traden4alpha

We know about the laws of supply and demand, but what if economics violates the laws of physics? Some academics are arguing that a model for consistent economic growth ignores diminishing energy supplies. As one professor puts it: "Neoclassical economics is inconsistent with the laws of thermodynamics."

Three reasons this is totally wrong (for now):

1) Growing total accessible raw energy. Even if we've reached peak oil, we're no where near peak uranium, peak solar, peak wind, peak coal, peak geothermal, peak hydroelectric, etc.
2) Growing efficiency of converting raw energy into usable energy: The efficiencies of solar cell, motors, etc. is increasing.
3) Growing efficiency of converting usable energy into economic outcomes: GDP per joule has improved nearly 40% in the past 30 years.

No doubt, there are physical limits but they are orders of magnitude away from where we are right now. Perhaps when we have a Dyson sphere and are capturing 100% of the Sun's output, then we'll need to worry.

Counting Up the Bank Failures

The puzzler for me is how banks with such high assets relative to deposits would lead to any costs to DIF.

It would seem that either: 1) the assets are NOT worth what the banks claim; or 2) that DIF is be used to bailout non-depositors; or 3) that other significant liabilities take priority over depositors in a bankruptcy. (Note: if bank merely had illiquid assets, that would not be a cost to DIF because the FDIC would be effectively lending money to the bank to cover short-term liquidity issues)

In any case, why are banks being allowed to operate so deeply into the red that DIF has such high costs?

If free markets fail because humans are irrational, aren't the regulations we impose irrational too?

Indeed! We have a choice between decentralized voluntary irrationality and centralized mandatory irrationality.

Chinese Numbers Are Starting to Look as Skewed as Ours

The underlying problem is that GDP seems to stand for Gross Debt Production and both the U.S. and the Chinese are doing it.

Time will tell whether all this new debt created new long-term productive assets or just stimulated short-term consumption. In any case, all that debt will need to be repaid and that will drag on equity prices because debtholders stand in line in front of shareholders.

Securitizing Life Insurance: An Interesting Concept

Excellent essay! It's clear that life settlements do change who subsidizes whom and will affect premiums.

There is a "social good" for all three parties (the insured, the insurer, and the life settlement investor). The "social good" for the poverty-stricken insured is increased money now -- the needy insured clearly gets an extra $100k in your example. The "social good" for the insurance company is in smoother cash flows and lower chance of a liquidity crisis -- the insurer keeps getting steady premium payments and making steady death benefit disbursements. This allows the insurance company to plan the durations of investments with less worry that an economic crisis will simultaneously increase demand for cash settlements at a time when the insurance company's long-term assets are undervalued or illiquid. The "social good" of the securitization for the life settlement investor (who provides the upfront cash to pay the settlement) is in aggregating across risks and smoothing the payoff.

Whether that "social good" justifies the 4% fee is another matter. But shouldn't the participants in the transaction (not some 3rd party) have the right to decide the fee-good tradeoff in a free country?

Expected Returns - Are They Unmeasurable?

I like your comment about beautiful theories. One of the facets of traditional economics that has bothered me is the stance that if the people in an economy don't behave according to economic theory, then it is the people, not the theory that is called "irrational."

One major problem with any theory of expected returns is that estimates of expected returns are NOT held exogenous to the system being estimated. Rather, the expectation of returns changes investment, strategic, financial, economic, and political decisions. These decisions will clearly change the true future return. An expectation of high returns for an asset class leads to higher investment in that asset class. This can create self-fulfilling returns in a good way (e.g., creating a semiconductor industry that maintains Moore's Law for longer than naive physics would suggest); self-fulfilling in a nasty way (e.g., creating a housing bubble), or self-limiting in the traditional economic sense (i.e., spawning over-investment that reverts the true returns).

The point is that expected returns influences actual returns in ways that totally violate the standard statistic notion of Expected_Estimate = True_Value + IID_Error.

The deeper issue is that "testability" in the scientific sense depends on the ability to do controlled experiments. That's hard for both practical and ethical reasons because we don't have a good sample size of global economies and we don't have the means to expose some global economies to a potentially harmful experimental treatments whilst holding other global economies constant in a fair double-blind trial. At best, we can: 1) do retrospective longitudinal analysis of the data for our one global economy; 2) do smaller cross-sectional studies of not-quite-independent components of that global economy; 3) do very small scale experimental/intervent... studies of agent behavior in the lab.

I agree with you about all the wrong theories. The true challenge for economics is in creating a modified approach to science that reflects and respects the internal nonlinear feedback loops in economic systems and the limits on the scientific method for economic systems.

Money Market Funds, Risk and Cash

One issue is that this innovation further erodes the roles of depository institutions (aka banks) in the financial economy. To the extent that consumers have one more channel for bypasing the traditional bank, then will.

This can be good or bad depending on the balance of effects. On the good side, it routes capital more efficiently from money provider (e.g., a consumer/investor) to a money user (e.g., short-term govt/high-grade commercial borrower). On the bad side, it presumes that the consumer/investor understands the risk and can tolerate it (vs. being bamboozled into thinking no risk exists or in being over confident of getting out before a crash). On the mixed side, it also spreads some of the tail risk from borrower to lender (this is analogous to the Islamic finance concept of risk sharing).

The larger point is that regulators can make banks risk free (if they want to) but they will have a harder time forcing consumers and businesses to deposit money in these banks if the banks don't offer a "competitive" rate of return. Floating NAV MMF create more competition for traditional banks.

5 Things You Need to Know When Analyzing Corporate Debt

Excellent Post!

First, one can also think about the duration of any debt relative to the cash assets and cash-flow of the company. All debts must be repaid (or rolled into new debt) and that creates risk if the company does not have enough cash to repay the debt. This crisis shows that companies can't assume that credit will always be easy to get. And if/when inflation rears it's ugly head, then rolling a debt might become extremely expensive. The point is that if a company has debt that's due in 5 years, for example, it should be creating cash-flow sufficient to repay the principal on that debt in 5 years.

Second, equity investors are last in line for the profits and assets of the company. The greater the debt, the longer the line of claimants standing in front of the equity investor. That's why equity investors need to think carefully about indebted companies.

Modern Finance: A Staple, or Discretionary?

Your analogy is quite apt -- we can't survive without finance (an amalgamation of services that match the supply and demand of money across durations and risks) and yet we can certainly have too much of a good thing and have become financially obese.

Perhaps we need a "Nutrition Label" equivalent for finance, financial conditions, financial products, and financial institutions. Continuing the food analogy, financial "protein" might be finance for infrastructure and innovation -- finance that builds structures underpinning the whole economy. Financial "carbohydrates" might be short-term energy finance such as day-to-day working capital. And financial "fat" might be for long-term energy storage -- saving money for winter or surviving in lean times.

A balanced diet of finance would include an appropriate total amount of finance (e.g., financial calories matched to the needs of a price-stable economy) with a balance of all three categories. That diet might vary across people, companies, or countries (e.g., an obese economy or anorexic economy might need less or more "fat".)

Empty Storefronts

Another theory says that commercial real estate is an ego investment -- owning a big building pays returns to the owner's psychological state as much as to the owner's financial state. Banks participate in CRE on the assumption that the psychologically-invested owner will do anything to keep their building to preserve their ego and their standing in the community. In more normal times, that psychological calculus works and the default risk is not that high. In bad times, the owner hits a financial brick wall and fails hard.

John Hussman: A Tale of Two Data Sets

Thanks for dissecting the deficit-pumped false-growth in GDP -- the recent use of borrowing from the future to finance the economy of today. But does this analysis go far enough? How much of recent GDP came from net consumer borrowing -- using inflated home equity and loose consumer credit to finance consumption. This seems to be missing from this analysis and other analyses that only look at the burgeoning level of public debt. Shouldn't one analyze the impact of all deficits and debts, both public and private, in creating the false appearance of GDP growth now and the high likelihood of lagging performance in the future?

Deficits and borrowing are not bad, per se, if they finance needed capital expenditures, new innovation, or productivity enhancements. Returns on borrowed funds can justify borrowing and contribute to real GDP improvements. But it's clear that the past decade has seen a large amount of consumer, corporate, and government borrowing that was squandered on short-term consumption, not long-term investment.

FDIC Rightly Worries About Consumer Confidence

Considering the multi-year trajectory of failures in the S&L crisis and the relative magnitudes of the Housing Bubble vs. the S&L Crisis, it's clear that the FDIC faces a rather large number of forthcoming failures -- 2X-3X what's been seen to date.

The current DIF is far too small and it's far too late to raise premiums/assessments to replenish DIF before the failures occur. Some form of loan or Treasury backstop seems inevitable.

FDIC's Private Equity Rule: So Much Can Go Wrong

Very good points, but does the FDIC really have much choice? It's a buyers' market for banks which means that the FDIC has to be more accommodating than would otherwise be prudent. When the patient has arterial bleeding, one doesn't stop to sterilize the bandage to prevent risk of later infection.

Of course, the flipside interpretation is that the FDIC wants to attract the greater fool to buy these toxic assets. Boosting the pool of bidders with inexperienced buyers will raise prices for distressed legacy assets and spread banking losses from the public coffers to rich PE investors. In that regard, it's a voluntary wealth transfer operation.

Time will tell who fooled whom.

Shrinking Banks

Interesting ideas, as always. I definitely agree about the debt- vs. equity issue. A 100% LTV mortgage is really more like an equity instrument (in it's delta sensitivity) than a debt instrument and the institutions that didn't know that are now paying the price.

But the deeper issue is that global banks are a reflection of our global times. Although national regulators can certainly impose new mandates that banks behave responsibly, regulators will have a harder time imposing responsible behavior on investors. Investors' stubborn search for excess-returns without excess risk (i.e, the over-caution seekers that spawned high-yield AAA toxic MBS) won't stop and if national banks can't deliver what global investors seek, then capital will leave that nation's banking system.

Regulators can de-globalize, but what if investors don't follow?

The Street Is Spooked by CIBC

The recently reported decline of cure rates in mortgages would certainly be one sign of future danger of credit card portfolios. If cure rates go down faster than delinquency rates, total losses will rise significantly on unsecured debts such as credit cards.

Does anyone have cure rate data on credit cards?