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Tom Armistead
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I am a retired accountant, having spent the early years of my career in the insurance industry and the later part in the field of accounting. My insurance experience has given me the willingness to accept investment risk if I feel the return justifies it; also, an interest in applying risk... More
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  • Banks, Collateral And Leverage 19 comments
    Sep 11, 2012 7:40 AM

    Article at Bloomberg today, about banks transforming collateral for clients. Collateral for derivative trades is required to be high grade, and many of the hedge funds involved don't have the proper collateral. Big banks to the rescue, they will transform it, as a service to clients. It's a kind of securities lending.

    Discussion of clearing houses, notional amounts, collateral ratios as low as .5%. That would be 200 to 1 leverage, backed by borrowed collateral.

    Meanwhile the amount of collateral required is material with respect to the amount of triple A in circulation. So there is additional demand for treasuries, to back derivative speculation.

    It is peculiar, the high leverage permitted to place speculative bets, many of which are designed to profit from systemic collapse or weakness. Meanwhile, the cost of capital for honest businesses, such as life insurance, is such that P/E's under 10 are the norm.

    It appears regulators, by focusing on the big banks, have forced them to operate in a relatively stable and secure way. The risk has been pushed out into uncharted areas of the financial system, mainly hedge funds and private equity. LTCM was big enough to endanger the system, with 20 to 1 leverage on a bond business. 200 to 1 on derivatives doesn't look good.

    At age 65, and with my portfolio close to meeting objective, I am starting to go defensive. That includes some hedging, as well as moving cash toward 20%.

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Comments (19)
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  • pemdas1
    , contributor
    Comments (263) | Send Message
    I will put this article in the "pending disasters" file, and add it to the "100 reasons not to buy big banks" list. Thanks, Tom.
    11 Sep 2012, 09:05 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » pemdas,


    I'm not sure you're getting the point.


    The big banks are being forced to operate in ways that will prevent them from blowing themselves up. However, they are carriers or transmitters of the disease of financial instability.


    I don't invest in big banks, because I don't like management's style, lack of ethics, arrogance and greed. Based on valuation, any of them are probably profitable investments going forward, particularly if management starts working on creating shareholder value.


    Investors who stay with good quality US equities are unlikely to be permanently injured by the consequences of the above, which consist of financial instability, periodic sell-offs, failures of large hedge funds, episodes of speculation in commodities, CDS, etc.
    11 Sep 2012, 09:13 AM Reply Like
  • pemdas1
    , contributor
    Comments (263) | Send Message
    I see dubious collateral will be concentrated on the bank balance sheets, because they want to collect fees. Last time it was collapse of housing value, next time it will be a collapse in the fair value of "transformed" collateral, leveraged up to 200:1.
    11 Sep 2012, 10:13 AM Reply Like
  • Amadon
    , contributor
    Comments (281) | Send Message
    Tom; I always enjoy your insightful articles however I wonder about your optimism that all would be well if government and business would mend their ways and return to prudent accounting practices.


    I am of the opinion that the world is in a negative growth period and this is producing a systemic problem which forces high risk on everyone.


    If in fact we are in the 'end game' then it seems that those who have the most control would get an early start on the gold rush in this real life game of 'survival'.


    I would greatly appreciate any optimism you can share with me concerning the bright future going forward from an accountants point of view.
    12 Sep 2012, 01:41 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » Trying to think along the lines of the first article you linked, real growth in GDP starting from the middle ages was dependent on new sources of energy and the technology to harness them. It moved along from muscle power to wind and water to coal and steam to oil and internal combustion to (sort of) nuclear. Meanwhile technology advanced along the lines of labor saving devices and improved communication and transportation.


    Trying to extend that thinking forward to 2050 which occurs in both articles you linked, the US possibly has a new source of cheap energy, natural gas, which will enable further growth until it is exhausted, perhaps around 2100. Increased population would come from immigration, legal or illegal.


    Debt ultimately consists of future promises, and experience has shown it can be used to drag future consumption forward and create growth and prosperity. This works better if there is real growth to back it, or a great deal of faith to keep it going like a Ponzi scheme.


    At some point many of the future promises will not be kept, and there is considerable strife about who will take the loss, which promises will take preference over others, so on and so forth. Hence the interest in gold, as a purportedly stable and universal store of wealth. Gold was confiscated in the US during the Depression.


    Robotics, meaning industrial machinery that can mimic human behavior, possessing sight and touch, is a new technology that may unleash a flood of low cost material goods, with the energy provided by low cost natural gas. The economic conundrum will be, how to create enough jobs to give everyone a way to earn money to buy things. From there, how does everyone control enough space to hold all their stuff? What is the economic potential of a person who owns a device that gives him access to all the information in the world, and all the computational power in the world, and the ability to communicate in real time with anyone in the world?


    My optimism is, that human beings multiply and thrive as long as they have access to adequate nutrition and sanitation. Once clearly above the subsistence level, reproduction slows to less then two children per couple.
    13 Sep 2012, 06:01 AM Reply Like
  • Amadon
    , contributor
    Comments (281) | Send Message
    Thanks for your reply and respectful consideration of my comment. Sometimes the reaction to information which is distasteful is to disparage the messenger.


    The point I was hoping to make regarding the moral hazard issue that you often write about concerning rogue banks and corporate entities is that if we are facing natural evolutionary macroeconomic headwinds there will be increased pressure to step over the line in order to survive.


    "A rising tide lifts all boats". If that old saw is true then what happens during ebb-tide? At the root of all human activity is terraforming. Every occupation from queen to bootblack is in support of this habitat creating activity. In the past if we depleted some natural resource or if our work was interrupted by nature we moved on. It appears that we may be in a climax environment with no place left to move to and insufficient resources to maintain our current population.


    If we were to ask ourselves the question "What is the maximum sustainable human population?", Google would respond with a wide divergence of opinions. If we qualified our question to eliminate cheap safe abundant energy from the equation what would the answer be? Should we also include preservation of biological diversity and quality of life?


    At my peril, I am going to suggest that the number may be in the range of 600 million. If that number is approximately correct then it seems our terraforming business may be overstaffed by a factor of about 1000.


    As a prudent and moral accountant should we consider downsizing to save the business or risk bankruptcy and extinction on hopes of rescue through innovation, efficiencies, and quantitative easing?


    Tom; I realize the question is probably beyond my pay grade or yours. I am hoping that all of us, especially those in industry and government will begin to address the issue of what is actually transforming the world economy now.
    13 Sep 2012, 08:21 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » That all depends on your view of human destiny and purpose, are we here to conquer, subdue and exploit the world, or as stewards, gardeners or even as one species among many?


    Of course that takes us pretty far off the investment topic. I'm going on the basis that the US and global economies expand 2% in real terms, driven by population growth.
    13 Sep 2012, 11:17 AM Reply Like
  • Amadon
    , contributor
    Comments (281) | Send Message
    Well said sir; Obviously we here to conquer, subdue and exploit the world. Getting back to the investment topic at hand Banks, Collateral And Leverage and the basis that the US and global economies expand 2% in real terms, driven by population growth leaves me wondering if there is any limits at all considering the amazing numbers involved in compound growth. My understanding is that the 'invisible hand' of the market sends us signals concerning our progress or lack of. I just read a curious statement this morning that you may have seen also:


    "The Shiller P/E of the S&P 500 is currently 23 — 50% higher than its long-term average. The average Shiller P/E ratio since 1880 is about 15. A move back to the average would take the S&P 500 back to 930. A move to bear market low valuations would take the S&P 500 back to roughly 400. Right now, it’s 1,432." ---Dan Amoss


    "At age 65, and with my portfolio close to meeting objective, I am starting to go defensive. That includes some hedging, as well as moving cash toward 20%." ---Tom Armistead


    "At age 75, and with my cash rapidly approaching intrinsic value, I am starting to go defensive with an investment in Smith & Wesson. That includes some hedges around my property as barriers to entry, as well as moving some physical gold toward a hole in the ground in my backyard. ---Amadon
    13 Sep 2012, 12:15 PM Reply Like
  • Amadon
    , contributor
    Comments (281) | Send Message
    Tom; How do you see yesterday's announcement by Dr. Ben. Is this action more to help the big banks or as he is trying to spin this to help main street. I just read Federal Reserves FAQs on Agency MBS Purchases (Text)
    and it seems like he is saying the best way to help main street and create jobs is to give some more free money to big banks.


    I wonder if the fed is going to take 40B of toxic MBS off the books of big banks and effectively sequester it in the basement of the fed and effectively nullifying the inflation effects of the new money on the economy. He is willing to do this an unlimited number of months until all the toxic debt stinking up the balance sheets of the big banks is off loaded onto taxpayers.


    It seems to me the real plan is to devalue the dollar which he has been trying to do all along. Any thoughts?
    14 Sep 2012, 10:03 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » I'm struggling with the decision.


    I read that the MBS bought will be new issues, presumably they mean Fannie and Freddie. That will inflate demand for mortgages, and likely banks will respond by dropping underwriting standards. It will end poorly if alllowed to continue too long.


    My conclusion is, Bernanke and the FOMC are working for the banks, and they are doing what is good for the big banks on the grounds that it is good for America.


    My biggest holdings are in life insurance, MET, PRU and HIG, the announcement is helping them, so I personally can't complain.


    I increased my hedge, and will continue to do so if the market continues to rise.


    14 Sep 2012, 10:31 AM Reply Like
  • Amadon
    , contributor
    Comments (281) | Send Message
    I agree. I wonder about your assessment of the long term effects of your life insurance investments considering I just read this on Market Currents:
    10:18 AM The life insurance industry has its outlook cut to negative by Moody's thanks to the expectation (certainly reinforced in the last 24 hours) "that interest rates will remain in the low single digits for the next few years ... continu(ing) to erode insurers' earnings and revenues." The Fed has one word for the insurers: Leverage.
    does that change your thinking?
    14 Sep 2012, 10:45 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » On MET, they have repetitiously explained that they are well hedged against low interest rates going out farther than the Fed's 2015.


    PRU also hedges but not as effectively as MET.


    HIG it's about releasing statutory capital, which means they can sell off bond positions that will be at high points.


    Finally, I simply don't think the Fed can hold inflation and interest rates in check. Speculators will game the system on commodities to include oil and that will make its way into core inflation in due course.


    The Life insurance idea is fairly long term, given the low P/E multiples and P/B well under 1.0 they will be able to create value by buybacks unless share prices rise.
    14 Sep 2012, 10:53 AM Reply Like
  • Amadon
    , contributor
    Comments (281) | Send Message
    10:47 AM Though the Fed didn't mention a target level for unemployment, Bill Gross suggests the bank has 7% in mind, and will buy MBS "until the cows come home." Recently making news for slashing his Treasury holdings (so far so good), Gross suggests "real assets ... gold ... a house."


    Tom, I know the old saw about "don't fight the FED", but as you know I believe the central banks are trying to reverse an ebb-tide. All of the central banks are making 'all in' bets in poker terms which means game over and someone must bust out and start the slow sad walk to the casino parking lot. I am willing to call that bet as I already have a little physical gold and a house.


    If you were advising such a deranged, inveterate, perverted client who was considering buying either TVIX or EDZ which one would you recommend for the most bang for the buck. Do you think I will get a better entry point later? There is something about this situation that reminds me about inflation and the French Revolution. We are living through historic times sir that will surely go down in the history books.
    14 Sep 2012, 11:15 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » I refuse to invest in VIX products.


    The point is, I'm not savvy about short-term trends and these type products will eat you alive long term if you stay in them. You can be right, and lose money.


    I agree, volatility is cheap, and it's a good idea to buy some. It's just that VIX products are not the kind thing I would be buying.


    When I go long in the money SPY puts, I go long volatility. I've been buying the SPY Jan 2014 160 puts. Also, I have been rolling various of my long postions, where I use in the money LEAPS, out from Jan 2013 to 2014. Volatility is very cheap on them right now, particularly on the Life insurers. If the market goes into a state of turmoil, the time value of my long positions will increase.


    These are just my opinions, please bear in mind I'm a retail investor, happy to talk shop, but not one to give advice.
    14 Sep 2012, 11:24 AM Reply Like
  • Amadon
    , contributor
    Comments (281) | Send Message
    Thanks for your comment Tom, point well taken and I will take it to heart.
    14 Sep 2012, 11:51 AM Reply Like
  • Amadon
    , contributor
    Comments (281) | Send Message
    More reasons why I think we will see circuit breakers popping very soon.:
    Despite signs that the economy is recovering, research firm ECRI has held to bearish predictions for the U.S. economy.


    ECRI co-founder Lakshman Achuthan spoke to Bloomberg's Tom Keene this morning to defend his recession call amid an onslaught of criticism.


    Achuthan provided a deeper look at how exactly ECRI makes its predictions, saying that it focuses on year-over-year indicators for output, employment, income and sales, and the consumer confidence index.


    In particular, he pointed to the relationship between year-over-year consumption and employment as perhaps the clearest sign that the U.S. is headed back into a recession.


    "People need to understand the sequence," he said. "I think the hope is that jobs growth will increase consumption in coming months, but in fact jobs growth follows consumption...There are many instances in which job growth precedes a recession."


    If we look at a graph of these two indicators, it is clear that past U.S. recoveries have virtually all relied on consumption growth... and that consumption growth is slowing down.


    Read more:
    14 Sep 2012, 12:38 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » Achuthan has been calling for a recession that was to have started in September last year. A stopped clock will be right twice a day.


    My take is, the most likely thing is a continued sluggish recovery. I did some work on FOR and DSR from the FRB website and they are both at points that in the past have preceeded strong expansions. Pent up demand for automobiles will be a driver.


    There is always the possibility of a severe problem, exacerbated by the speculative fuel in the forms of CDS and CDO's with CDS collateral, the whole house of cards. In Europe they have quite a bit of that, my opinion, if they don't keep things propped up, it could be ugly.


    Somewhere between S&P 1,500 and 1,600 I would probably take most of my chips off the table. Mainly, if the market is at a midpoint and future growth is going to be sluggish, there would be no reason to accept the volatility risk of being in equities.


    US companies are fundamentally strong.
    14 Sep 2012, 01:03 PM Reply Like
  • anonymous#12
    , contributor
    Comments (545) | Send Message
    There is a lot of pent up demand just looking at the Durable Goods,Residential Investment and Equipment and Software Spending components of GDP. They are very low in relation to GDP and well below the average of past decades.


    That's a big reason why the recovery isn't so strong and why I think we are a couple of years from another decline in output.
    15 Sep 2012, 10:15 AM Reply Like
  • Amadon
    , contributor
    Comments (281) | Send Message
    Many people, including Tom Armistead the author of many articles on SA, use the 150 year U.S. annual growth rate in output per capita of 2%. The growth rate for the two decades from 1987-2007 was 1.8%.


    Professor Robert J Gordon of Northwestern University and CEPR research fellow in his Policy Insight No. 63 paper entitled "Is US economic growth over? Faltering innovation confronts the six headwinds". He is one of the world's leading experts on inflation, unemployment, and productivity growth. The full text can be downloaded here.


    The six headwinds referred to in the title are:
    1. The end of the “demographic dividend”.
    2. Rising inequality.
    3. Factor price equalisation stemming from the interplay
    between globalisation and the internet.
    4. The twin educational problems of cost inflation in
    higher education and poor secondary student performance.
    5. The consequences of environmental regulations and taxes
    will make growth harder to achieve than a century ago.
    6. The overhang of consumer and government debt.


    He goes on to explain the reasons for the slowdown and why it will continue with an exercise in subtraction.
    September 2012: An exercise in subtraction.
    "The benefits of ongoing innovation on the standard of living will not stop and will continue, albeit at a slower pace than in the past. But future growth will be held back from the potential fruits of innovation by six “headwinds” buffeting the US economy, some of which are shared in common with other countries and others are uniquely American. Future growth in real GDP per capita will be slower than in any extended period since the late 19th century, and growth in real consumption per capita for the bottom 99% of the income distribution will be even slower than that."


    How large might be the numerical effect of the six headwinds? A plausible set of numbers can be constructed to reduce the growth rate of real per-capita consumption of the bottom 99% of the income distribution down to 0.2% per year,


    "Baby-boomer retirement (the reversal of the demographic dividend) brings us down to 1.6% and the failure of educational attainment to
    continue its historical rise takes us to 1.4%. If inequality continues to rise as it did in the last two decades, income for the bottom 99% of
    the income distribution will grow about half a point slower than 1.4%, bringing us down to 0.9%. Globalisation could continue to hollow out middle-level jobs, bringing the rate down to 0.7%. Higher energy taxes could bring the rate down to 0.5%. And a combination of consumer debt repayments, income tax increases, and reduced transfer payments, could plausibly reach the 0.2% annual rate."


    Why 0.2% you may ask. According to his paper he explains, "The particular numbers don’t matter, and there is no magic in the choice of 0.2% as the long-run growth rate. That was chosen for “shock value” as the rate of growth for the UK between 1300 and 1700. Any other number below 1.0% could be chosen and it would represent an epochal decline in growth from the US record of the last 150 years of 2.0% annual growth rate in output per capita.


    The insights presented in this paper could very explain why the FED is "agog" that the inflationary policies of QE1 and 2 have failed to produce the desired and expected results, and why the "all in" and "unlimited" QE3 will also fail as they do not address the real systemic problem.


    Professor Gordon makes a compelling case that the economy of the past 150 years is and was a singular event in human history, a 'pulse' as it were and is now in the process of reverting to its historical mean average of 0.2% without so much as a courteous "by your leave, sir". The most frightening aspect of this journey back to medieval times is that we will be taking 19000 nuclear warheads with us which is playing out as a preview of "Coming Attractions" on a television set near you.
    15 Sep 2012, 01:06 PM Reply Like
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