Shut-up, CNBC: Carney on Muni bonds edition

Yesterday, Carney, when discussing risks to the Municipal markets said something I feel is inaccurate and deserves correction.

5. Information Cost is High. Muni issuers are not subject to the same disclosure requirements as corporate borrowers. The market is illiquid so pricing is opaque. The swaps market—the market for tradable credit protection—is thin and unreliable. This means that bond buyers may be taking on risks that they are not aware of. This is a recipe for panic once a triggering event occurs. 

First of all, CDS trading on a LOT of things is very thin. The municipal market is not a monolith, it is composed of thousands of issuers and so, yeah, swaps are probably pretty thin for many issuers. Just like bond and CDS mkts would be thin for most corporate issuers. Second of all, municipal market is dominated by retail, for obvious reasons. Joe Smith looking for safe tax-free bonds isn't exactly your average CDS trader.

Secondly, information is not that hard to come by if you know how to look and are not lazy. Anyone that's lending anyone money should do their homework, or at least pay an adviser or fund manager that has fiduciary duty to do it for them. MSRB is a wonderful resource, including a freely available trade history and, as Bond Girl has pointed out before, MSRB's EMMA allows you to find many issues' official disclosure documents.

Lastly, if you are the kind of investor that doesn't need an adviser or fund manager and is buying large amounts of municipal bonds, you can probably afford a subscription to The Bond Buyer and professional research from the rating agencies (ignore the rating and read the analyst's report).

6. Arbitrage Buying Leads to Bubbles. Much of the demand for muni bonds is not a function of credit analysis or a desire for exposure to the revenue streams of local governments. It is done for a technical, legal reason—to take advantage of the tax-free status of muni bond income. This creates an artificially high demand—a bubble—much like Basel accord capital requirements led banks to overinvest in mortgage bonds.

As Bond Girl wrote a few weeks ago, the last few years have seen some demand destruction, not only from a shift in investor's appetite for municipals relative to other securities, but by the departure of a number of leveraged actors that, through the use of short-term funding schemes created additional demand at the long ends of the curve. We're also seeing that "the muni market is transitioning from an interest rate space to a credit space." I can't go into it here, but you should really read Bond Girl's piece, it is excellently written and informative in a way no newspaper ever will be. But, getting back to my point, tax-free income doesn't necessarily increase demand.

Tax-free yield is attractive and investors are usually willing to take smaller yields for tax-free debt because it is still attractive in a taxable-equivalent basis. However, tax-free yields are only attractive to investors that benefit from preferential tax-treatment, limiting the universe of potential buyers--this is why the BAB program was introduced, to stabilize demand by introducing new participants. In my opinion, the tax-exempt yield of municipals actually hurts demand by restricting the universe of potential buyers. One only needs to look at the disparities between non-taxable TEY and BAB yields earlier in the year to see this at work.

The solution here, in my opinion, is for the federal government to refund issuers directly, like in the BAB program. Investors will receive higher yields that are equivalent on a taxable-equivalent basis and municipalities can offset the additional cost of debt service with refunds from the tax collectors paid for by the tax collected on the new, taxable issues. Otherwise, we risk a market where municipals can actually pay a premium, as they trade not only on their taxable-equivalent basis, but also on any extra risk or liquidity premium required by the restricted universe of buyers, increasing volatility and therefore the cost to issuers.

Shut-up, NYT: Mankiw Will Work Less if Taxed More (see also: Laffer curve)

The bright and extremely personable professor of economics at Harvard University, Greg Mankiw, writes in the NYT about how higher taxes mean he'll end up working less.

HERE’S the bottom line: Without any taxes, accepting that editor’s assignment would have yielded my children an extra $10,000. With taxes, it yields only $1,000. In effect, once the entire tax system is taken into account, my family’s marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?

I'd like to personally thank Greg for this eloquent explanation of the Laffer curve. I'm sure it's included in once of his excellent textbooks, although this article was certainly more memorable. My issue is with his last thought, though:

Now you might not care if I supply less of my services to the marketplace — although, because you are reading this article, you are one of my customers. But I bet there are some high-income taxpayers whose services you enjoy.

Maybe you are looking forward to a particular actor’s next movie or a particular novelist’s next book. Perhaps you wish that your favorite singer would have a concert near where you live. Or, someday, you may need treatment from a highly trained surgeon, or your child may need braces from the local orthodontist. Like me, these individuals respond to incentives. (Indeed, some studies report that high-income taxpayers are particularly responsive to taxes.) As they face higher tax rates, their services will be in shorter supply.

Yes, maybe. But Greg is making the assumption that if he doesn't provide his services, someone else wouldn't step-in to fill in the gaps. I'd see this argument being valid when we are close to full employment levels, but the unemployment rate amongst individuals, even if lower than the less educated, is still elevated.

Image source: Calculated Risk

I'm sure that there is plenty of unemployed or underemployed economists who would be happy to take that work Greg doesn't really want, many of which are probably adequately qualified, even if they lack his reputation.  To Greg's possible substitutes that fall under a lesser marginal tax-rate, this same work would yield more savings, meaning they'd be more willing to take on that extra work even if their supply curves are identical. Those who are less financially comfortable and are more willing to sell their labor may be willing to provide the same services for the lesser compensation they might be offered as a result of lacking Greg's name-recognition. So my final comment to Greg is that it may be worth considering that maybe this is not so much about "how much the government should redistribute income" but about how much government should redistribute the opportunity to work. And right now, Greg, there is plenty of us that would be perfectly willing to provide our services for both income, and the opportunity to create a name for ourselves so that one day we too can turn down jobs because, after taxes, they don't pay that much.

As a final nitpick, that 90% estimate is kind-of a worst-case scenario. If Greg's concern is really how much taxes are going to reduce what he finally leaves his children and grandchildren, he should look into estate-planning and all of the opportunities there is to distribute accumulated wealth to heirs over time to reduce the tax-impact, whether it is tax-exempt gift allowances, 529 Plans, or other of the products that are available for these purposes. If you are interested in any of those services, Greg, please feel free to leave a comment and I will make sure to put you in touch with some financial professionals that are both highly-qualified and very much willing to work.

Shut-up, WSJ: "Bond Bubble" edition

There has been a lot of noise in the blogosphere about the "bond bubble" (1) (2) lately. For what it's worth, I don't think there is so much a bond bubble as there is a system awash in liquidity that has to go somewhere. Some money is chasing momentum, some is chasing income, some is chasing yield that has more stability than equities can provide. I do think rates are absurdly low, but that's what happens in deflationary environments. The JGB bubble has been a "no-brainer" short for 15 years, but that trade has been a consistent loser for just as long. In general, I think bonds have limited potential to enter "bubble" territory right now because their value has a natural cap (that they trend to as maturity approaches) and because bubbles--in my mind at least--require massive amounts of credit to finance the purchases of the asset in a bubble, and that demand for loans would, you know, be reflected in higher interest rates that would halt the appreciation of bonds.

More on refinancing negative-equity loans

 Josh Rosner over at The Big Picture has a response to a plan similar to the one I proposed last week. I argued that breaking-off the underwater part of a mortgage and turning it into a full-recourse uncollateralized loan was likely to have little effect, since the collateral wasn't going to magically be worth more just because the banks needed it to. I wrote:

The government could create a facility that lends money to underwater homeowners that need to free themselves from a home.

This is not a giveaway, it is a loan. This is not a below-market-rate loan, and therefore carries no implicit subsidy. The loans should be made at a rate similar to or slightly higher than the original mortgage rate. Home-owners who are underwater and are being held-back from taking a job in a different area should be offered the loans, which would be contingent on a job offer. The loans would be used to pay-off negative equity at the time of a home sale. The borrower could then free him or herself from the home anchoring him or her down and return to employment
...
If the lender vowed to reduce the rate on the loans by a set amount if the borrower transformed the loan into a second lien on any new property bought, it could furthermore enhance the quality of these loans. These loans could then either be kept until maturity or sold to banks for securitization

The original idea behind this was that, especially for a distressed, undercollateralized loan, if you increase the quality of the borrower, you increase the value of the loan. I argued that because the Fed owns $2Tin MBS and Fannie and Freddie guarantee so much of the rest, it would actually be in the financial interest of the taxpayer to do this.

Josh, however, is responding to a slightly different plan. a mass, streamlined refinancing of underwater-mortgages. I tend to agree with some of the logic behind the idea, but, operationally, it would be a total nightmare.  I still think the best way to deal with it would be for banks to allow homeowners with no second lien to convert the underwater portion of their mortgages into a separate, uncollateralized recourse loan and refinance the house at an appropriate LTV. This help people sell their homes and downsize or move, without being forced to default on their debt.  Josh didn't respond to my plan. Josh doesn't know that I exist. In fact, judging by the traffic stats, only about 1.7 people have ever read this blog, but I like to chime in on everything.  Here is Josh's objections (along with my response):

- As a result of another prepayment-shock and the inability to model future prepayment shocks, investors would become even more unwilling to invest in MBS gong forward, or would begin to demand higher yields going forward; unwilling to invest in MBS going forward, or would begin to demand higher yields going forward;

 Oh, no! The government would stop subsidizing people earning abnormally high yields with unusually low prepayment rates! Shut up, Josh. Anyone who bought MBS in size knows that there is an embedded call option in the loans and how negative convexity works against you when interest rates drop. I agree that the streamlined refi process would be a mess, but that doesn't matter for a plan like mine.

- The interest rate risk that this would cause, as banks and the GSEs themselves all had to re-hedge their books at the same time, could precipitate a systemic risk issue;

Yes. They are all going to have to do that at the same time. By this same logic, why didn't the unusually low prepayment rates wreak havoc on their prepayment models and therefore their hedges?

- The prepayments would cost investors more than half a trillion in lost interest income;

I was under the impression that the government was trying to get out of the business of subsidizing bond holders at the expense of everyone else. I'm sure investors will find new ways to reach for yield or invest that money in, oh, I don't know, a value-creating process?

- Such a “streamlined” refi program would cost state and municipalities billions of dollars in transfer fees that they would normally be able to charge on a refinancing;

Well, if it wasn't for the program, the states and municipalities wouldn't get any fees, because underwater homes can't be refinances anyway. So they aren't really losing anything at all. They are just a road-block that's being worked around. Since the states just got $26B from Uncle Sam last week, they should just keep their mouths shut. Not to mention the benefits they'll reap from would-be defaulters and foreclosures staying current.

- Keeping borrowers in their homes with rate reductions could be argued to be consistent with maximizing value under conservatorship. A streamlined and across the board refi program that treats all borrower LTVs and other features the same would appear to violate the conservatorship;

I agree with the first part. The second part I'll leave to the lawyers. I do think that a mass-rate-decrease might be the cheapest way to minimize costs for the guarantors, though.

- The GSEs, according to their trust agreements, are prohibited from soliciting prepayments. If they were in receivership these agreements could be abrogated but they would still have to pay value on the contracts; and

- Servicer’s could solicit borrowers to prepay on the program but it would be a nightmare to operationalize and oversee such a massive program. 

Touché. 

Some comments on an aging population and demand for securities

The Reformed Broker writes:

According to USA Today, there are approximately 79 million boomers in the American populace and the first wave of them turn 65 in the next year.

Wealth managers, brokers, investment advisors, financial planners, and family office guys will all feel the effects of this retirement onslaught, but nowhere on The Street will it be felt more than in the mutual fund complex.

I'm picking on him because he is linking to garbage. The linked USA Today article says:

The past three months alone, the average stock mutual fund has shrunk by 10%, according to Lipper, which tracks the funds. The past 10 years, the average stock fund has gained an average 0.2% — far below the stock market's average annual gain of 9.7% since 1926.

Ummmm, no. is 10% in terms of clients? Assets under management? Could this be caused by the recent draw down in equities? Where does the author get off trying to make a point saying MF assets have only grown by 0.2% per year over the last decade? That's clearly measuring from the 2000 peak (S&P @ 1,500) of a bull to somewhere in a bear market. Maybe assets didn't grow because valuations are actually lower now than they were in 2000--substantially so. How does the 1926-present average have anything to do with anything? Also, has the writer ever considered that MF assets could shrink as people move to ETFs or third-party money manager services?

Shut up, bloggers: The Fed is full of eeeediots & "Secret-sauce" sell-in-May porfolios

I read quite a few finance and economics blogs, many more than the list on the right would have you believe, and while they are really good for the most part, sometimes people make mistakes. Today I call out two people on their mistakes: Barry Ritholtz of the excellent The Big Picture and Jake of EconomPic Data, who makes some of the better eye candy in the economics blogosphere.

The Fed is full of Eeeeediots
This morning, Barry called the economists at the Federal Reserve innumerate.  As someone who has a decent grasp on numbers and studied economics, I resent that. Listen here, Ritholtz, the .com bubble was a no-brainer in 1999 and late 1998 and the housing bubble was obvious in 2005/2006 when even the Gawkerites had that long running joke about never being able to afford a brownstone in Brooklyn and "Flip This House" was a hit TV show. That all was straight out of "Extraordinary Popular Delusions and the Madness of Crowds" but calling a nascent bubble in 2003/2004 wasn't so simple. I like to rag on timmay, benny, hankay and the maestro as much as anyone--although never Volcker, he's my boy--but they are not stupid, much less innumerate. Their version of  Do The Right Thing might differ from yours and mine, but we are just going to have to accept that since we can't vote for Fed chairmen ourselves.

Also, remember in 2004 Greenspan started to move towards higher rates, with 17 hikes? By 2005 the yield curve went inverted. I remember because I was in undergrad Money and Banking at the time and my teacher, an insufferably monotone man, was basically doing back-flips in excitement, telling us all about how special a moment that was and how we should consider revising our portfolios because he expected a recession.  Well, the point is the far end didn't move up. Whether it is because of what Koo calls "debt rejection syndrome" or not, I' don't know. The point is that the Fed DID move too cool down credit-fueled speculation but, if you believe Koo, the monetary approach was impotent. The Fed did the right thing, albeit too late and with tools that didn't work. Hindsight 20/20 etc. If you want to hate on the Fed and The Beard, maybe you should poke fun at His Beardedness' suggestion that the BoJ buy Ketchup, like Koo did. Yeah, Koo again. Goddamnit Barry, why can't you be more like Koo?!?!?! (j/k, you are much entertaining and your books was much more fun to read)

Sell in May and go buy secret-sauce bonds?
Today, Jake posted a graph of what would have happened if you invested in this instead of that. I hate those graphs, they are remarkably useless 99.9% of the time and are just screaming DATA MINING. As a fellow economist, I expected more from you Jake.

Seriously guy. Look at how that interest-rate graph behaved and look at how the secret-sauce portfolio started outperforming in the mid 80s when interest rates were coming down from all-time highs. Of course holding on to fixed income instruments at a time of dropping rates is going to result in gains, duh! Try the experiment again with floaters, callables or anything with negative convexity and see what happens. My guess is it won't be quite as spectacular. Try it with full-year "secret sauce",  or zero-coupons for the Summer and watch your fake portfolio make. it. rain.