Inflation — the arch nemesis not just of the fixed-income market, but potentially of a nation’s entire economy (see Zimbabwe).  There has been increased talk of potential inflation in the U.S. as the federal government debt zooms past $11 trillion with ubiquitous predictions of multi-trillion dollar deficits exacerbating the problem.

Obviously, a rising federal government debt has negative implications for future inflation.  However, this is far from the only debt threatening to storm the gates.  State and local governments are facing some of their most trying times ever in balancing their budgets — taxes are being raised and services are being cut — yet bankruptcy is a looming possibility for more and more municipalities.  Add to this the frightening situation over unfunded pension liabilities and you have a recipe for disaster.

Already, fears of governments not being able to fund their growing liabilities are spooking investors.  Just last week, Great Britain was unable to sell 1.75 billion pounds of 40-year gilts (British Treasury bonds).  The hegemony of the U.S. dollar has made it highly doubtful that the U.S. would default on its debt, though by running the printing presses overtime, the government may simply “monetize” its debt, rendering the value of the currency in which the debt is paid all but useless.

Recently, both Russia and China have made noises regarding the risks (to all countries without the initials USA) of maintaining the U.S. dollar’s place at the top of the global currency pecking order.  Last Thursday, China’s mere suggestion of introducing a global reserve currency caused a vicious selloff in the dollar on world currency markets.  Later, a United Nations panel ran with the same idea.  Clearly, a pattern of nervousness is growing in the guts of some of our country’s biggest debtholders (China currently holds a $700 billion-plus IOU with Uncle Sam’s autograph at the bottom of it).

Inflation hasn’t been a huge problem in the U.S. in a generation.  But the days of 18% mortgage rates and WIN (Whip Inflation Now) buttons could be just around the corner.  When inflation strikes, the cost of protection will be prohibitive.  What follows can be thought of as the personification of The Lamb’s Rule #7 — “If you’re gonna panic, make sure you’re the first.”

There are several ways to protect oneself from the dangers of inflation.  While some are simpler than others, each carries varying degrees of difficulty and liquidity built into it.

*TIPS — An acronym for Treasury Inflation-Protected Securities, these are U.S. Treasury notes that pay a fixed coupon plus the rate of inflation.  For example, the current 10YR TIP carries a real yield of approximately 1.25%.  That means that, if bought and held to maturity, an investor would earn 1.25% plus the rate of inflation as measured by the U.S. Consumer Price Index (CPI).  TIPS can be bought from myriad securities dealers and from Treasury Direct. 

However, while the coupon on TIPS moves in step with inflation (via adjustments to the bond’s principal), TIPS do not protect investors from increases in market interest rates.  In other words, as real yields rise, the value of TIPS will fall, often precipitously given their very high durations.  Only by concurrently shorting nominal Treasury securities against a long position in TIPS (somewhat difficult from a practical standpoint) can an investor protect himself against an increase in real rates.  As a final caveat, the CPI figure’s components are determined and calculated by the very entity paying the coupon (the U.S. government), creating somewhat of a conflict of interest.

*Rate ETFs — Exchange-traded funds (ETFs) have been around for several years.  They are relatively liquid and trade very much like stocks.  They were created to enable investors to participate in strategies or to purchase combinations of stocks (similar to mutual funds) in which they would otherwise be unable to.  The PST and TBT ETFs offer a leveraged view on Treasury Note performance.  Their performance is intended to correlate closely with double the inverse total return of different segments of the Treasury curve.

One downside to these ETFs is that rates must increase by enough to cover the coupons earned by the underlying securities.  In other words, unless rates rise by a large amount, an investor would still see her investment decline in value should the rate move be less than the coupon payments.

*Foreign Exchange ETFs –  These ETFs offer investors the opportunity to profit from a decline in the value of the U.S. dollar in relation to other currencies, without the difficulty of trading foreign exchange directly with a currency dealer.  If/when inflation becomes more pronounced as both capital account and current account deficits overwhelm the U.S. economy, the value of the dollar could fall.  These ETFs offer some measure of protection.  The CYB and UDN ETFs offer a short position in the U.S. dollar versus the Chinese Yuan and a basket of currencies (British Pound, Canadian Dollar, Euro, Japanese Yen, Swedish Korona, and Swiss Franc), respectively.

Of course, as inflation rises and the Federal Reserve attempts to fight it, the Fed could raise short-term interest rates (as Chairman Paul Volcker did in the late 1970s).  This could squeeze U.S. dollar shorts as the cost of financing those positions increases.

*Commodity ETFs — Like other ETFs, these funds make it easier for investors to gain exposure to a given asset class, in this case — commodities.  Precious metals such as gold are often considered the “classic” inflation hedge.  However, any commodity denominated in U.S. dollars can serve as an effective inflation hedge.  There are a variety of commodity ETFs available, including ones for gold (GLD), oil (USO), and grains (DBA).  There are also more generic commodity ETFs that cover a more diverse set products, such as the GSG ETF.  Essentially, in purchasing these ETFs, an investor is wagering on the relative value of these products against the U.S. dollar.  In a sense, buying equities accomplishes much the same thing.

*”Hard” Assets — Vacant land, a farm, even the house in which you live (if you own rather than rent) can serve as an effective inflation hedge.  This is perhaps the simplest and easiest way to hedge against inflation.  Simply by owning a home, one can protect against the ravages of inflation.  Owning a home can have a dual benefit, depending on how it is financed.  This leads to the next inflation hedge…

*Financing — As long as payments are affordable, financing a large (80%?) portion of any purchase on a fixed-rate basis, particularly one as large as a home, has several (inflation fighting) advantages.  For example, take a homebuyer who borrows money at, say, 6%.  If inflation and interest rates skyrocket, as occurred some thirty years ago (remember those 18% mortgage rates), not only has the borrower saved himself a huge opportunity cost, but he can essentially monetize his debt to the bank by investing any current savings/income in higher interest bearing instruments, effectively arbitraging the remainder of his loan.  Fixed-rate financing brings with it another built-in advantage — if mortgage rates drop, the homeowner can refinance (assuming adequate equity) at a lower rate, decreasing his monthly payments.  This exemplifies positive convexity, a key benefit of a mortgage’s refinancing option.

*Payer Swaption — This is The Lamb’s preferred means of inflation protection.  As a background note, The Lamb is a HUGE fan of insurance.  You name the insurance, The Lamb owns it —  health, property, life, long-term care — The Lamb’s got it all.  He likes the safety, the protection, and most of all, the peace of mind.  So, it should come as no surprise that The Lamb likes “payers” as inflation protection.  Like other insurance, a payer swaption can be thought of as an “option premium”, or the cost of buying insurance.  Your “downside” is that nothing happens, and all you’ve lost is the premium you paid for the insurance. 

While most insurance doesn’t pay off, and is viewed by some as a waste of money, try buying hurricane insurance in Miami when a Category 5 monster is in the Florida Straits — you may find it a tad expensive.  It’s the same with inflation.  Buying protection is cheapest before you see the whites of its eyes.

So, back to payer swaptions.  Essentially, payer swaptions give the buyer, in exchange for an upfront premium (just like insurance), the right (but not the obligation) to pay a pre-determined fixed interest rate for a certain period of time beginning at a certain time in the future.  Think of them as puts on interest rates.  For example, if you own a payer swaption struck at 6% and rates are at 8% when the put expires, you would exercise the option and pay a 6% interest rate when market rates are at 8% (as a practical matter, you would “cash settle” the trade, pocketing the present value of the difference between the two rates).

Payer swaptions can be utilized to garner inflation protection while only risking a small cash outlay.  As an example, a payer swaption giving the buyer the right to pay a 5.50% fixed rate (versus a series of floating three-month rates equal to LIBOR) for ten years, beginning in ten years, can be purchased for roughly 3% of the notional amount (e.g. — $30,000 for a $1,000,000 swaption).  A relatively small premium, an investor can lose 3% in just one day of stock market moves. 

If, in ten years, inflation and interest rates are higher, say even at just 7% (just above the average over the past 20 years, and far below the 10% in 1989, and the mid-teens reached a decade before that), the swaption would be worth approximately $100,000 — more than triple the initial premium.  What’s more, unlike other types of insurance, this insurance provides ten years worth of protection.

Via The Bloomberg (click on image for better view):

Historic 10YR Swap Rates

Last November, The Lamb wrote that Uncle Sam should eschew saving General Motors.  He argued that the attempt would be tantamount to keeping alive a terminal patient, with the suffering borne by the American taxpayer.

Fast forward nearly two months.  While The Lamb’s opinion on rescuing GM hasn’t changed, the status of the company’s finances has.  Last week, GM “received $4 billion in initial rescue loans from the U.S. Treasury to help it avoid collapse.”  Many more billions of dollars in loans and other financial assistance is likely forthcoming.  As the Treasury said last week in explaining its current and future assistance to the auto industry (via Bloomberg.com):

“Treasury may consider, among other things, the importance of the institution to production by, or financing of, the American automotive industry.”  The government will weigh “whether a major disruption of the institution’s operations would likely have a materially adverse effect on employment and thereby produce negative spillover effects on economic performance” or on credit markets.

Well, if that doesn’t telegraph that more aid to General Motors is in the cards, The Lamb doesn’t know what does; add to this a newly-inaugurated President Obama’s likely aversion to having one of the most iconic American companies go toes-up on his watch, and you have the makings of an open-ended rescue program.

Just as in the case of the AIG bailout, which carried an initial $85 billion price tag, Uncle Sam has a nasty habit of throwing good money after old money.  He hates to take a loss, especially one that would receive such loud press coverage.  Rather than lose a few billion of taxpayer dollars, he habitually continues to bolster old investments with new money.  With AIG, for instance, over $67 billion (now a total of $152 billion, if you’re keeping score at home) has thus far been promised to the beleagured insurer to protect/bolster/insure the original $85 billion.

Now recall last month that The Lamb advocated investing money in certain institutions that had received money from Uncle Sam in return for preferred stock.  The idea is that owning senior debt of companies that had issued preferred stock to the government was a good risk/reward trade in that Uncle Sam could not recoup any of his principal unless and until you received yours, as senior debt is ahead of preferred stock in a company’s capital structure.

As The Lamb said then and still fervently believes today, “Uncle Sam is gonna get his money back.  You will, too.”

The loan(s) that Uncle Sam provides GM will, in all likelihood, be senior to any senior debt of GM and will not obviate the risk of GM’s defaulting on its senior debt.  However, The Lamb believes that there is a better than decent chance, similar to that of the AIG situation, that Uncle Sam will be loathe to let a company to which it has lent billions of dollars go bankrupt.

Now, it is certainly possible that there will eventually be a (coerced) debt-for-equity exchange, a shotgun merger, or even a pre-packaged bankruptcy.  Each of these could easily result in a significant haircut for GM bondholders.  However, the recovery value for GM debt is likely to be around 10 cents on the dollar, somewhat mitigating any loss.  GM bonds are unquestionably very risky — both Moody’s and S&P have them rated well into the nether regions of junk status.

However, with all this in mind, one interesting and admittedly very risky investment idea is to purchase relatively short-dated senior debt of General Motors.  Though only for investors with the greatest predilection for pushing the risk/reward envelope, 2-year maturity senior debt of GM currently carries a tantalizing yield-to-maturity of over 100%.  Translation:  if the bonds mature at par (100 cents on the dollar), an investor will quadruple his money over a two-year period, including coupon payments.

The GM 7.20s of 1-15-2011 are currently (as of Friday) priced at a dollar price of 25.03, according to the bond market’s Financial Industry Regulatory Authority’s (FINRA) pricing service.  This equates to a yield of 100.46%, and is a low enough dollar price that even a 10 cent recovery value brought about by bankruptcy will not completely wipe out the investment.

As a final caveat, before making this or any other investment, The Lamb strongly urges you to repeat Rule #2 at least three times while standing in front of a mirror:  “Know and understand what you own.”

Disclosure:  The Lamb currently has a small amount of the above-mentioned GM 7.20s tucked neatly into a dark little corner of his portfolio.

Prediction #5 — Global trade tariffs will increase

As countries around the world suffer through recessionand anemic growth rates, they will be under enormous pressure to protect their domestic industries.  Historically, tariffs have been the easiest sale to a nation’s citizenry, but also the most deleterious on a long-term basis.

What will essentially amount to protectionism will have little effect but to decrease demand and increase deadweight loss, further damaging an already fragile global economy.  Special interest groups both here and abroad will put inordinate pressure on their governments for protection from cheap (more efficient) imports, what these groups deem to be “dumping.”

As new and greater tariffs are erected, existing trade agreements will be torn down.  The U.S. will even be under pressure from labor organizations to repeal or alter the historic North American Free Trade Agreement (NAFTA).

The resulting decrease in overseas demand will further damage already weak exports for U.S. multinational corporations and severely crimp their earnings.  The lack of trading will risk putting a cap on equity prices for the next several years.

Tomorrow:  Prediction #6 — Oil and Gold

With apologies to Dire Straits, The Lamb can think of no better description than the title of this post for describing the investment opportunities currently available courtesy of Uncle Sam.  No, he’s not talking about the zero (or negative) yields available from U.S. Treasury Bills.

The Lamb is speaking about some good, old-fashioned, generic corporate bonds.  As a refresher, corporate bonds are simply IOUs from corporations — you lend them money, they agree to pay you back that money on a pre-set date in the future, as well as paying you interest along the way.  Of course, the risk is that the company goes bankrupt, defaults on its promise, and you’re left fighting for recovery value (the amount ultimately received in a bankruptcy proceeding).

As the economy has headed south recently, default rates have crept up and are expected to continue to rise.  And certainly, debt of many financial companies carries with it at least the same amount of risk as non-financial debt.  Or does it?

As mentioned in several earlier posts (Fannie, Freddie, and Sam; John Smiles, Milton Cries, The Lamb Sighs; and Uncle Sam vs. Uncle Sam) the “Bailout Binge” has been in full force for many months now.  The time has come for investors to take advantage of this government insurance/subsidy.  After all, your tax dollars are what’s bolstering these guarantees.  Shouldn’t you be compensated for your generosity?

Let’s take a small step back.  On October 13th, the FDIC (these are the same good people who insure the deposits, with certain restrictions, at most of your local banks) adopted the Temporary Liquidity Guarantee Program (TLGP).  Essentially, this program puts Uncle Sam’s good name behind some newly issued financial debt that matures on or before June 30, 2012.

The TLGP is in addition to Uncle Sam’s buying (again, with your money) preferred stock (which must remain outstanding for a minimum of three years) in these very same financial institutions.  Currently, these investments are (mostly) under water.  But hey, what’s $8 billion or so between friends?

Now, before we get to the good stuff, let’s review what happens in the event that a corporation goes bust and (in the unlikely event) its assets and liabilities are not assumed by another institution.  The first ones to get their money back are secured creditors.  These are the ones that lent money to the company, but only in exchange for receiving an unfettered claim on certain assets of the borrower.  Next (remember this part, this is what we care about) are the debt holders (senior, than junior, etc.).  Then come the preferred stock holders, followed last in line by common stock holders.

The Lamb’s view is this:  Uncle Sam is going to be loathe to let any institution in which it has invested taxpayer money actually NOT pay that money back.  The public relations black eye, not to mention the financial fallout, would be just too great to bear.

However, Uncle Sam would not be first in line to get paid back if a company went toes up.  Before Uncle Sam, as a preferred stock holder, received dime one, the senior debt holders would have to get every single penny of their money back, including accrued interest.

Now freely available for your investing pleasure are the senior debt of the very same financial institutions that have sold preferred stock to Uncle Sam.  For a not-necessarily exhaustive list of these firms, click here.

Many of these institutions have senior debt trading in the market which matures before the preferred stock can be retired.  And, it’s yielding as much as five percentage points or higher than its corresponding TLGP counterparts, some at yields around 10%.  Granted, this debt does not carry the expressed FDIC guarantee behind it.  But do you really think that Uncle Sam, in the unlikely event that one of these banks goes under, will be willing to face Ma and Pa taxpayer and tell them that the hundreds of billions of dollars they spent on preferred stock is not going to be repaid?

Neither does The Lamb.  He recemmends buying the short-term (less than three years) senior debt of companies that have sold preferred stock to Uncle Sam.  Uncle Sam is gonna get his money back.  You will, too.

Disclosure:  The Lamb owns senior (non-TLGP) debt of Merrill Lynch (soon to be Bank of America), Goldman Sachs, Morgan Stanley, and AIG.  He is looking to purchase more.

Several weeks ago, The Lamb announced that he would be accepting submissions for Guest Posting. Today, we inaugurate this concept with a post from Hank (name changed to protect the camera-shy).  Hank works as a bond trader for a foreign bank on Wall Street.  Below, he comments on the current financial tsunami, how we got here, who’s to blame, and what should be changed.

Without further adieu, The Lamb presents Hank:

I’m asked at times by those outside of the financial business how this mess could have happened. Although my background isn’t in subprime mortgages or CDOs, but in another corner of the credit markets, the attitudes that led to this blow-up and the subsequent bailouts are the same.  The truth is that everyone with any sense at all saw this coming for years, but too much money was being made in the meantime to worry about what might happen when the music eventually stopped.  And stop it did.

Back in the last recession earlier in the decade, credit traders were licking their wounds, like they are now.  The Federal Reserve drove rates to 1% and saved the day.  Soon it became obvious that there was a lot of cheap money sloshing around the system.  The economy was set to boom for some good reasons (tax cuts) and some bad ones (very low interest rates).

With threats of deflation (“We’ll be like Japan!”) still out there, the Fed was in no rush to raise rates after the immediate economic slow-down was past us.  Meanwhile, traders were looking at their daily profit & loss statements and finding that momentum was turning in their favor.  Activity was way up.  Cash kept coming into their markets and increasing the returns of their bond positions while the costs they incurred (the interest they paid for the money borrowed to hold their positions) were staying relatively low.  Seemingly every day that they sat on these high-yielding and out-of-favor credit positions they were making money.

In early 2004, bonuses were being paid again at the banks for traders who made money in 2003.  And you made money in 2003 if you were smart enough to convince your managers to let you hold on to your underwater positions.  Later in 2004, the stock markets began to drift lower as the Fed began to raise interest rates once again, and some were calling for a return to the recent lows in the stock market.  But the smart traders realized that there was just too much cash in the system to let that happen.  Sure, interest rates were moving higher, but the spreads on their bonds (the differences between the cost of owning bonds and the interest rate paid by those bonds) remained very enticing, or at the very least, positive.

By 2005, the markets were briefly smacked down on concern that General Motors would go bust.  It should have, but it didn’t.  And as an aside, if there were worries about automakers at the absolute peak of the availability of consumer credit, these guys don’t have a chance to survive as going concerns now.  But the markets moved past this.

And this is when the real troubles began.  For the next two years, the typical trading desk went from having a split of traders with positive outlooks and negative outlooks to being universally convinced that their best interest was in owning as much credit risk as their banks allowed.  How did this happen?  The traders who were paid bonuses were paid based on their share of their firm’s and their group’s profits.  The ones who weren’t paid were the ones who didn’t own enough risk, who didn’t buy into the new paradigm.  If you made a ton of money in 2004, you were paid.  If you didn’t, you weren’t paid and, even worse, in the eyes of your manager you were wrong.  Traders learned that to keep their jobs, they had to compete for profits and the only way to do that was to take more and more risks.

2005 should have been the end of the bubble, but it took another two years for it to pop.  The Fed should have acknowledged that risk-taking was out of control, but they didn’t.  Congress should have realized that lending standards for mortgages had become non-existent.  They only had to watch the ads that lenders were running to realize it was too good to be true, but the lobbyist cash was too good to pass up.  For those traders who were cautious or prudent with their firm’s capital, it was a nightmare.  You could fight the trend for only so long before losing your job, and many gave in to the momentum of the bull-market hoping that they could get out before it collapsed.

Phrases heard in 2006-2007:

“There’s a wall of money out there!”  This was supposed to mean that there was so much cash out there (sovereign, hedge fund, etc) waiting on the sidelines to buy into the market that to fight against the trend and bet against rising asset prices was basically career suicide.  The reply to that statement, “It’s not cash, it’s leverage… and leverage can unwind quickly,” was dismissed as ridiculous.

“It’s the Rio trade.”  This meant that the trader had built such a huge position (with the firm’s permission, by the way) that she would either get paid massively or she would take her prior earnings (and her severance) and take a year on the beach if it didn’t work out.

“Clients love him.”  This is the answer to the question of why a bank would hire a trader who was just fired from another bank because he blew up and lost a ton of money.  Another answer might be: “He’s comfortable taking risk.”  No kidding!  But he’s bad and reckless at it.  But no matter, it’s a competitive business and every shop wants the best!  As the CEO of Bank of America said last year, roughly, “Making money for four years and then giving it all up in the fifth is not a business model.”

A few logical steps to diminish the chance that credit traders blow up banks again:

Investment banks should not be public companies.  They should be partnerships.  This will automatically limit the size of the risks that their underlings put on their books.

Sadly, deposit-taking institutions should not be allowed to position credit risks for trading purposes, outside of generic commercial lending.  Now that the remaining large investment banks have converted to bank holding companies, they should be severely restricted in their risk-taking abilities.  The government can not subsidize glorified hedge funds.

Credit derivatives allow risk-taking at banks without cash being put up at the start of the trade (for now anyway).  There are collateral requirements with counterparties currently, but there should be cash requirements involved in putting these trades on the books comparable to what there are with bonds.  Actual costs that will come out of a trader’s P&L should be levied at the start of any credit derivatives trade.

Revert to the reputed Bear Stearns model of old:  traders will not get paid for any “positive carry.”  Traders should be forced to make their budgets based on their trading skills (turning over positions, buying low and selling high).  “Buy-and-hold” shouldn’t get rewarded.  If a trader puts the firm’s capital on the line and then simply clips coupons on bonds, the firm should not be allowed to reward him for it.  From what I was told years back, this was the policy at the old Bear Stearns of the 1990s.  They should have stuck with it.

More regulation for investment banks is inevitable and justified.  Let’s face it, managers at investment banks are lemmings.  If one ambitious investment bank allows a return to the old rules (allowing carry, etc.), a typical bidding war for talented risk-takers will emerge and all the bad habits will return.

Banks should throw the Value-at-Risk (VAR) models out the window.  These models gauge the riskiness of bonds or other assets basically by looking at their historic volatility (how much their prices bounced around in the past).  Forget that the products themselves only existed for perhaps a few years during an economic upswing and a bull market.  If the notional risks are big compared to the bank’s capital, cut the positions.  This leads to the next point…

Regulate rating agencies.  When accused of negligence or worse, they often fall back on the argument that they should be protected by their “freedom of speech.”  This is absolute rubbish.  They are getting paid for advice on financial products and they should be held accountable.  Of course, it’s an imperfect world and they make judgments that may prove incorrect at times — they should be given some slack.  But the conflicts of interest, sloppiness and laziness in this ratings business is endemic.

Investors need to stop whining.  You lost money in GM?  Why in the world did you own this credit?  They’ve been in decline for decades.  Anyone who didn’t see this coming should be banished from the industry.  Your subprime AAA portfolio was wiped out?  Did you even read the prospectuses or think for a moment that Moody’s might be wrong about their valuations for an essentially new product?  And besides, can you honestly claim to be shocked that there was a housing bubble and that it eventually had to burst?

One-by-one, traders set aside their disbelief over the last five years.  They thought the right thing to do was to buy as much risk as they could.  It’s what their employers wanted them to do and they were to be rewarded for it.  While twenty years ago trading was dominated by skilled market-makers (it really is a talent), over the last five years these dinosaurs disappeared and were replaced by two new types of traders:  the “quants” and the “monkeys.”

The quants are traders who employed models to tell them (statistically) what was a good bet.  This is despite the dearth of statistical data (and its relevance).  After all, financial markets are not driven by natural laws but often by psychology and unpredictable cycles.  The monkeys are traders who only know “buying.”  Buying risk is equal to profits for their banks and for them.  Each of these new class of trader never understood, never paused to think about, and never really cared about the risks that he would be taking on if the music stopped.  And they all blew it.

If we’re lucky, the risk-taking will be left to the professionals (at investment funds that are “disposable” in that they are not too big to be allowed to fail) and the market-makers will return to the banks.These amateurs should go back to studying physics (the quants) or simply kicked out of the business (the monkeys).

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If you are interested in sharing your views with the blogosphere, simply click the “Contact The Lamb” button on the upper left of this site, and give The Lamb your thoughts about what is or what should be.

The Lamb is cynical by nature.  He is a paid-up subscriber to the axioms “If it sounds too good to be true, it probably is,” and “Where there’s smoke, there’s arson.”

Recently, a friend of The Lamb, Adam (name changed to protect the imprudent), told him about a new website called OneSeason.com.  Adam is a willing, though very suspicious, participant in the OneSeason market.  Essentially, this site allows “investors” to buy and sell shares in their favorite players and teams from the world of sports.  There are both primary and secondary markets.

In the primary market, OneSeason conducts initial public offerings (IPOs) of shares for both teams and players (with a price set at $5 per share) via an allocation algorithm.  These shares are then traded in the secondary market, splitting if/when the price reaches $20 per share.  The company makes money by charging commissions of 5% on IPOs and 1% on secondary trades.  Presumably, fixed and variable costs are de minimus. 

Now for the fun part.  Unlike traditional shares of company stock which entitle the holder to a fractional ownership of that company’s net profits, holders of OneSeason shares simply own the bragging rights to a given player or team.  Unfortunately, bragging rights, much like gold and vacant land, are not positive carry investments.  Then again, land and gold are both tangible assets and offer at least the potential of capital appreciation.

Of course, OneSeason shares can go up in value.  An investor simply has to find someone to pay a higher price than he paid — the so-called “greater fool theory.”  The Lamb certainly feels that OneSeason participants are entitled to purchase shares as they wish – (The Lamb’s Rule #5 — “You pay your money, you take your choice.”)  However, he feels that OneSeason has essentially created a somewhat mitigated pyramid scheme.  This “venture” differs only slightly from the early 20th century Ponzi Scheme. 

Charles Ponzi's Mugshot

The product (service?) OneSeason sells has no intrinsic value save for the aforementioned bragging rights of player/team cyber-ownership.  This may be a good time for potential OneSeason participants to repeat to themselves The Lamb’s Rule #2 — “Know and understand what you own.”

One may ask how this is any different from owning a baseball card or even a work of art.  The difference is that in owning one of these two types of positional goods, an investor has possession of a tangible item, and more importantly, one which is of finite supply– 

Pablo Picasso is not going to be composing many more paintings, and the American Tobacco Company threw away the mold for the T206 Honus Wagner baseball card nearly a century ago.

As amazing as it seems to The Lamb that this market exists, more incredible still is that it has actually spawned websites for OneSeason investors (again, the term “investors” is used extremely loosely here) to exchange opinions and information about share prices of players and teams, much like websites devoted to fantasy football/baseball enthusiasts.  Sites like OneSeasonNation.com and OneSeasonTrader.com garner far more hits than does your editor’s humble corner of the blogosphere.

Trade shares at OneSeason.com if you wish.  But keep The Lamb’s Rule #4 (An asset is only worth what someone else is ready, willing, and able to pay for it) safely in the front of your mind. 

Right now, Adam is wishing he had remembered it…

Note:  This post is in no way meant to endorse, oppose, compliment, or impugn any person or political party.

Monday, January 28th, 2013

President Palin sat alone in the Oval Office wondering if the plan she had developed with her financial S.W.A.T. Team would be enough to extricate the country from its latest economic crisis.  She was barely one week into her first 100 days in office, and things were going from bad to worse.  She thought back to her predecessor and the challenges he faced during his four years in her position.

It was late summer 2009 and the previous year’s credit crisis already seemed like a distant memory.  The 0.125% federal funds rate and enormous federal bailout programs appeared to have stabilized the financial markets.  The Dow had clawed and scratched its way back above the 11,000 mark and there had been a nearly one year absence of major corporate failures. 

However, the easy monetary policy masked a deeper dilemma.  With memories of 2008 still fresh in their minds, financial institutions remained fearful of committing capital for longer-term projects.  As many banks began facing maturities on their debt, rollovers became a looming problem.  The 2008 guarantee of bank debt issuance had failed to lower term funding costs significantly as investors had grown leery of just what that U.S. government guarantee was really worth.

With small and large banks alike experiencing growing funding difficulties, President Obama called on Treasury Secretary Lawrence Summers to find a solution.  Working with Fed Chairman Robert Rubin, who had reluctantly assumed his position after Ben Bernanke had been “asked” to leave by the President, Summers embarked on a bold solution. 

Loathe to face the specter of another large bank failure, the duo ordered (the official stance was “strongly encouraged”) the marriages of the country’s few remaining “super” banks.  Goldman Sachs was sent kicking and screaming into the arms of Citigroup, and Morgan Stanley was reunited with its ex-spouse JP Morgan.  The restriction on any institution holding more than 10% of total U.S. deposits was conveniently repealed.

Unfortunately, this failed to stem the rising tide of consumer bankruptcies.  Credit card debt was now crippling the country.  By late 2010, credit card debt in the United States had skyrocketed from $27 billion in 2007, past the 2009 level of $96 billion (estimated by NBC News), to a staggering $200 billion, as households tapped any possible source to pay for day-to-day living expenses.

Faced with a public outcry and using the 2008 bank bailout as precedent, President Obama ordered Secretary Summers and Chairman Rubin to enact a freeze on all credit card interest charges effective as of December 1st, 2010.  To mollify the credit card companies, the Treasury would begin making the interest payments on all balances as of this date, though at a rate of just 9%.  Though this was below what they were currently slated to earn from consumer balances, the credit card companies acceded to the plan as it dramatically reduced their allowances for bad debts and strengthened their deteriorating balance sheets.

Financial blows continued to batter the global economy.  South American nations, borrowing more and more money in an effort to grow their own economies out of the three year recession, faced spiraling inflation.  Playing their trump card, they threatened an oil embargo against the U.S.  With oil already having soared above $350 per barrel after the June 2011 Israel-Iran War and the American public demanding a reprieve from crippling gas prices, the United States approved low-interest loans to Brazil, Venezuela, and Argentina in exchange for their promise to maintain the flow of oil.

The dire financial straits of consumers and declining property values culminated in much lower tax receipts for municipalities, just when this money was most badly needed.  California, already buckling under huge fiscal strains and unwilling/unable to repeal Proposition 13, in early 2012 became the largest municipal bankruptcy on record, easily eclipsing Orange County in 1994, Alabama’s Jefferson County in 2009, and even the 2011 State of Arizona filing.

In an effort to forestall cascading municipal failures which threatened to paralyze essential state and local services from education to police and fire departments, in the summer of 2012 Congress passed the Municipal Assistance Rescue Program (MARP).  The MARP allowed state and local governments to borrow money interest free from Uncle Sam for up to three years.

However, as the conga line of municipalities lining up to take MARP funds grew, the national debt soared, as did interest rates on everything from U.S. Treasury securities to home mortgages.  Inflation, that scourge not seen since the late 1970s, skyrocketed past 12% and the U.S. Dollar, already battered by the proliferation of government bailouts the past four years, sank like a stone. 

Many banks were now unwilling to make loans in dollars, fearful of the currency’s continued depreciation and unable to effectively hedge themselves in the increasingly illiquid foreign exchange markets.

As summer turned to fall with the economic and financial landscape looking increasingly bleak, the nation elected its first female president — Senator Sarah Palin of Texas.

Sitting in the Oval Office, President Palin greeted newly appointed Fed Chairman Timothy Geithner.  The President wanted reassurance that her campaign pledge of lowering inflation and crippling interest rates could be accomplished.  The Chairman, taking a page from one of his predecessors, Paul Volcker (who had raised the federal funds rate to as high as 20%), reiterated faith in their plan to raise the funds rate from the current 10% all the way to 18%.

In response to the President’s hesitancy to increase rates, Chairman Geithner explained its necessity in wringing inflation out of the system.  The Chairman admitted that he had learned his lessons from the ill-planned bailout binge that he had helped orchestrate and sustain as President of the Federal Reserve Bank of New York during the presidencies of George Bush and Barack Obama.  He said that the country now needed to take its financial medicine, no matter how bad the taste, in order to cure the disease of inflation.

Besides, he elaborated, raising short-term rates might be enough to reverse the outflow of foreign capital that had been occurring for most of the past year.  China and Japan, for example, had sold nearly $1.5 trillion of dollar-denominated debt, mostly U.S. Treasury and Agency securities.  America’s runaway inflation had shaken their faith in its ability to service its debt, now owned predominantly by foreign governments.

If this did not work, Geithner worried, the country might be forced to return to some version of the gold standard, not seen in the United States since President Nixon abandoned it in 1971.

As February turned to March and March to April, the economic climate began to improve.  Data showed that foreign capital was returning to the U.S., taking advantage of higher short-term yields.  As inflation fears abated, fixed-rate mortgage rates dropped precipitously, falling below the psychologically important 10% level.  Even the Dow had closed above the 5,000 mark for the first time since late 2011.

The country was learning (forced?) to live within its means after an arduous period of stagflation.  Long-gone were the days of easy credit and government safety nets.  But a more disciplined and realistic debtor-creditor relationship had emerged, one which held the promise of stable prices and moderate long-term growth.

The Lamb has always been fascinated by the concept of hyperinflation — the rapid and extreme rise in the price of goods and services — (and by Michigan Football’s inability to stop a spread offense, but that’s another story).  The most fundamental causes of (hyper)inflation are an increase in the supply of money and/or a (corresponding) decrease in that money’s value.

Perhaps the most dramatic example of hyperinflation occurred in Germany during 1923-24.  Following World War I, the Allies forced Germany to sign the punitive Treaty of Versailles.  Among other things, the Treaty forced Germany to admit responsibility for the war and to pay for its damages.  The German economy, in tatters following the war, was unable to generate enough money to pay its debts.  The country embarked on a crash course of currency creation, running its printing presses non-stop.

This had the effect of quickly eviscerating the value of the German currency.  At the beginning of 1923, it took 9000 German Marks to buy one U.S. dollar.  One year later, the rate was 100 trillion marks to the dollar.  The country was futilely attempting to print its way out of debt, but only succeeded in making its currency next to worthless:

In Germany one morning in early 1924, a woman was on her way to the bakery to buy bread for her family.  Suddenly, a man accosted her, grabbing the bag she was dragging behind her which carried the trillions of marks she needed to buy bread.  As she begged him to return her money, he emptied the bills onto the street and replied, “Keep the money, I just want the bag.”

One Trillion Marks -- Almost Enough For Bread in 1924

Segue back to this side of the pond.  Congress has passed and the President has signed the now (in)famous $700 billion bailout/stimulus/rescue plan.  Now, $700 billion (the final tab could be less) may not be huge when compared to our roughly $14 trillion economy.  Yet, this spending/printing of dollars is all too typical of America’s solution to economic problems (see 1980’s Chrysler loan guarantee, 1989’s Savings & Loan bailout, and this year’s massive Bear Stearns backstop and AIG rescue, just to name a few).  Uncle Sam has even committed money to protecting over $2 trillion in money market fund assets — see the post 2 + a + 7 = 50,000,000,000.

One may argue that the Feds undertook a similar strategy in the 1930’s to counteract the consequences of the Great Depression, with relatively few ill effects from runaway inflation.  While we can debate the wisdom of New Deal programs, the fact is that the United States was a creditor nation then (an idea that is a distant memory now) and, more importantly, was on the gold standard.  Our current system of fiat money leaves us far more susceptible to a rapid decrease in the value of the dollar.

The Fed, under its last two Chairmen, has been more concerned with deflation than inflation.  They have targeted a low federal funds rate, or as The Lamb calls it, “growth at any cost.”  In fact, Fed Chairman Bernanke has given speeches bemoaning the dangers of deflation. Unfortunately, by the time inflation rears it ugly head the next time, it may already be too great to contain.

The deadweight loss created by the Troubled Asset Relief Program (TARP) is just the latest in a tragedy of financial errors — see the post Brother, Can You Spare 7 Trillion Dimes? And when considered alongside our roughly $800 billion current account debt (cumulative trade deficits) and our $10.1 trillion national debt (not to mention future expenditures for entitlement programs like Medicare and Social Security), you get total debt of nearly 80% of the U.S. gross domestic product (GDP) and rising…

Now, not even The Lamb, as long-term bearish as he is on the U.S. Dollar, believes that we are on the cusp of hyperinflation.  Though the Dollar has been on a terrible slide this decade (see chart below of the U.S. Dollar Index, courtesy of fxstreet.com), it has shown signs of life the past few months.

Look Out Below.....

However, the recent strengthening of the greenback is due largely to the ubiquitous need of corporations and banks to make outright purchases of needed dollars that they are unable to borrow in the credit markets for their ongoing financing activities.  The dollar may very well continue to rise until lending in the money markets returns to equilibrium.

But if/when the dollar restarts its slide, it may be swift. That may be a good time to put The Lamb’s Rule #7 into action — If you’re gonna panic, make sure you’re the first.

Severe inflation would have a few tertiary advantages for some.  Homeowners’ existing fixed-rate mortgages would effectively be wiped out as the dollar’s value plummeted, essentially producing mortgage-free homes.  Other hard assets, from cotton to coffee and from silver to soybeans, would also rise in value on a dollar-basis.  Those that owned these “real” assets would enjoy a modicum of protection from the ravages of breakneck inflation.

However, there would be a catastrophic downside.  Interest rates would soar and those lenders that hadn’t already been forced into bankruptcy would be wary of lending at all but the most punitive of terms.  Furthermore, the price of goods and services would soar as sellers sought to stay one step ahead of our crashing currency.  Commerce would screech to a halt.

Let’s remember, a slowing economy, even a recession, is not the end of the world.  It’s called the business cycle.  This country, actually most countries, go through periods of economic contraction.  This is a natural way for the economy to build a stronger and more stable base from which to maintain long-term growth.  As painful as economic slowdowns might be, they are far less deleterious than the flip side — runaway price increases.  See Zimbabwe’s current 531 billion percent inflation as a savage example.

Call The Lamb Chicken Little, but he’ll take a weak economy every now and then if it means he’ll never be emptying out a bag packed with cash just to make it easier to carry.

Disclosure: The Lamb owns UDN and CYB, two exchange-traded funds expressing bearish views on the U.S. Dollar.  The Lamb also owns GLD, a trust that buys and holds gold bullion.

One of The Lamb’s favorite movies is Trading Places with Dan Aykroyd and Eddie Murphy. In one scene, Aykroyd’s character, the haughty Louis Winthorpe III, is desperately trying to obtain money by selling his fancy watch to the only buyer around — a pawnbroker, played in a great cameo role by Bo Diddley:

Pawnbroker: I’ll give you fifty bucks for it.
Louis Winthorpe III: Fifty bucks? No, no, no. This is a Rouchefoucauld. The finest water-resistant watch in the world. Singularly unique, sculptured in design, hand-crafted in Switzerland and water resistant to three atmospheres. This is the sports watch of the ’80s. Six thousand, nine hundred and fifty five dollars retail!
Pawnbroker: You got a receipt?
Louis Winthorpe III: It tells time simultaneously in Monte Carlo, Beverly Hills, London, Paris, Rome and Gstaad.
Pawnbroker: In Philadelphia, it’s worth 50 bucks.

This scene is exemplary of The Lamb’s Rule #4: an asset is only worth what someone else is ready, willing, and able to pay for it. While it is fine to boast that an asset is “singularly unique” and “sculptured in design,” the best bid was $50 dollars, so Aykroyd’s watch was worth $50.

(Sidebar: if you haven’t seen Trading Places, (1) Aykroyd sold the watch to the pawnbroker for the proffered $50; and (2) You should proceed immediately to your nearest church/temple/mosque for a full confession).

Many of us have heard the bobbleheads on CNBC and elsewhere prattle on recently about the lack of pricing transparency in certain asset classes. They’ve placed part of the blame for the economic carnage currently engulfing America’s financial institutions on the opaqueness of credit default swaps and other assets that don’t actively trade on exchanges.

But now, these same critics are supporting proposals to allow firms to inflate the marks-to-market of many of these same assets to levels above their true current market levels. They state that forcing firms to mark their positions at what they consider “fire-sale” prices (what others might call “current market” prices) is the root cause of the problem, not the fact that these assets have simply decreased in value.

They assert that suspending mark-to-market pricing, also known as fair-value accounting, will alleviate pressure on these firms who now find themselves with assets on their books which they bought voluntarily and whose values have since declined.

Fortunately, the SEC and the Financial Accounting Standards Board (FASB) are trying to hold the line against this lunacy. From the above Bloomberg.com article:

JP Morgan Chase analyst Dane Mott: “Blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick.”

Invesco’s Diane Garnick adds, “Suspending the mark-to-market prices is the most irresponsible thing to do. Accounting does not make corporate earnings or balance sheets more volatile. Accounting just increases the transparency of volatility in earnings.”

To grasp the gravity of the risk of suspending/eliminating fair-value accounting, look at the enormous volume of assets that firms had on their books as of August 15, 2008, which they listed as so-called Level 3 assets, or those in which values may be based on management’s expectations of what they will (may?) eventually be worth:

[Click on each graph for a clearer view]

(Graphs via econompicdata.blogspot.com)

Notice that the seven firms taken over by Uncle Sam (or nationalized, or bailed out, or forced into a merger, etc.) — Freddie Mac, Fannie Mae, Merrill Lynch, AIG, Lehman Brothers, Wachovia, and Indy Mac — had nearly half a trillion dollars worth of Level 3 assets as of August 15, 2008!

Notice also that five of the seven firms with the highest amount of Level 3 assets as a percentage of equity as of this same date (Freddie Mac, Indy Mac, Merrill Lynch, Fannie Mae, and Lehman Brothers) have since been “Uncle Sam’d.”  Freddie’s Level 3 assets were ten times more than its equity and Indy Mac’s Level 3s represented nearly 100% of its total assets!

Against this backdrop, do we really want to allow firms to value such a large amount of assets at something other than current realizable market values? Is inflating these values really going to give the public a better understanding of these firms’ true financial conditions?

No one is saying that firms shouldn’t be allowed to raise the prices of assets on their books if/when buyers emerge at higher levels. But until that happens, firms should only value their assets at what Bo Diddley or anyone else is ready, willing and able to pay for them.

This past weekend, The Lamb returned to his alma mater to watch his Michigan Wolverines take on the ninth-ranked Wisconsin Badgers. Along with 109,832 others, he watched as Michigan pulled off the biggest home comeback in school history in what was the 500th game at Michigan Stadium.

The great thing about comebacks, assuming that you are the on the right side of them, is that they are not only such exciting experiences, but they are also so surprising. The bigger the comeback, the greater the excitement and the surprise.

Though the odds seem long and sentiment keeps vacillating between negative and dire, many of the major asset classes are crossing their fingers and hoping for a comeback of their own.

“Markets hate uncertainty” is a common refrain in financial circles. But the proposed Bailout Bill, christened “The Emergency Economic Stabilization Act of 2008,” currently slugging its way through Congress may remove some of the uncertainty hanging over the markets. A look at the 52-Week charts of some asset classes is not for the faint of heart, but these assets may just be setting the stage for their own comebacks.

Equities (S&P 500 Index):

Source: www.bigcharts.com

Investment Grade Corporate Bonds (LQD Exchange-Traded Fund):

Commodities (Dow Jones AIG Commodity Index):

Real Estate (S&P/Case-Shiller Home Price Index):

Source: Standard & Poors

… and while C is for “Comeback,” and many of us are hoping for these charts to begin making a U shape, let us not forget that above all C is for…

 
Disclosure: The Lamb owns SPY, LQD, GLD, USO, DBA, and a New York City co-op.