more volatile. MLPs also have built-in inflation protection. In the case of many midstream businesses, the assets they own are regulated by the Federal Energy Regulatory Commission (FERC), which controls annual price increases. This is to prevent the owner of a pipeline who may have a monopoly on transporting oil between two points from gouging captive customers. Price increases are pegged to the Producer Price Index (PPI) measure of inflation, so if inflation picks up it feeds right back through their revenues. Because of this, many MLPs are able to automatically pass through price increases above inflation. Even so, MLPs are partnerships, not corporations, and that’s probably most of the reason their yields are 5 to 6 percent and not closer to 3 to 4 percent. They’re “pass-through” vehicles, which means that they pay minimal or no corporate income tax. This avoids the double bite that

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taxes take out of dividends, in that corporations pay tax before distributing part of their after-tax income as dividends to their investors, who in turn pay tax on this income. Investors in MLPs own a proportionate share of the underlying assets, rather than shares in a corporation. The tax consequence of this is that investors receive a K-1 instead of a 1099, which substantially reduces the pool of potential buyers. K-1s require more work when you’re filing your tax return, and as a result they’re appropriate only for investors who have an accountant prepare their taxes. While we’re on that topic, nothing written here should be construed as tax advice, and anyone contemplating an investment in MLPs should talk to their accountant first. Because MLPs depreciate their assets but don’t use the write-off against their taxes, the tax benefit passes on to their investors (commonly called unit holders since they own LP units in a partnership rather than shares in a corporation). Consequently, in many cases, MLP distributions are classified as a return of capital (rather than a return on capital), which greatly reduces the amount of taxable income an individual needs to report. It turns out to be a tax deferral because the amount of the distribution not taxed as income reduces the cost basis of the investment. Income tax is assessed from this reduced level when the units are sold. I’ve been investing in MLPs for many years, and in my experience the K-1s are worth the trouble. It’s not easy to find investments yielding 5 to 6 percent nowadays, and tax-deferred yields at that level are even less common. Over time, MLPs have handily outperformed the major asset classes. But a bear market in MLPs is seldom fun, and when they fall, they can fall fast. Because they are mainly bought for yield, rising bond yields can depress MLP prices. However, they are equities (MLPs issue debt, but that’s not nearly as interesting), and falling equity markets can hurt MLPs as well. In 2008 the Alerian MLP Index was down 37 percent. Sitting tight was the right decision back then as with most things, since the index roared back to deliver +76 percent in 2009. Nonetheless, while 2008 was clearly exceptional, MLP investors should be prepared for price drops of 10 percent or more. There’s always the risk that their favored tax status could be removed as Congress searches for new sources of revenue. Occasionally, this

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205

issue receives attention in Washington, yet legislators have historically acknowledged the vital role of energy infrastructure to the economy. Impeding capital formation by raising taxes has never gained much support, and the industry trade group the National Association of Publicly Traded Partnerships (NAPTP) is an effective lobbyist in favor of the status quo. I regard them as an inflation-protected fixed income asset, albeit with more risk than high-grade bonds. The best way to access MLPs is through direct investments in a diversified portfolio of names (10 to 15 is sufficient). There are a growing number of ways to invest in MLPs through exchange-traded funds (ETFs), closed-end funds, and exchange-traded notes. These products all have the advantage of replacing the K-1 with a 1099, and the disadvantage of losing the tax deferral benefits and in some cases incurring additional taxes. While they might be appropriate for investors with $100,000 or less to invest, high-net-worth investors will probably find it worthwhile to invest directly rather than through any of these vehicles.

DEEP VALUE EQUITIES Value investing is an investment style that, while often misunderstood, consists of using independent fundamental analysis to value a company’s expected financial performance. It involves determining what a security is worth and only investing in securities trading for less than a conservatively calculated intrinsic value. It is a disciplined set of investment principles to protect principal and earn an adequate return. Some of the most successful money managers are value investors of one form or another. Overall, securities prices move more than values, and the value investor seeks to identify those situations with the widest discrepancy between the two.

DEBT IS BAD A constant theme throughout this book and in the suggested steps for investors is that debt is bad. Investing in debt has been rendered largely

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unattractive through central bank policy. “Returnless risk” is a good description. Companies with too much debt run the risk of liquidity problems and even bankruptcy if business turns down unexpectedly. Investors using debt, or leverage, to increase their return potential give up the timing flexibility that they have without leverage. When you borrow money to invest, you care about the path your investment takes in reaching your objective. Your stock pick could ultimately double from your purchase price, although if in the meantime it loses half its value and you’ve borrowed half your investment, you’ll be wiped out. Many well-run companies use debt to finance seasonal fluctuations in their working capital and to make capital investments with an expected return above their cost of capital. Conservatively run corporate balance sheets need not be debt free, but ideally more of the capital a company uses will be sourced from equity holders rather than debt. Millions of Americans have mortgages, and although the credit crisis revealed some excesses, the vast majority of homeowners use debt to finance their home. Governments have borrowed money since such things could be measured, and many economists believe that government deficits maintained at an appropriate percentage of the economy are quite acceptable. Conventional wisdom is still that government debt can grow indefinitely as long as it doesn’t grow faster than the economy. What we’ve seen though is that, in the United States at least, there isn’t a reliable mechanism to prevent one generation trampling on the interests of future ones and passing down obligations that can be unsustainable. Thomas Jefferson put it as succinctly as anyone: Loading up the nation with debt and leaving it for the following generations to pay is morally irresponsible. Excessive debt is a means by which governments oppress the people and waste their substance. No nation has a right to contract debt for periods longer than the majority contracting it can expect to live.

Jefferson even went so far as to advocate a constitutional amendment preventing the federal government from borrowing at all. Future generations of Americans may well consider it worthwhile to revisit this idea.

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BONDS ARE NOT FOREVER All the strategies described in this chapter are employed in my investment business. My money is in all of them, alongside my clients’. I invite you to learn more by visiting our web site (www.sl-advisors .com) or contacting us. Some of the strategies are designed to produce modest returns with low risk, such as the hedged dividend capture strategy, which is a form of dividend harvesting. MLPs can be compared with high-yield bonds. Although they’re equities, the steady distribution growth and relatively low leverage make them an attractive substitute for high-yield bonds. Both sectors will move up and down with equities, yet MLPs provide stable growth with attractive yields. A portfolio that included MLPs instead of high-yield bonds would have been more efficient. A portfolio of low-beta stocks provides equity exposure with broadly less volatility than being invested in the overall market.Value stocks are equity risk. The point though is that there are enough sectors and ways to arrange stocks that you can invest in several strategies that range from income generating potential to growth opportunities and turnaround stories. The thoughtful investor can shun bonds entirely, and yet, through a combination of these strategies and cash weighted according to his return objectives and risk tolerance, construct a portfolio with much better prospects of retaining its purchasing power than one including the return-less risk of bonds. Moreover, this approach is fundamentally optimistic, but not recklessly so. America is an amazing country. It is truly the shining city on the hill, a beacon of freedom for so many people around the world. I am an immigrant myself, having grown up in Britain. I am very proud of my heritage and of the values Britain shares with the United States. However, I also know the intense desire of an erstwhile immigrant to move here, and after more than 30 years my conviction of the rightness of that decision remains as strong as ever. Since its founding, the New World has confounded doomsayers, as Americans have confronted challenges, surmounted them, and provided inspiration to so many. Its economy is as flexible and dynamic as any in the world. No doubt, we face substantial problems with the obligations we have amassed. Working through them

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won’t be painless, and some may conclude that our best days are behind us. However, 237 years of history make that look like a bad bet. Perhaps the most risky decision is the apparent rejection of risk so many bond investors are making today. Through their investment choices, they are conceding to a steady loss of purchasing power as the best that they can expect for the future. By shunning exposure to America’s entrepreneurial spirit and perpetual economic reinvention, they are implicitly betting that our star is falling. In the long run, that will be the most risky bet of all.

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REFERENCES

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GLOSSARY

alpha The amount by which a security outperforms its benchmark after adjusting for its riskiness. arbitrage The simultaneous buying of one security and selling of a similar or identical security so as to lock in a profit between the two transactions. asset management fees Fees charged by a money manager to the client based on a percentage of the account size or assets being managed. basis point value (BPV) A measure of risk commonly used in bonds. One basis point is 0.01 percent. BPV measures the change in price of a bond if the yield moves by one basis point. It is conceptually similar to duration. beta A measure of a security’s risk relative to the benchmark, based on volatility of a security’s price history. A beta of 1 indicates a security move in step with the market. bid and ask prices Market makers routinely quote a price at which they’d buy a security (“bid price”) and a higher price at which they’d sell it (“ask price”). bid/ask spread The gap between the bid and ask prices is a measure of the costs incurred by an investor in doing a trade. Less liquid markets have a wider bid/ ask spread, reflecting higher access costs for investors. Big Bang The 1986 deregulation of London’s financial markets. blue button A trainee broker on the floor of the London Stock Exchange. bond fund A mutual fund or exchange-traded fund (ETF) that holds bonds. Capital Asset Pricing Model (CAPM) A widely used theory that underpins the pricing of securities. Key principles include that markets are efficient, that

215

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diversification is good, that more risky securities must generate commensurately higher returns, and that investors all seek to maximize their returns for a given level of risk. convexity Measures how the sensitivity (such as BPV) of a fixed income security changes with interest rates. cognitive dissonance An opinion maintained in spite of overwhelming contrary evidence. consols Short for consolidated annuities, perpetual bonds issued by the U.K. Treasury. credit intermediation The removal of banks from the process of borrowing and lending. Examples might include a corporation borrowing money directly from an investor rather than from a bank, or a homeowner taking out a mortgage from a nonbank lender. credit scoring A numerical measure of an individual’s credit risk. currency relationships Typical price of one currency versus another. Stable currency relationships are generally held to promote economic growth by reducing uncertainty around investment returns and therefore allowing for long-term commitments. debt monetization The partial repayment of debt owed by a government in currency whose value is falling because of inflation. Some classify this as a form of debt default, since it results in debt being repaid in money that is worth less than when it was borrowed. deep value equities An investing style that selects equity securities that are deeply undervalued, in the opinion of the investor. deficit premium The additional interest charged by bond investors to compensate them for the existence of a large fiscal deficit run by a government. U.S. government bond yields in the 1980s and early 1990s were commonly believed to be higher than would otherwise be the case because of the U.S. government’s persistent budget deficits. derivatives Financial instruments whose value is “derived” from actual assets. An example might be a futures contract on the S&P 500 U.S. equity benchmark. Derivatives may be exchange traded, as in this example, or OTC (over-thecounter), meaning they are privately executed. The growth of derivatives is one of the defining features of finance since 1980. duration Sensitivity of the price of a bond to a change in interest rates. Eton An elite English public school (English “public” schools are actually private, fee-paying institutions). exchange-traded options Options that trade on an exchange, such as a call option on a stock. fiat money Currency whose value is not backed by tangible assets (such as gold) but instead derives its value from the users’ collective belief in its continued value. fixed commissions Commission rates that are fixed by regulation, as opposed to by competition among brokers.

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217

fixed-rate payer The counterparty in an interest rate swap that seeks to hedge against (or benefit from) higher interest rates. forward rate agreements (FRAs) A type of derivative that provides a onetime payoff based on where a short-term interest rate (usually LIBOR) is set. futures hedge A hedge of some other transaction or exposure carried out by using futures, which are typically highly liquid. HFT High-frequency trading. initial public offering (IPO) A private company issuing shares to the public for the first time does so through an IPO, becoming a public company in the process. interest rate swaps A widely used type of OTC derivative that is used to hedge against or speculate on anticipated moves in interest rates. jobbers Market makers on the London Stock Exchange pre-1986, whose role was to trade securities only with brokers (i.e., not the general public). K-1 A tax form issued to U.S. investors reporting that investor’s specific share of profits and other items. Most U.S. corporations issue investors a 1099 tax form. K-1s are issued by businesses organized as partnerships, and generally their inclusion in a taxpayer’s tax return can add to the return’s complexity. LIBOR London Interbank Offered Rate. A measure of short-term interest rates charged among banks for maturities up to one year. Marginal Revenue = Marginal Cost An economic equation that states that a seller of a product or service will be willing to sell as long as the sales cover the marginal cost, the point being that any net profit as a result can contribute toward other fixed costs (such as rent). mark to market The valuation of any asset against its current market price, as opposed to its historic cost, replacement cost, or (in the case of fixed maturity bonds) the repayment expected at maturity. nominal yields The yield on a security (as opposed to the real yield, which is the nominal yield minus inflation). notional outstanding Normally used when referring to the face value of all the OTC derivatives outstanding. It’s invariably an unimaginably large number and not very useful. open primaries A form of election primary used in some U.S. states in which candidates from both parties run against one another, as a precursor to the general election. operating leverage The extent to which a company’s increased sales lead to profits. A company that has high fixed costs (i.e., an expensive factory) but low variable costs (products that are incrementally cheap to manufacture) would have high operating leverage because increased sales result in a relatively small increase in costs. A consulting business whose employees are billed at an hourly rate would have low operating leverage. overnight call money rates “Call” money is a type of loan that can be “called” or repaid at the demand of the lender. Overnight call money can be called on one day’s notice. It’s therefore a form of very short-term borrowing.

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par Face value of a bond. P/E Price/earnings ratio. Stock price divided by the per-share earnings. quantitative easing The U.S. Federal Reserve’s policy of using unconventional means to achieve low interest rates, carried out through large-scale purchases of longer-maturity bonds. Regulation Q A now-defunct U.S. regulation that, among other things, limited the interest rate U.S. banks could pay on deposits. revolving line of credit Typically extended by a bank, this allows the borrower to borrow up to a maximum amount at a predetermined interest rate on an asneeded basis. seignorage The profit a central bank makes from selling physical currency to banks in excess of the costs of producing it. In the United States and many other countries, such profits are remitted back to the government. sell-side equity analysts Research analysts who produce research on equities and specifically work for “sell-side” firms, typically brokerage firms that charge commissions and underwriting fees. By contrast, “buy-side” firms are money managers that invest in securities often sold to them by the sell-side. stockbroker belt Expensive suburban neighborhoods south of London within daily commuting distance. The City London’s financial district and also its financial community; analogous to “Wall Street” in the United States. transaction costs The full cost an investor incurs when doing a trade. Typically, the largest component is cost of the market’s “bid/ask” spread. This can be hard to measure, but in most cases commissions are only part of the true transactions cost borne by investors when they trade. two-way price The practice whereby a market maker quotes a bid and ask price indicating where he would buy and sell a security. By explicitly showing the difference between his buy and sell prices, he provides information about the transactions costs borne by the investor. U.K. gilt market The market for U.K. government bonds. value at risk (VaR) A statistical measure of what an investment portfolio might lose on an atypical but not completely rare day. VaR has often been criticized for leading to actual losses far in excess of estimates, often due to the user’s failure to account for shortcomings in a single statistical measure of potential losses.

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ABOUT THE AUTHOR

Simon Lack spent 23 years with JPMorgan before retiring to manage his own money in 2009. Much of his career with JPMorgan was spent in North American Fixed Income Derivatives and Forward FX trading, a business that he ran successfully through several bank mergers and numerous economic cycles. Simon Lack sat on JPMorgan’s investment committee, allocating over $1 billion to hedge fund managers, and founded the JPMorgan Incubator Funds, two private equity vehicles that took economic stakes in emerging hedge fund managers. Simon now runs SL Advisors, LLC, an investment firm he founded in 2009, where he manages money for himself and clients in a variety of strategies. Simon chairs the Investment Committee of Wardlaw-Hartridge School in Edison, New Jersey, and also chairs the Memorial Endowment Trust Investment Committee of St. Paul’s Church in Westfield, New Jersey. He grew up in the United Kingdom and moved to the United States in 1982. He lives in Westfield, New Jersey, with his wife and three children.

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INDEX

A AIG, 68–69 Akroyd & Smithers, 7, 29–30 Alerian MLP Index, 204 Anglo-Saxon countries, 14 Annual stress testing, 195 Apex Electrical Distributing Company, 36–37 Arbitrage, 57, 59, 62, 70, 109, 146, 147, 153, 215 Aristotle, 25 Assets under management (AUM), 199–200 Auto loans, 156 Automated teller machine (ATM), 97 Average vs. median, 148, 170–171, 185 B Baby boom, 18 Bank bailouts, 2 Bank of England, 28 Bankers Trust, 103–106 Banque de France, 151 Basis risk, 97, 99–100, 104, 107, 152 Behavioral Finance, 82 Berkshire Hathaway, 50, 67 Bernanke, Ben, 161, 181–182, 196 Bernholz, Peter, 168, 169 Biais, Bruno, 87–88

Bianco, Jim, 183 “Big Bang,” 8, 11, 52, 215 Big borrowers in history, 43–45 Big mismatch, 109 Blackbird, 85 Blackrock, 90 Black-Scholes, 96, 109 Bloomberg, 183 “Blue button,” 10, 215 Bonds creating your own, 195–198 funds, 89–90, 215 market inefficiencies, 73–91 change, slowness of, 79–81 municipal bonds, 87–91 stocks vs. bonds, 76–79 structured notes, 81–84 swaps, Internet threat to, 84–87 payout, 197 Bretton Woods Accord, 4 British Empire, 14 Broadly diversified business, 94, 198 Brokers, 74–76, 78, 79, 85, 89–91, 158 Brookings Institution, 48 Brownian motion, 109 Buffett, Warren, 60, 67–68, 70

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222

INDEX

Building and loan societies, 31 Built-in inflation protection, 203 Bull market, greatest, 5 Bundesbank, 168–169 Bureau of Economic Analysis, 156 Bureau of Labor Statistics, U.S. (BLS), 170, 172–175, 177–180, 182–186 Bush, George H. W., 140 Bush, George W., 124 C California Public Employees Retirement System (CalPERS), 47 Capital Asset Pricing Model (CAPM), 199–201, 215 Capital formation, 20, 98, 143, 149, 156, 205 Castile, 166 Chase Manhattan, 14, 85, 103 Chemical Bank, 14, 103, 108–112, 148 Chicago Board Options Exchange (CBOE), 96–97 Chicago Board of Trade (CBOT), 97 Chicago Mercantile Exchange (CME), 97, 99 China, 44, 138–139, 160 economy, 44, 138–139 U.S. government debt, 191–192 Citigroup, 108 “The City” (London financial district), 6, 8, 10, 52, 61, 141, 218 Class system, 8–10 Clinton, Bill, 16–17, 121, 137 clo, 30 Cold War, 138 Collateralized mortgage obligation, 58 Collective inflation forecast, 175 Commercial loan demand, 37 Commercial paper, 99, 107, 108, 152 Commission on Social Security Reform, 125–126 Communism, 133, 139 Competition for power, 44 Complete nonstarter, 85 Computing technology, 51 Congressional Budget Office (CBO), 45–46 Consolidated annuities (consols), 6, 29, 216 Constant utility, 178–181, 184 Consumer credit, 18, 34–36, 70–71 Consumer Price Index for All Urban Consumers (CPI-U), 172 Corporations, 21, 57, 77, 88, 106–107, 204 Cox and Rubinstein, 108, 111 Crash of 2008, 6, 21, 88, 159, 174

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Credit, medieval, 26–28 Credit card receivables, 58, 156 Credit cards, 93–94, 157 Credit crisis, 195, 206 Credit intermediation, 14–16, 216 Credit Suisse, 105 Currency debasement, 165 Current U.S. situation, 45–49 D Davies, John, 52 Day traders, 77 Debt binge, 47 buildup, 39–40, 128, 157, 162, 194–195 history of, 23–49 ancient times, interest rates in, 23–25 big borrowers in history, 43–45 borrowing reaches mass market, 31–38 current debt, 45–49 medieval credit, 26–28 modern-day finance, beginnings of, 28–30 student debt, 39–43 monetization, 133–136, 216 outstanding, 21, 46–49 unattractiveness of, 205–206 Debt-induced financial crisis, 161–163 Deep value equities, 205, 216 Deficit premium, 121, 216 Dejoux, Jacques, 63–64 Delinquency rates, higher, 38 Den Norske Credit, 69–71 Depression, 2, 31, 36, 37, 162, 169 Der Spiegel (Jung), 168 Derivatives, 51–71, 73, 77, 81–84, 93–113, 141, 145, 147, 148, 152–153, 156, 216 growth, 51–71 early, 56–61 size, 65–67 swaps take off, 61–65 OTC, 57, 77, 81, 97 trading, 93–113 by the book, 107–110 business strategy, 103–105 Chemical Bank, 110–112 computers and swaps, 96–97 financial innovation, 97–101 missteps, 105–107 Volcker Rule, 102–103 Diminishing marginal utility, 179 Dionysius, 166 Disintermediation, 58

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Index Disparities in income, 160 Dividend growth potential, 196 Dizzying growth, 62 Dodd-Frank legislation, 146 Dougherty, Tommy, 54–55 E Economic decision making, 165, 172 Economic forces and trends, 21 The Economist, 48, 88, 127 Edelson, Steve, 111 Efficient Markets Theory, 101 Electronic exchange, 76 Entitlement obligations, 46 Equities, 5, 19, 60, 65, 67, 76–77, 80, 82, 86, 88, 148–149, 189, 195, 197, 199, 201–202, 204, 205, 207 deep value, 205, 216 Equity rally, 60 Eton, 11 Euro, 44, 146, 150–151, 169 Euro sovereign debt crisis, 21 Eurobrokers, 55 Eurodollar deposits, 53–54, 61, 62 Eurodollar futures market, 59, 99, 146, 152–154 European Central Bank (ECB), 169 Excess return above inflation, 161 Excessive debt, 24, 113, 187, 195, 206 F Failure of leadership, 41 Fair Vote, 119–120 Fannie Mae, 17, 32, 58, 70, 177 Federal debt, total, 46 Federal Open Market Committee (FOMC), 175, 196 Federal Reserve, 31, 43, 54, 66, 97, 99, 124–125, 130, 131, 133–134, 145, 161–162, 169–171, 174–175, 182, 190–191, 195–196 stress tests, 66, 195 Survey of Consumer Finances, 124–125, 170 Ferguson, Niall, 182 FICO system, 38, 94 Finance companies, 34–37 Financial derivatives, 109 Financial Industry Regulatory Authority (FINRA), 84, 106 Financial repression, 42, 131, 186 Financial repression tax, 131 Fiscal crisis, U.S., 21, 123 Fixed income vs. equity, 160

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223

Flash crash, 80 Flexible risk taking, 147 Flounders, Joe, 54–56 Forest School, 9 Forward Rate Agreements (FRAs), 69, 150, 217 Freddie Mac, 17, 32–33, 177 Futures trading, 57 G GDP value added, 12, 15, 156 Gen Re Securities, 67–68 General Electric Contracts Corporation (GECC), 36 General Motors Acceptance Corporation (GMAC), 34 Genoa, 27 Germany, 13, 44, 118, 138, 150, 167–170 defining economic experience, 167–170 Gerry, Elbridge, 117 Gibson Greetings, 105 Gilts, 5–8, 10, 11, 30 trading in, 5–8 U.K. gilt market, 7–8, 10–12, 29, 95, 218 Ginnie Mae, 58, 70 Global bear market, 5 Global debt clock, 48 Godsell LDA, 52–53 Goldman Sachs, 81, 98, 108 Government-controlled investing, 115–141 concerns, 116–127 debt growth, 141 future of, 129–133 imperial overstretch, 136–140 monetization, 133–136 Government National Mortgage Association (GNMA; Ginnie Mae), 58, 70 Government policy, 58, 96, 176, 187, 190 Great Recession, 39, 171 Great Society, 4 Greatest bull market, 5 Greece, 44, 129, 167 Green, Richard, 87–88 Greenspan, Alan, 59, 99, 121, 125, 174–175 Commission on Social Security Reform, 125–126 Greenwood and Scharfstein, 12–13, 19, 156, 157, 159 Gresham’s Law, 166 H Happy conclusion, 112 Harvard Business School, 12

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INDEX

Heavy moral obligation, 122 The Hedge Fund Mirage:The Illusion of Big Money and Why It’s Too Good to Be True (Lack), 20, 150, 189 Hedge funds, 146–147, 157, 189 Hedged dividend capture strategy, 201–202 Hewlett Packard 12C, 153 High card, 85 High-frequency trading (HFT), 20, 80, 158, 217 High ratio of home prices to rents, 176 High tuition inflation, 39 Hirshik, Larry, 63, 69 A History of Interest Rates (Homer & Sylla), 29, 122 Hitler, Adolf, 168 Ho, Dan, 111 Hoffman, Henry, 183 House, David, 96 House prices, rising, 174, 176 Household Finance Company, 35 Housing bubble, 17, 33, 145, 174–176. See also Mortgage crisis; Real estate crash; 2007–2008 crisis investing after, 20–22 sources of responsibility for, 176–177 Hyperinflation, 3, 131, 166, 168 I IBM, 57, 95 Icor, 85 Imperial overstretch, 45, 136–140 Income disparity, increased, 21 Inflation, 1–22, 165–187 “conspiracy,” 181–185 history, 165–187 critics’ opinions on, 181–183 current, 170–174 Fed’s huge mistake, 174–177 Germany’s defining economic experience, 167–170 measuring, 183–187 quality adjustments, 177–181 rampant, 5, 174 statistics, 172–174, 185 Interest rate cap, 107, 109, 152 Interest rate swap market, 56 Interest rates in ancient times, 23–25 International Monetary Fund (IMF), 2 International Swaps Dealers Association (ISDA), 65 Inventory financing, 34

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iPad, 178–180, 185–186f Ito’s Lemma, 109 J Japanese banks, 59 Jefferson, Thomas, 206 “Jim,” 152–155 Jobbers, 7, 11, 29, 30, 95, 217 Jorisdochter, Elsken, 28 JPMorgan, 14, 39, 103, 108, 149, 171, 194 JPMorgan Chase, 62, 112 Jung, Alexander, 168 K Kaiser, Jutta, 69, 70 Kennedy, Paul, 44–45, 136–137, 139 Kidder Peabody, 63 Korean won, 104, 105 L Larsen, Jeff, 110 Latin America, 3, 44, 166, 167 Layton, Don, 110 Lekdyk Bovendams Company, 28 Leverage, 56, 66, 71, 88, 124, 137, 147, 149, 194, 195, 199–201, 206, 207 operating, 200, 217 Liquidity, 38, 53, 60, 61, 73, 75, 77, 78, 80, 84–88, 101, 143–144, 151, 206 Loan sharks, 35–37, 54 London financial district (“The City”), 6, 8, 10, 52, 61, 141, 218 London Interbank Offered Rate (LIBOR), 99, 107–109, 112, 217 London Stock Exchange, 7–8, 12 Long dated swaps, 67 Lord, Albert, 40 Low-Beta Anomaly, 199–201 Low-beta names, 198–199, 201–202 LQD, 90 M Maastricht criteria, 46 Mabon, Nugent, Godsell, 53 Mackey, John, 35 Macy’s, 38 Manufacturers Hanover Trust, 14, 62, 102, 108, 112, 146, 148 Marine Midland, 63–64 Market making, risk-oriented. See Risk, managing

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Index Market model, 73–91 Markup, 83, 89, 100, 190 Mass market lending, 94 Mass production, 34–35, 94 Master limited partnerships (MLPs), 202–205, 207 McGillicuddy, John, 112 Median household, 20, 124–125, 159–160, 170, 193 Medicaid, 46, 116, 180 Medicare, 42, 46, 116, 123, 124–127, 180, 192 Medicare Prescription Drug Benefit, 124 Mexican War, 140 “The Microstructure of the Bond Market in the 20th Century” (Biais & Green), 87–88 Minor revolution, 38 Momentum investing, 189 Monetary Regimes and Inflation—History, Economic and Political Relationships (Bernholz), 168, 169 Monetization, 133–136 Moore, Gordon, 96 Mortgage crisis, 13. See also Housing bubble; Real estate crash; 2007–2008 crisis Mullins, 10–11 Municipal bonds, 86, 87–91 Mutual savings banks, 31 N 1938 Survey, 37 Napoleonic Wars, 131 Nassau, 54 National Association of Publicly Traded Partnerships (NAPTP), 205 National Association of Realtors, 16 National Bureau of Economic Research (NBER), 12 Negative real rates, 132, 135–136, 162, 191 Net interest income (NII), 60 Net present value (NPV), 100 Network effects, 78–79 New York Stock Exchange (NYSE), 20, 87, 158 New York University, 40 New York–London “link,” 61–62 Newsweek, 182 Newton-Raphson method, 94 Nominal yields, 149, 175, 190, 217 Noonan, 69 Northern Illinois Finance Company, 34 Notional principal, 66

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225

O OPEC, 4, 54 Operating leverage, 200, 217 Options, 82–83, 96–97, 106, 107, 109, 110–113, 148 exchange-traded, 82 OTC derivatives, 57, 77, 81, 97 Owners’ Equivalent Rent (OER), 172–173 P Partial remedy, 42 Pass-throughs, 58, 203 Paul, Ron, 181–182 Peace Dividend, 133 Pension funds, 47, 77 Peter G. Peterson Foundation, 46, 138 Philippon, Thomas, 158–159 Pimco, 7 Piwowar, Michael, 87 Plain vanilla swaps, 104 Plausible outcomes, 115, 129 Poland, 44, 167 Polonius, 36 Populist monetary policies, 195 Positive spread, 59 Prebon, 53, 55, 61, 69 Prestiti, 26–27 Price information, 27, 75–76, 79, 145, 149, 190 Pricing and valuation, 83 Procter & Gamble, 105 Producer Price Index (PPI), 203 Profit to mid, 100 Proprietary trading, 102, 144, 147 Public policy initiatives, 70 Q Quality adjustments, 177, 180, 182–183 Quantitative easing, 115, 130, 133–135, 218 Quants, 109 R Rates business, 148–149 Reagan, Ronald, 4, 45, 51, 60, 137, 202 Real estate crash, 21, 159, 174. See also Housing bubble; Mortgage crisis; 2007–2008 crisis Real world, 191, 199 Regulation Q, 54, 218 Reinhart and Rogoff, 42–44, 122, 166 Republic Finance & Investment Company, 37 Residual risks, 145 Retirement, planning, 172

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INDEX

Revelation, 52 Revolving credit, 38 The Rise and Fall of the Powers (Kennedy), 44–45, 136–137 Risk, managing, 143–163 debt growth, 156–163 global trading, growth of, 149–152 obscure, 152–155 social purpose, 155–156 traders and risk, 145–149 Risk appetite, increasing, 103 Risk exposure, 62 Risk tolerance, 101, 144, 147, 198, 207 Roman law, 24–25 Russia, 44, 138, 167 S Saad, Peter, 53 Salomon Brothers, 108 Savings-and-loan (S&L) exposure, 171 Screen-based trading, 77, 81, 86 “Secondary Trading Costs in the Municipal Bond Market” (Harris & Piwowar), 87 Securities and Exchange Commission (SEC), 83 Secret model, 111 Securities and credit intermediation, 14–16 Seignorage, 134, 218 Septimus Severus, 166 Shadow Government Statistics, 182 Shakespeare, 36 Shipley, Walter, 112 Sobel, Ira, 62, 95 Soros, George, 151 Sparks, Jeff, 103–104 Specialist finance companies, 37 “Sponging Boomers” (The Economist), 127 Stagnant real incomes, 169 Status quo, preserving, 76 Stealth default, 43 Stocks, high-dividend, low-beta, 198–201 Structured notes, 81–84, 104, 106, 149 Student debt, 39–43, 47, 124 Student Loan Marketing Association (SLMA; Sallie Mae), 39–41 Suez Crisis (1956), 2 Survey of Consumer Finances, 124–125, 170 Swaps, 61–65, 84–87 Internet threat to, 84–87 Swaptions, 107–108

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T 2007–2008 crisis, 81, 86, 145. See also Housing bubble; Mortgage crisis; Real estate crash Tax deferral, 204–205 Tax Reform Act (1986), 202 Thai bhat, 105 Thatcher, Margaret, 4 Three-decade boom, 162 “Top Two,” 119–120 Total federal debt, 46 Trade unions, 2–4 Transaction costs, 76, 86–89, 149, 190, 195, 218 Transaction Revenue (T Rev), 100–102 Treasury Inflation Protected Securities (TIPS), 175 Treaty of Versailles, 167 Trimble, Judge P. J., 37 Trends, important, 51 Tulipomania, 96 U U.K. gilt market, 7–8, 10–12, 29, 95, 218 Unintended consequences, 41, 102 Urban Institute, 124 Usury laws, 35, 37 V Value at risk, 66, 218 Venice, medieval, 26 Vertically integrated business, 37 Volcker, Paul, 32, 60, 97, 99 Volcker Rule, 102–103 W Wall Street, 16, 18, 20, 60, 61, 86, 97, 103, 141, 144, 145, 156–163, 171, 192–195 Weimar Republic, 167 Westbury, Charlie, 64 Western capitalism, 139 Wheat, Allen, 105 Williams, John, 182, 183 Wilson, Don, 152 WIN (Whip Inflation Now), 2 World Bank, 57, 138 World Trade Center, 55–56, 133, 138 Y Yield curve, 59–60, 104–105, 171, 191

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