Monday, May 6, 2013

Global CIO - A macro view

Finally the day has come that your Ivy League (please note that the spell checker capitalized that, not me) education and hard work are paying off: Congratulations, you were just appointed Global CIO.  You are now responsible for investing all of the world’s financial assets and, given your history as a highly educated CIO, steeped in finance and highly experienced managing other pools of capital your goal is to create a diversified portfolio with uncorrelated assets.

On the first day of work you decided to use a three step process in setting up the portfolio 1) see what you have, 2) determine what you want to have and 3) make changes to create the desired portfolio.

The first thing you do is send your star analyst to give you a rundown of what is in the portfolio you inherited. S/he starts out with collating and aggregating the portfolio which consists of stocks, bonds, and a number of derivatives such as futures, options and credit default swaps as well as a number of hedge fund investments.  After burning the midnight oil s/he comes to your office with a shocking discovery - all the long and short derivative positions are offsetting and net to zero, the short equity and bond positions in hedge fund portfolios are offset by levered longs held by other funds and therefore also net out to zero and all you have in net exposure is a portfolio of stocks and bonds.

You may want to re-read the above paragraphs a few times to make a small dent in you denial that on the most extreme macro level of financial instruments all there are is stocks and bonds.

Once you start to get your head around this observation is becomes easier to understand that there only are three return streams available to a financial investor and they are dividends, interest payments and capital appreciation/depreciation on equities. Three you say - what happened to capital appreciation on bonds, which have done so well?


Let's assume you buy a 6%  US10 year treasury note when it is issued at par. Soon after you bought it rates go down to 5% and, as the Wall Street Journal so tirelessly points out, the price of bonds moves inversely with yields, and the bond price goes up to 107. You just made 7% in just a few short months courtesy of the Fed/ financial markets/ your investment genius! However, as you are the Global CIO and own all financial assets you have nobody to sell it to. So you hold it to maturity and which point the bond gets redeemed at, you guessed it, par. Total capital appreciation over the life of the bond: zero. You did however collect 10 years worth of interest.


Even the capital appreciation on equities is a paper-only exercise. You can’t “realize” the gain because you can’t sell. On a macro level this is exactly what happens in the real world; collectively market participants cannot sell their positions and that is what sets assets up for large price swings which can’t be explained by fundamentals. The notion that a certain asset is over or under owned is nonsensical – somebody always owns the asset – you can’t sell without somebody else buying it from you. Markets then function primarily as a wealth redistribution mechanism and a valuation tool secondly although when it matters that function does not seem to work.


As Global CIO all you can do is sit there, lean back and collect interest, dividends and watch the value of your stocks and bonds fluctuate with the level of economic activity and whatever financial models you choose to use to value them and the psychology of market participants. On occasion you buy new stock and bond offerings and write off assets which went to zero. Your investment genius or lack thereof has no effect on the cash flows, stock and bond valuations or the value of the portfolio overall. Brokers won’t take you golfing or for steak dinners either because they no longer have any secondary trading activity nor the fees that come along with that.

(So perhaps you don’t want to be the Global CIO but engage in something useful like teach finance and share what you learned with them or learn how to make an omelet.)

On the second day on the job it has become obvious that collectively your active strategies add no value so you redeem in kind from all your active managers and collapse all offsetting positions. And that, surprise, surprise will cause your performance to better than the performance in the world where there are lots of separate pools of capital especially when actively managed. Actually, you’re shocked by how much better the collective performance is than the sum of the individual performances. The amount of money paid in transaction costs, management fees and incentive fees and financing charges is absolutely staggering. The concept of negative carry no longer exists and bid/offer, slippage and netting risk also are removed from your financial vocabulary. In fact, the only words your financial vocabulary contains at this point are issue price, coupon, dividend, credit and business risk.

Clearly this financial model would have issues, mainly lack of discipline on the side of the issuers of financial instruments because the Global CIO is a forced buyer and therefore a price taker, but it makes for an interesting thought experiment. And although derivatives like futures net out to zero the risk transfer function of them can add value to the real economy by redistributing risk……

Friday, February 1, 2013

Some (un)intended consequences of mortgage refinancing

As mortgage rates are decreasing and households take on mortgages with lower rates there are several consequences, not all of them obvious.

The amount of interest paid, C.P goes down which at first glance is a good thing. The consumer now has the option to allocate the difference between the old and the new payment to other purposes. The downside of lower payments is that somebody else is now receiving less, and likely that somebody else is a pension fund, life Insurance Company or another entity which needs long dated cash flows. Chances are that as the homeowner refinances the NPV of his/her pension or insurance decreases at the same time. The economic effect of the increased cash flows to the household sector and the decreased cash flows to pension funds, life insurance companies et al. is not symmetrical because the household sector has a high marginal propensity to consume – they spend most of the savings – whereas the financial savings institutions buy financial assets (in other words, they save).

Another aspect of refinancing, and the generally lowering of interest rates on mortgage debt is less obvious though which is worth looking at.

Assuming a 100,000 mortgage for 30 years at 8% the monthly payment is 733 of which (for the first month) 666 is interest, 67 is principal and therefore the initial ratio of interest to principal (I/P) is 9.9. When that mortgage gets refinanced to 4% the payment decreases to 477, interest is 333 and principal is 144 so the I/P ratio goes to 2.3.

This means that the homeowner in a lower rate environment builds equity much, much faster which means that it has a positive effect on household net worth even if the reduction in payments is completely consumed.  If homeowners were to take the monthly savings in interest and use it to prepay their mortgage the equity build would be even faster. The flip side is of course that the holder of the mortgage has reduced interest income and an increased principal flow which needs to be reinvested. At the same time the total monthly cash flow to be invested (presumably in financial assets) by the mortgage holder goes down).

As the amount of interest paid by the household sector decreases so does the tax deduction they receive on this. In other words, the lower the interest paid by the household sector the higher their effective tax rate, c.p.. That means that although rate reductions lead to an increased ability to consume, it is less than 100% of the interest savings, and tax revenues increase.

Another consequence is that as total monthly payments go down the servicing fees servicers receive decrease as well. Generally servicing fees are a fixed percentage of the monthly payment so less dollars flow into the financial sector. Similarly, as rates fall the interest rate exposure which needs to be hedged by parties who want to neutralize interest rate risk also is reduced. This is because as rates go down the dollar value per basis point also shrinks, and leads to reduced dollar weighted interest rate hedging transaction.

The overall this aspect of lower rates, a policy with the initial intention to rescue the financial sector and secondarily to increase aggregate demand, may have the (unintended?) effect of transferring wealth from the financial sector to the household sector and the government.

Sunday, December 16, 2012

Scope of analysis

Awareness of boundary issues and scope of analysis is essential in critical thinking.

Let’s take a look at energy. We tend to bucket energy sources in buckets like renewable, fossil fuels and nuclear, but what does that really mean?

On the face of it fossil fuels and energy sources like solar, wind and hydro have nothing in common and are seem contradictory.  Solar energy obviously is energy captured from the sun and as wind is also a phenomena caused by solar heat it too is a solar derivative.  With respect to hydro, the sun heats water which, with the help of wind evaporates, forms clouds and then rains down in mountains where we can use the water to run turbines and capture kinetic energy. Therefore hydro is also a solar derivative.

Fossil fuels are the product of organic remnants of primarily plants which lived a long time ago, died and were transformed under heat and pressure into various forms of fuels like coal, oil and natural gas. Those source plants however were powered by the sun, so as we zoom out fossil fuels too are a form of solar energy.

That leaves us with nuclear as a true separate and distinct energy source. Or is it?

The sun is a ball of gas which is so large that the particles on the inside are squeezed together to the point where they fuse. In other words, a nuclear (fusion) reaction. The sun then is a form of nuclear energy.

That leaves us to the inevitable conclusion that at the macro-most level all energy sources that we have access to and are aware of are nuclear at their core. So when we talk about renewables, fossil fuels etcetera keep in mind that these are distinctions which exist only because of a choice in the scope of analysis.

Monday, September 24, 2012

Fed Musings /2

The only way to have a chance at implementing the inflation mandate is to have complete control over either one side or both the demand and supply side of currency. Although the Fed as agent of the department of treasury and in theory is the issuer of currency in the US and therefore should have a supply side monopoly on currency creation, there is a fly in the currency creation ointment. As per MMTs horizontal and vertical currency concept the Fed does not appear have material control, or chooses not to materially control the fractional reserve lending system, let alone the shadow banking system. Government can try to regulate the minimum reserve requirements (although they can be, and are circumvented through a number of pathways) but the government (yet) cannot impose maximum reserve ratios (force banks to lend a certain minimum amount visa viz their reserves). Whether commercial banks use a fractional reserve of 10% of 12% has a very significant impact on the actual number of currency units floating around in the economy and the Fed has no direct control over it although it can has a number of tools which in the short term can increase or decrease the amount of money in the system.

All this puts commercial banks in the de facto position of issuers of the currency. When you go to a bank for a loan the money which the bank puts into your account does not exist until the bank creates it out of thin air and “lent” it you. In other words, that commercial bank created more currency units without a corresponding increase in goods and services to maintain the currency’s value. As long as you don’t use the newly deposited money now sitting in your checking account to buy goods/services you won’t be creating inflation but that is unlikely because one generally does not take an interest bearing loan without the a probability of spending the money of greater than zero. In the meanwhile the banking system charges the borrower interest on money on which in effect it only pays interest on 10% of the balance and the other 90%, which the banking system wished into existence, it pays net zero.  As a numerical example, if you go to the bank and borrow 1000 at 4% the bank does not pay a depositor say 2% on 1000. Because of the magic of fractional reserve banking the banking system pays a depositor 2% on 100 and charges the lender 4% on 1000. The missing 900 was in effect pulled out of thin air at zero cost to the bank. To be clear, one has to look at this on a system basis, not an individual bank basis. Just looking at the interest, for the 1000 loan it receives 40 in interest and pays 2 to the depositor.

Net Interest Margin, or NIM in short then is a deceiving measure because it doesn’t equalize for dollar amounts but for percentages.

As a suggestion then in fractional reserve banking then one theoretically should be able to borrow and lend at the same rate as the fractional 90% at zero cost provides the profit margin.


As an aside, inflation is similar to obesity in that a large pantry does not make you fat, but consuming its contents faster than one uses the energy content does. Money is similar that way; as long it is not used to buy goods/services there won’t be upwards pressure on prices. And that is why the Federal Reserve pays interest on reserves; as long as the money is parked at the Fed not too much money is chasing goods/services, thereby containing the quantity of money available to buy goods/services. It is likely though that at some point those reserves will no longer be parked at the Fed at which point roughly 10 times that amount will be available, although not necessarily used, for investment/consumption.


Zero inflation in a complex economy is difficult to achieve because there are so many different moving parts both on with respect to the demand for goods and services as well as the combined currency supply of the Fed and commercial banks. As the quantity of goods and services changes continually the money supply in an ideal world would change in the same amount at the same time. That is highly unlikely to happen. Take a look at BEAs GDP series – the Q/Q gyrations are significant and it would be impossible to match the quantity of money in real time.

Human activity is by nature deflationary. Whatever we humans do, we will try to do it better/faster the next time we do it. And generally we succeed. The change from one try to the next may not be necessarily significant but even a 1% improvement adds up quickly.

Saturday, August 25, 2012

Fed Musings

I’m going to post a short series on The Federal Reserve, its mandates and some of the consequences.

The stated mandates of the Federal Reserve, an institution which is neither federal nor has reserves, are laid out in section 2A of the Federal Reserve Act (as amended) the triple (not dual as so often is stated) goals are : "to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates”.

With regard to stable prices note that on February 25th, 2012 Dr. Bernanke announced that the Fed’s inflation target was 2% because it was best aligned with the mandated goals of full employment and price stability.

The first observation is that Dr. Bernanke appears to be doing congress’s job by changing the mandate of stable prices without any apparent instruction to do so from congress.

 An inflation target other than zero by definition means that prices are not stable. If balance in your Certificate of Deposit went down by 2% per year you would not call the balance of your CD “stable”, yet that is exactly what Dr. Bernanke’s announced goal is.

Inflation has not been zero for a long time so one way to interpret Bernanke’s inflation target as acknowledging that the “stable” part of the mandate is not reality. However, as the only time in recent history the US has had negative inflation was in the 1920s and 1930’s and, depending on the horizon of analysis long term inflation seems to have settled out around 3 percent even the non-congressionally mandated target of 2% is problematic and a systemic bias which has socially disturbing consequences.  An inflation rate different from zero causes winners and losers by means other than the actor’s actions, and to the extent the Fed has an effect on inflation the Fed is in the judge’s seat against the specific direction (“Stable prices”) of congress.

Let’s take a look at inflation.

Inflation causes a transfer of wealth from those who save currency to those who borrow currency. Inflation is also a wealth tax on the currency part and the non-currency part of one’s wealth which depreciates and which requires currency to be maintained. An inflation rate other than zero therefore introduces an asymmetry in the financial system at large and in the allocation function between savers and investors/borrowers specifically.

Please note that the US government, with whom the Federal Reserve is closely aligned is a significant borrower in the financial markets. 

Inflation, and perhaps even more importantly, the variability of inflation and inflation expectations over time and the variability in extend to which specific baskets of goods and services are subjected to inflation therefore introduces a temporal bias in the term structure of inflation expectations and biases other than the fundamental value (whatever that is (a topic for another post perhaps)) of specific asset classes and economic sectors.

If one’s net worth is greater than zero cash is not the place to hold your net worth when inflation is greater than zero. Inflation drives wealth out of cash and into non-cash / real assets because generally non-cash assets will keep pace with inflation. One of the consequences of this is that it reduces liquidity because the holder of the asset faces a hurdle in switching asset classes – transaction costs and lack of pricing transparency. Furthermore, viewed purely from a “store of value” perspective, not a business venture approach, the non-income producing real assets most investors have access to have are negative carry assets. The negative carry on a home owner occupied house with zero financing is somewhere around 2% - the same as Bernanke’s inflation goal.  As a private individual even if you own non-income producing assets such as a forest or oil fields you will have negative carry because of property taxes, ongoing expenses and amortized transaction costs. The only holders of real assets who have significantly less negative carry, and perhaps even have positive carry are entities which receive taxes, not pay them – entities with the power to tax. Precious metals come with storage costs, whether implicit such is when one buys an ETF or explicit when one rents storage space.  

As an aside, don’t confuse commodity futures with real assets – for every long position there is a short position and the net of both is always zero.  Even if one were to buy a physical commodity and put it in storage, because of the negative carry nature of storage at some point the commodity will be sold back into the market so the net effect on quantity supplied is zero. However, it is possible that speculation increases the volatility of the commodity price and that very well may have knock-on effects on longer term supply and demand decisions.

Inflation then drives holders of cash to relative illiquidity with the attendant lack of price discovery and thereby interferes with capital formation because it hinders capital movement.

Note that this is in direct conflict with what the Fed and other central banks have been doing in recent times by attempting to “create liquidity” in a greater than zero inflation environment.

The medicine then is partially responsible for the disease.
To be continued.

Friday, July 6, 2012


Energy Return On Energy Invested and its variations is a metric frequently used to look at our efficiency in harvesting energy with respect to the energy input.

As an aside, regarding fossil fuels in day to day use we talk about energy production when strictly speaking we don’t produce coal/oil/gas but extract it and sometimes convert it.  Strictly technically speaking fossil fuels as well as renewables are solar energy; one is previously accumulated stock and the other is flow. Think balance sheet versus income statement.

EROEI is an attractive concept but has a number of issues which can reduce its utility significantly.  The main issue with EROEI is that it suffers from boundary issues along a number of vectors.

1.       The first boundary issue is that although it is relatively easy to measure the energy produced it is significantly more difficult to determine the energy consumed in producing the energy. Should only direct energy inputs be counted (for example the energy to turn the drill on an oil rig), or should second order inputs (the energy the workers on the rig used going to work) or even third order inputs (the energy used to make the car which the worker uses to go to the rig) count?

2.       Another boundary issue is that of the input fuel source. If the Input energy is fossil fuel based the EROEI analysis will tell you how efficient the energy extraction process is with respect to energy use, and therefore how much energy ultimately can be extracted. If, however, the input energy is renewable even if the energy conversion process is seemingly inefficient in at the end of the process one has in total more energy than one started, which is quite the opposite from when the input was fossil fuel based.

3.       Another consideration is that of the energy density of the fuel produced/ extracted. Generally the higher the energy density of a fuel the higher its utility is. Methanol and gasoline are both liquid fuels but one has a higher utility because of its higher energy density. Specifically, in mobile applications the energy density of the fuel you carry has a very direct impact on the end user utility.

Aside from boundary issues EROEI does not take into account the different utility associated with different energy carriers. Instead there is an implicit assumption that all BTUs are created equal. In real life though some BTUs are more equal than others.

Once you move from an entropic system (where energy flows from a highly concentrated state to a less concentrated state) to a negative entropy system (where you capture some form of diffuse solar energy and concentrate it) everything changes. Instead of running down finite energy sources you are now adding to the quantity of energy available. There will be other limits, but not energy per se. In a system relying on non-renewable energy, no matter what your EROEI is eventually you'll run out of fuel. In an open system therefore EROEI is interesting as a conversion efficiency measure, but irrelevant with respect to sustainability of the energy input of energy production.

If humanity wants to continue to exist in a form recognizable to us making the switch from an entropic energy supply to a negative entropy energy supply is unavoidable. Without making that switch the game will be over at some point.  We are starting to feel the first hints of limits to growth along a number of vectors, both on the input side as well as the output side of economic activity. Specifically, what you're seeing now is that there is a tension between a financial system which requires growth to exist and a natural system (resources) which naturally deplete and which have an extraction rate which at some point can no longer be increased. Switching to a negative entropy energy system would be an important step towards dealing with this problem.