grant's interest rate observer x-mas issue

8/13/2019 Grant's Interest Rate Observer X-Mas Issue

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Vol. 31 Winter Break DECEMBER 26, 2013

(January 11, 2013) Like a well-fed

teenager, the national debt keepsgrowing and growing. On Dec. 31, itbumped its head against the statutoryceiling that never seems to containit. That would be $16.394 trillion, orthe cash equivalent of 360.7 millionpounds of $100 bills. We write in sup-port of the ceiling.

Reciprocally, we write against thedebt. At prevailing pygmy interest rates,we are bearish on the bonds of which itconsists. We oppose, too, the sneaky no-menclature of American public finance,including the title affixed to the De-partment of the Debt. Inasmuch as theTreasury holds no net treasure, TimothyGeithners agency should be properlyand frankly rebranded. And we opposethe monetary legerdemain by which somuch of the debt is financed, notablythe nonstop bond buying of the Depart-ment of Money Printing. This is the bu-reau known officiallyanother misno-meras Americas central bank.

The operating procedures of the de-partments of Debt and Money Print-ing didnt come from nowhere. Theysprang from the heads of learnedeconomists. As imbibed by somewhatless learned politicians and journalists,the economists ideas were reducedto bite-size, destructive, policy-readyform, e.g., We owe it to ourselves,and America issues the worlds re-serve currency, so whats the harm?and A family has to balance its bud-get but a nation is different.

The first debt ceiling was enactedin 1917 after the United States enteredWorld War I. It authorized the sale oflong-dated 4% bonds in the sum of

apprehensions of an 18th-century wor-

rywart. Just how correct was the authorof The Wealth of Nations may beseen in the fact that the United Stateshas been able to continue to fund itselfdespite not one but two defaults overthe past 80 years: in 1933, when thedollar was devalued to one-thirty-fifthof an ounce of gold from a little morethan one-twentieth of an ounce, and in1971 when the government stoppedexchanging dollars for gold at any rate.

J.P. Morgan, too, had a point when headmonished that a bear on Americawould certainly go broke.

But neither Smith nor Morgan livedto see the pure paper dollar or todaysroutine immense peacetime budgetdeficits. Nor did they live to see thetriumph of the ideas of the economistswho neglected to consider the tempta-tions inherent in the reserve-currencygimmick. Borrow what you like,America, in effect, the architects ofthe post-1971 monetary arrangementsproposed, you can pay your bills,foreign and domestic, in the currencythat only you may lawfully print. Now,

just dont go printing too much. A na-tion of saints might resist the urge tooverdo it. As for us mortals, the debtceiling speaks for itself. Perhaps, ob-serving affairs from the economic andfinancial wing of the kingdom of heav-en, Smith and Morgan are just as wor-ried as Grantsis.

In fiscal and monetary thought,there is the modern era and the pre-modern era. The modern era is theage of heavy public indebtednessand paper money; were in it. Theancient era, the age of minimum in-

$7.5 billion; the 1917 gross national

product amounted to $60 billion. (Forperspective, todays $16 trillion-plusdebt ceiling stacks up against a $15.7trillion GDP.) It was no good omenthat the Senate passed the 1917 actwithout a dissenting vote in recordtime, according to The New York Times.The next year Congress enacted an in-terest-rate ceiling that prohibited thesale of any U.S. Treasury bond withany coupon greater than 41/4%.

Since 1917, observes colleagueCharley Grant, the ceiling has beenraised 107 times. Expressed as a com-pound annual rate of growth, the debtceiling has risen by 8.4%, the nomi-nal GDP by 6%. Twenty-nine moreyears on this track and the debt ceilingwould be double the size of GDP.

There is a great deal of ruin in anation, said Adam Smith to calm the

Lower the debt ceiling

Id advise you to stop shorting Amazon.


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Winter Break-GRANTS/DECEMBER 26, 2013 2SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994

debtedness and a convertible cur-rency, is the one that your professordismissed with a smile in Economics101. Grantsstands for a modern adap-tation of ancient thinking.

The creation in time of peace of adebt likely to become permanent is anevil for which there is no equivalent,said President Martin Van Buren,speaking for the ancients, in his thirdannual message to Congress in 1839.

As the sole manufacturer of dollars,whose debt is denominated in dol-lars, the U.S. government can neverbecome insolvent, i.e., unable to payits bills, write Brett W. Fawley andLuciana Juvenal, economists at theFederal Reserve Bank of St. Louis, onbehalf of the moderns. In this sense,the government is not dependent oncredit markets to remain operational.Moreover, there will always be a mar-ket for U.S. government debt at homebecause the U.S. government has theonly means of creating risk-free dollar-denominated assets. . . .

The Van Buren approach has thelonger pedigree, the better groundingin history and the surer claim to horsesense. The St. Louis approach, al-though ahistorical and actually a littlebit crazy, is the doctrine of the Ph.D.s.

The prejudice against peacetimeborrowing persisted through the1920s. It lingered into the 1930sFranklin D. Roosevelt himself aspiredto balance the budgetand made abrief return appearance after the closeof World War II. On June 3, 1946, theSenate passed by unanimous consent a

bill to reduce the federal debt limit to$275 billion from $300 billion. Wide-ly viewed in Congress as a definitestep toward the end of deficit financ-ing by the Government, said The NewYork Timesof the measure in which theHouse concurred and which the presi-dent, Harry S. Truman, signed.

The Iraq and Afghan wars have, ofcourse, been fought on the cuff. Notso the Korean War; in the early 1950s,the debt ceiling went unraised. Be-cause the [war] was mostly financedby higher taxes rather than by in-creased debt, says the Congress-ional Research Services new history of

the debt ceiling, the limit remainedat $275 billion until 1954. Not untilMarch 1962 did the debt limit againreach $300 billion, where it had origi-nally been set in 1945.

Meanwhile, the rate of inflation wascreeping higher, pressuring bond pric-

es. The Eisenhower administrationwas stymied by the aforementioned1918 law that capped long-dated Trea-sury coupons at 41/4%. The administra-tion of John F. Kennedy, however, wasnot so inhibited. Shortly after the 1961inauguration, the presidents brother,Attorney General Robert F. Kennedy,ruled that the interest-rate cap did notbar the issuance of a 4 1/4% bond pricedat a discount to par, and, therefore, at ayield higher than 41/4%.

The New York Times report of thislegal innovation is more than a little

timely amid urgings (including that byformer House Speaker Nancy Pelosi)that President Obama do an end runaround Congress and raise the debtceiling by executive order.

That was not a new finding, saidthe Timesaccount of the attorney gen-erals ruling. The Eisenhower admin-istration found the same thingthat itwas legally possible to get around theceiling. The Eisenhower administra-tion did not try this, however, becauseit didnt think it could get away withit. Interest rates were already highin 1959. They were a hot political is-sue. The Democrats were in controlof Congress. In short, the climate for

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Debt trap

30-year Treasury yield (left scale)and federal debt limit in trillions of dollars (right scale)

sources: The Bloomberg, Office of Management and Budget

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ederaldebtintrillions

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good as anothers.Constant readers know well the

flight path of dollars both west andeast across the Pacific. Buying morefrom China than China buys from theUnited States, American consumersship dollars to their Chinese ven-dors. The vendors sell the dollars tothe Peoples Bank, which exchangesthem for newly created renminbi.And what else would the PeoplesBank do with its hundreds of billionsof greenbacks except to invest them?Andseeking to suppress the valueof the renminbi to enhance Chinasexportsthe Peoples Bank doesntexchange its dollars for an alternativecurrency but rather invests them inU.S. Treasurys or federally guaran-teed mortgages. Running up its debts(and at generation-low interest rates,too), America never winces: Neverhas it hurt so little to borrow so much.As a matter of definition, the publicdebt is deferred taxes, pure and sim-ple. As a fact of political life, the em-phasis goes on the word deferredrather than on the word taxes.

Since Oct. 1, 1981, long-dated Trea-sury yields have plunged to 3% from15%, whereas the gross public debt haszoomed to $16 trillion from $1 trillion.The compound rate of growth in thedebt has outstripped the compoundrate of growth in federal receipts by afactor of two to one.

Although it took 64 years for the debtlimit to be raised to $1 trillion, Grant

observes, it took just four more years todouble: Congress voted to increase theceiling to $2.079 trillion in December1985. The bill passed the House, 271-154, and the Senate, 61-31. Containedin the bill was a mandate to balance thefederal budget by fiscal year 1991, withthe now familiar provision for automaticspending cuts across the board shoulddeficit reduction targets fail to be met.The federal budget deficit in 1991 to-taled $269.2 billion, or 4.5% of GDP.

Skipping ahead, Grant continues,George W. Bush left the presidencyin January 2009 with a debt limit of

$11.315 trillion, a 90.2% increase overthe ceiling of $5.95 trillion he inher-ited. He presided over seven sepa-rate boosts in the statutory borrowingcapacity, which the Democrats dulyprotested. During this administra-tion, Sen. Max Baucus (D., Mont.),

top Democrat on the Senate FinanceCommittee, declared in March 2006,Americas debt, that is, the total ofthe deficits, has increased by $3 tril-lion. Thats a 40% increase in the en-tire federal debt accrued by our coun-try in its entire history. This time, theSenate voted by a margin of 52-48 toraise the ceiling.

When the vote was taken onMarch 20, 2006, a young and popularDemocratic senator from Illinois vot-ed against the debt-ceiling increase(to $8.97 trillion from $8.18 trillion)

and took the opportunity to lecturethe administration on the state ofAmerican public finance. The factthat we are here today to debateraising Americas debt limit is a signof leadership failure, Sen. BarackObama complained. It is a sign thatthe U.S. government cant pay its ownbills. It is a sign that we now dependon ongoing financial assistance fromforeign countries to finance our gov-ernments reckless fiscal policies.

As the senator spoke, foreign gov-ernments and their obedient centralbanks owned at least $1.59 trillion ofU.S. government and federal agencysecurities. As of Jan. 2, the same over-seas institutions owned at least $3.23

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Treasury bill holdings as a percent of the Feds total assets

source: The Federal Reserve

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trillion of U.S. government and fed-eral agency securities. The apoliticaltruth is that the cause of this depen-dency lies in the nature of the worldsmonetary arrangements. With thereserve-currency bane, America pos-sesses the dubious gift of amassing

deficits without tears in the wordsof the late, great French economist,

Jacques Rueff.At this moment of writing,

wrote Tilden in 1935, nearly allthe small nationsand all the greatonesare solvent only by rhetoricalcourtesy, or by the growing difficul-ty, in a hysterical world, of decidingwhat constitutes bankruptcy. In2013, the split-rated United States isa solvent credit (the market says so),but a deteriorating one.

Most of the historical checks on

public borrowing have, of course,fallen away. Keyness theories havedisplaced Martin Van Burens con-victions, while the paper dollar hasshoved aside the golden one. Willingmercantilist creditors and the greatbull bond market complete the circleof seduction. The debt ceiling is oneof the few remaining inhibitions onthe running up of the federal debt.

It would do the quality of debate aworld of good if someone would moveto reduce the ceiling, not to raise it.Granted, such a demarche could proveembarrassing if the proposing politi-cian had ever taken an alternativeposition. I think its important thatthe outcomebased on the outcomeof the vote, as I mentioned, the fullfaith and credit was not in doubtthefull faith and credit of our governmentand the economy was not in doubt.So stammered the White House presssecretary, Robert Gibbs, in January2011 when he was asked to explainthe apparent inconsistency betweenthe positions taken on the debt ques-tion by the former Sen. Obama andthe current President Obama.

And what reasons might a hypothet-ical congressman from, say, the imagi-nary district of Wall Street give to sup-port a cause so apparently quixotic asa reductionjust a small, newsworthy,symbolic reductionin the statutorydebt limit? He might observe that theFed is buying $85 billion of bondsa month, or $1.02 trillion at an an-nual rate, which represents more than100% of the OMB-projected fiscal2013 budget deficit; it is a fact out of

the pages of Andrew Dickson WhitesFiat Money Inflation in France. Hecould say that, although conventionalinflation might seem a remote danger,the consequences of the worldwideexperiment in monetary force-feedingwill probably be inflationary and that,in the way of the world, they are likelyto materialize unexpectedly.

Continuing, the member from WallStreet might point out that the Fed, as

a consequence of Operation Twist,is fresh out of Treasury bills and isloaded to the gunwales with long-dated assets, including $1.35 trillionof bonds that mature in more than 10years and $867 billion of notes thatfall due in more than five years butin fewer than 11 years. Have you everheard, he would quiz his colleagues,of the Feds bills-only policy? Inthe Eisenhower era, the central bankrefrained from buying coupons lest itdistort the structure of interest rates.Now it buys coupons precisely in orderto manipulate the structure of interestrates. Anyway, in a bond bear market,the Fed would find it inconvenient tosell (and the taxpayers would find itirksome to absorb the central bankstrading losses).

For the benefit of new arrivals, thecongressman could review the futilehistory of attempts to contain the defi-cit through improved oversight (e.g.,the 1974 founding of the CongressionalBudget Office) or through force of law(e.g., the 1985 Gramm-Rudman-Hol-lings Balanced Budget Act, the 1990Budget Enforcement Act or the 2011Budget Control Act). What is oversight,or even law, when set against the com-bined power of easy money and thereserve-currency bane?

Quoting from a recent blog post ofthe former chief economist of North-ern Trust Co., Paul Kasriel, the mem-ber from Wall Street could shed somewelcome light on the pickle in whichthe contending parties find them-selves. One party wants higher taxes,the other lower spending. Each pro-

fesses to seek reduced deficits and aslower rate of rise in the public debt.But neither seems to reckon with theconsequences of the recently exactedAmerican Taxpayer Relief Act, thelaw that made permanent the Bush43-era tax cuts for all but the hated1%. If the Congressional Budget Of-fice is on the beam, the not-so-grandfiscal compromise will reduce federalincome tax revenues by $3.75 tril-

lion (82.5 million pounds of C-notes)in the 10 years to 2022, compared tothe revenues that would have beenbooked in absence of the law. Itseems an odd way to bring about theprofessed bipartisan determinationto effect a $4 trillion reduction in thedebt over the next 10 years.

Then, too, our man from WallStreetan authority on interest rates,as it happenswould not fail to re-mind his colleagues about the fatefulfinancial year of 1981. As the debt ceil-ing passed $1 trillion and bond yieldspierced 15%, an economic consultantnamed Alan Greenspan was quoted inThe New York Times on the troublingarithmetic of ultra-high interest rates.In a technical sense, the interestpayments are the most uncontrollablepart of the budget, said Greenspan.You can change the entitlements byCongressional legislation [just try ited.], but you cannot change the levelof national debt.

On an average net debt of $750.7billion in the fiscal years 1980 and1981 (i.e., debt in the hands of thepublic, excluding the portion held ingovernment accounts), the Treasurybore net interest expense of $68.8billion; the average interest rate was9.2%. Compare and contrast the pres-ent day. On an average net debt of$10.853 trillion in fiscal years 2011and 2012, the Treasury bore net inter-est expense of $224.8 billion; the av-erage interest rate was 2.1%. Had theaverage rate been 4%, the governmentwould have spent more than 90% asmuch on interest outlays than it actu-

Net interest expense in 2012 at varying average interest rates(in $ billions)

Average interest rate 2.1% 3.0% 4.0% 5.0% 6.0% 7.0% 9.2%

Net interest expense $224.8 $325.6 $434.1 $542.7 $651.2 $759.7 $998.5

Share of 2012 federal recs. 9.2% 13.3% 17.7% 22.2% 26.6% 31.0% 40.8%

sources: Office of Management and Budget, the Treasury Department


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ally did on Medicare.The congressman would close his

speech on behalf of a symbolically re-duced debt ceiling with another bor-rowing from the Kasriel post. In thepast 10 years to fiscal 2012, compoundannual growth in federal receipts

worked out to 2.8%, that in federaloutlays 5.8%. Inasmuch as the growthin receipts was much below the his-torical median (which, since 1967, hadbeen 6.75% a year), one mightjustfor arguments sakesay that thecountry had an income problem. Butthat is in the past. It will imminentlyhave a much bigger spending problemas the entitled Americans of the babyboom generation claim what is lawful-ly theirs. Too bad about the $3.75 tril-lion in receipts that wont be received.

Imagine such a fiscal impossibility,

the representative from Wall Streetsays. And imagine such a monetarytemptation: Will our money-conjur-ing central bank not find it irresistibleto bridge the gap between insuffi-cient federal receipts and extravagantfederal promises?

Get the debt under control, ourconceptual politician thunders. Getthe Fed under control and address theunderlying monetary problem. Alter-natively, he advises his legislative col-leagues, quit public life to take up acareer as a bond traderon the shortside, chiefly, of course.

A personal message forLarry Summers

(November 29, 2013) I thought Iheard a wistful tone in your voice asyou delivered your widely YouTubedremarks at the IMF Annual ResearchConference on Nov. 8. In particular,I detected a note of regret when youbegan a sentence with the phrase,Were I a member of the official sec-tor. . . . Believe me, I know what itslike to be excluded from the officialsector. Out of the blue in 2011, RonPaul announced that I would be hisFed chairman if he won the presi-dency. Well, he didnt win, and Imstill editing Grants. So here we aretogether, disappointed non-centralbankers. I expect you feel the samekinship toward me as I do toward you.

Anyway, Im presuming on our

shared experience to write you aboutyour IMF speech. Blood brother toblood brother, it was enough to curlthe hair of a normal non-economist.How to restore Americas once andfuture economic vitality? Why, yousaidor allowed the audience to infer

you meantthat the government mustborrow more, spend more, print more,because even zero is too high an inter-est rate for the world in which we live,a world of secular stagnation, youcalled it. And to think, as between youand Janet Yellen, you were supposed tobe the reasonable one.

I did love the part of your speechwhere you compared a financial crisisto a power failure. The lights go off,the grid goes dark and the economystops cold. In response to which, asyou conjectured, There would be

a set of economists who would sitaround explaining that electricity wasonly 4% of the economy and so if youlost 80% of electricity you couldntpossibly have lost more than 3% of theeconomy! And there would be peoplein Minnesota and Chicago writing thatpaper! It was good to hear the know-ing laughter you raised in that audi-ence of economists. Wisdom beginswith self-awareness.

Allow me to observe, my fellownon-Fed chairman, that you seemnot to admit the possibility that whatails American enterprise is the insti-tution that neither one of us is run-ning. I am going to say that ZIRP,QE and Twist have so distorted cur-

rent and prospective rates of returnthat entrepreneurs are stymied rath-er than stimulated. Biotech stocksare going up a percent a day. Creditspreads have collapsed. Pieces ofmiddlebrow contemporary art fetch$100 million at Christies.

You seem to welcome these orbitingasset values. As you put it to the audi-ence, It has been demonstrated, lessconclusively but presumptively, thatwhen short-term interest rates are zero,monetary policy can affect a constella-tion of other asset prices in ways thatsupport demand. . . . But, if you dontmind my asking, what kind of demandand for how long?

I dont have to tell you that realAmerican median income was low-er last year than it was in 1989, thatstudent debt tops $1 trillion (more

than auto loans, credit-card loans andhome-equity balances combined) andthat companies that cater to the mid-dle class are treading water, if not slip-ping under it. Target Corp., Wal-Martand Gap are reporting essentially flatsame-store sales.

Casual dining is an especially in-structive disaster area: From 2006through 2012, same-store sales at RedLobster, LongHorn Steakhouse andthe Olive Garden fell a cumulative13.8%, 8.9% and 6.2%, respectively, ac-cording to a J.P. Morgan research notedated Oct. 8. Because, over the samespan, inflation increased by 16.7%, realsame-store sales at the aforementionedchains dropped by a quarter. Darden

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Too bad about the customers

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Isnt that charming?

Well-marked book

(December 14, 2012) iStar Finan-

cial (SFI on the New York StockExchange) lives and breathes. Thisseemingly minor claim to fame isno small accolade for a real estatefinance business that borrowed tobuy at the top of the market in 2007.But, like Marleys ghost, iStar reallydoes exist, and Grantsis bullish onit.

Let us only say that there arewarts. The income statement is afright, the directors vote no divi-dend and management wont cometo the phone (at least, not to talk to

us). The $6 billion balance sheet,though less encumbered than itused to be, is still leveraged, andnonperforming loans are still a dragon earnings. The CEO, Jay Sugar-man, 50, earned $25.9 million in2011, a figure that puts him in therunning for a new title that thestaff of Grantshas teased from theBloomberg data base. This is thetitle: recipient of the highest totalcompensation as a percentage of themarket cap of the company that theCEO leads.

iStar, which is organized as a realestate investment trust, opened forbusiness in 1993, went public in1998 andskipping ahead a fulldecadepurchased the commercialand construction loan portfolio ofthe Fremont, Calif., General Bankin July 2007 at the opening gun ofthe great debt contraction. Overthe next 16 months, the SFI shareprice, too, did some contracting, to$1 from $45. Then, on March 16,2009, iStar negotiated a $1 billionsecured term loan from its bankers.The clouds parted, the sun shoneand Sugarman exhaled.

Its funding base secured, re-lates colleague David Peligal, iS-tar showed its mettle by buyingback boatloads of stock at hugediscounts to book and hundreds ofmillions of dollars of debt at mean-ingful discounts to par. Before thecrisis broke, there were 131 mil-lion iStar shares outstanding. To-day, there are 83.6 million, at $7.88each. After shooting itself in the

guesswork put the figure in the teens.And do you know how the administra-tions of Woodrow Wilson and WarrenG. Harding met this calamity? Theybalanced the budget and, through theFederal Reserve, raisednot low-eredinterest rates. They made no

attempt to prop up wages or prices butlet them find their own level (the Fedwas, in fact, promoting deflation). Afterwhich, a vibrant and job-filled recov-ery began and the 1920s proverbiallyroared. Say, I happen to have writtena short book on the 1920-21 depres-sion that Simon & Schuster is going topublish next year. The working title is,Triumph of the Invisible Hand. MayI count on you for a blurb?

We can all agree that the Americaneconomy is in a kind of trance. You pinthe blamethe immediate blameon

the government, saying, or again imply-ing, that it hasnt done nearly enough.Imagine, you said at the IMF, a sit-uation where natural and equilibriuminterest rates have fallen significantlybelow zero. In such a situation, youbroadly hint, QE forever would be justwhat the doctor ordered.

Maybe youve seen John B. Taylorscritique of your speech. In rebuttal,that eminent Stanford economist saystheres no need to imagine the causeof our long-lingering non-recovery.The Affordable Care Act, Dodd-Frankand the 2013 payroll-tax hike are star-ing us right in the face. I happen toagree with Taylor. But Im beginningto wonder if the supposed science ofmacroeconomics isnt just politicsdressed up in algebra.

One more thing: On camera withBloomberg TV on Nov. 21, youseemed awfully sure of yourself thathistory would vindicate todays radicalmonetary measures. On the questionof whether the Fed stepping up andproviding liquidity when no one elsewould was the right thing to do, I thinkhistorians are going to judge that about98 to 2, were your exact words.

Concerning what future historiansmight or might not say, you should re-ally treat yourself to the YouTube clipof former President George W. Bushbantering with Jay Leno. Bush is say-ing that hes been reading some re-cently published books about GeorgeWashington. If theyre still writingbiographies of the first guy, drawls W.in his funny-humble way, the 43rdguydoesnt have to worry about it.

Restaurants (DRI on the New YorkStock Exchange), which owns thoseoutlets and derives 88% of its revenuefrom them, earned 11.4% on assets infiscal 2006 but only 6.4% on assets infiscal 2013, ended May.

And heres the kicker: The stock

market loves Darden. It loves it forits financial engineering. It wasnt thefood that generated growth in earningsper share of 5.4% a year between 2006and 2013. The secret to this feat wasgrowth in debt; net borrowings wereup by 22.2% a year over the same span.Now the shares change hands at 18.7times earnings and 9.6 times enter-prise value (market cap plus net debt)to EBITDA (earnings before interest,taxes, depreciation and amortization).Its almost as rich a valuation as theones that made the peak of the 2007

private-equity boom.My friend John Hamburger, presi-

dent of Restaurant Finance Monitor,sponsored his annual restaurant financeconference in Las Vegas this month.And do you know what he reported tohis subscribers about that event? Hetold them that among the attendeeswere the largest number of restaurantlenders, investors and restaurant op-erators on hand in our 24-year history.And he added, While were more thanhappy to take credit for superior orga-nizing skills, a big shout-out goes tothe Bernanke-Yellen credit palooza. .. . It cant be a good sign that work-ing Americans can hardly afford to eatat the restaurants on which the bankersand promoters continue to extract feesand to heap leverage.

I think I can guess what youre go-ing to say, because you said it at theIMF meeting. Youre going to say thatBen Bernankes Stakhanovite feats ofmoney conjuring very likely saved theworld from having to reprise the years1929-33. You cant prove it, and I cantdisprove it. But why this harking to theGreat Depression and only the GreatDepression? Youd think it was theonly cyclical event in American history.

I myself have been thinking aboutthe depression of 1920-21. Measuredfrom peak to trough, this bump in theroad featured drops of 31.6% in indus-trial production, 46.6% in stock pricesand 40.8% in wholesale prices. The col-lapse in wholesale prices was reckonedthe most violent in American annals upuntil that time. No reliable data existon unemployment, but contemporary


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foot with the Fremont purchase,iStar smartly managed its liabilitiesduring the crisis. There arent toomany financials, especially credit-focused ones, that had both thewill and the way to shrink theirshare counts. Except for manage-

ments coolness under fireto besure, fire it had partly trained on it-selfthe iStar book value per sharewould certainly be lower than the$10.23 one can simplistically cal-culate today: $1.4 billion of bookequity minus $545 million for thepreferreds divided by 83.6 millionof outstanding common shares.

Lending is iStars main operatingbusiness. Real estate developers areits principal customers, and they bor-row from $20 million to $150 millionfor periods of three to 10 years. Whole

loans, loan participations and debt se-curities stock the iStar portfolio.

Sometimes the borrowers bite offmore than they can service or repay,which opens the door to a secondbusiness line. iStar acquires prop-erties, or shells of half-completedproperties, through foreclosure,deed in lieu of foreclosure, or insatisfaction of nonperforming loans.These buildings, and this land, aremainly what make us bullish.

A third line of business is thenet-lease assets divisionleasing afinished property to a single credit-worthy corporate tenant. There aremiscellaneous investments besides,

including a 24.2% stake in LNRProperty, a mortgage special servicer.

Chief sources of revenue for iS-tar are interest income and leaseincome, but neither is adequate todeliver a net profit. Losses beforeearnings from equity-method in-vestments and other items totaled$288.4 million in the first ninemonths of 2012, better than the$1.34 billion recognized in 2009, buta loss nonetheless. Apple, Peligalremarks, the company is not.

It is not a beat-and-raisestory, Peligal continues, nor a

my-estimates-are-higher-than-the-Streets story. Its not even aI-think-theyre-going-to-make-a-lot-of-money-on-a-GAAP-income-basis kind of story. Theyre goingto lose money over the next fewquarters, and it wouldnt be sur-prising if book value fell a little bitduring that time.

iStar is rather the story of assetvalues still hidden butperhapswith an assist from Chairman BenBernankeultimately to be realizedon a $900 million land portfolio thatis going to be sold to home build-ers over the next 12 to 36 months,and on a $400 million condominiumportfolio that is in the process ofbeing sold, unit by deluxe unit, towealthy home buyers. The valueproposition we judge to be compel-ling, but instant gratification playsno part in it.

Landthe companys high-quali-ty acres destined for master-plannedcommunities or for waterfront de-velopmentwas a topic on thethird-quarter conference call. Themanaged land portfolio, Sugarmantold dialers-in, . . .can be brokendown a few different ways, but onesimple way is to group them accord-ing to when they will begin produc-tion. Our current portfolio has 10%of assets by book value already inproduction, and we anticipate hav-ing approximately 60% by book val-ue to be in production by the end of2014. The remainder are expected

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price

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10/27


to begin production between 2015and 2017. This portfolio should bea strong contributor to future earn-ings, though not until a majority ofthe projects are in full selling modeand will remain both cash flow andearnings negative until then.

The companys condominiumexposure consists of $264 millionin performing loans, $65 millionin nonperforming loans andthestuff with the upside potential, we

judge$389 mill ion in other realestate owned. The iStar OREOportfolio features such sanctuariesfor the one-tenth of 1% of Americanearners as 10 Rittenhouse Squarein Philadelphia (an unfinished,6,900-square-foot space will costyou $7 million, not that you shouldeven blink) and Ocean House in

South Beach in Miami, Fla. Bothprojects are said to be more than70% sold. Two years ago, relatesPeligal, there was a lot of doubtabout iStars condo portfolio. To-day, there is not.

The process by which a lenderby trade becomes an owner and de-veloper begins with someones mis-calculation. Lets say, says Peli-gal, iStar lent to a condominiumdeveloper, the developer couldntpay and iStar repossessed the collat-eral. The project is stalled, so iStarmust complete it. The lobby needswork, the fixtures are uninstalled,whatever. Money goes out of iStarsdoor to salvageand to improve andenhancethe value of the project.The expenses go on and onforsecurity guards, maintenance, utili-ties. As long as these outlays con-tinue, the condo will remain an eye-sore on iStars income statement.But its not a terrible assumption tomake that the dollars theyre invest-ing today are going to allow them tosell the building for a 30% gain com-pared to where it is marked on thebalance sheet.

But this assumption is one that aninvestor will have to make him- orherself. Goldman Sachs may markits assets to market, but iStar doessomething else. It estimates what anasset might be worth in the future,but discounts that value by what theasset might fetch today. Fair valueaccountingthe kind that iStar, afinance company, employsdefersthe recognition of any accretion in

value of repossessed collateral un-til the moment of sale or leasing.The bottom line, notes Peligal,is that it takes a very long time forthese assets to generate what lookslike GAAP earnings. But we couldpotentially see $100 million to $150

million in gains thrown off from thestable of repossessed condos in thenext 18 months.

Ori Uziel, a big iStar ownerandanda paid-up subscriber toGrants, tells Peligal that what theiStar doubters miss is the quality ofthe iStar assets. Most people dontknow the tracts of land were talk-ing about, Uziel says. If you doknow what tracts of land were talk-ing about, you should be encour-aged, but its a long-tailed process.. . . For an investor to invest here,

you have to realize that book valueis worth more than what is stated inthe 10-Q. This is because the credittenant lease assets are worth morethan book, the condos are worthmore than book, their stake in LNR

is worth more than book, etc. Thereis probably not much loss contenton the loans, although some peoplepoint to mezzanine loans in Europeas potentially a problem. But its notvery much. What youre left with isa big bet on residential land and the

potential to restart the lending busi-ness. Almost all the land is single-family residential and its marked atabout, according to my calculations,40 to 45 cents on the dollar vs. peakprices. Some of it is less than that,some of it is more than that. They

just sold a piece of property in Hol-lywood, Calif., to Kilroy Realty forbasically the peak market price. iS-tar actually had it on its books forthat price and it was the piece ofland I was most worried about. Thisis because it was sold for $15 mil-

lion in 2003 and then $66 millionin 2006. iStar had it on its books for$64.5 million, and they just sold itfor $65 million. Those are the num-bers. The market is marking down awell-marked book.

10 Rittenhouse Square, Philadelphiaan iStar trophy


11/27


12/27


If you think about the numbers,theres potentially $5 a share to $10a share of upside for the land port-folio, and probably only a few bucksof downside.

Break ball in billiards

(April 19, 2013) In the game of eightball, the first shot is the break shot, inwhich the lady or gent with the cuestick scatters 15 balls all over the feltedtable. In order to do this, advises anonline authority on the physics of bil-liards, you must hit the cue ball witha certain force a certain distance awayfrom the rack and at a certain angle.

Two weeks ago, Haruhiko Kuro-da, newly installed governor of the

Bank of Japan, set markets in motionwith a powerfully struck break shot.Where the caroming monetary, inter-est-rate and volatility balls will cometo rest is the subject at hand. Theanswer in preview: They will cometo rest in places the central bankershavent thought of.

Markets were prepared to hear abouta ramping up of Japanese QE, but thenew governor astounded them. Hepromised to double the size of the Japa-nese monetary base by the end of 2014,and to buy not only JGBs but also eq-uity ETFs and real estate investmenttruststo buy what, on the scale ofAmericas GDP, would amount to $190billions worth of assets each month,compared to the mere $85 billion permonth that the Fed is putting away.With all of this, Kuroda redefined theterm radical ease. Compared to theBank of Japan, the Federal Reservenow seems just moderately wild-haired.The BoJ has succeeded in out-Bernan-ke-ing even the chairman of the Fed.

Since Kuroda hefted his cue stick,bond yields have declined in the West,though they have risen in Japan. Theyen has weakened and the Nikkei haslifted. These, perhaps with the ex-ception of the action in JGBs (the 10-year rate has vaulted to 0.581% from0.441%), are the consequences thatKuroda intended. Still to come are theconsequences he didnt intend.

Many are the possibilities un-der the always interesting headingof Things the Authorities DidntThink of Before They Ran the Press-es and Overrode the Price Mecha-

nism. Already, the Bank of Japan hasmade its mark on bond yields. Pres-ently, it may leave its calling card inChina, where credit formation wasalready fast and furious before theyen exchange rate dipped, and in thevolatility markets. But the nature of

clacking and clicking billiard balls isthat they go where they will. Kuroda-san has launched the world on a newfinancial adventure.

On one consequence, we canbank, however. By instigating an-other lurch higher in bond prices,Kuroda will, by that increment, de-value credit analysis. And by devalu-ing credit analysis, he will speed theday of the next crisis of lending andborrowing. By legitimizing a new,even more radical strain of QE, hewill embolden othersthe incoming

governor of the Bank of England,Mark Carney, seems a likely candi-dateto experiment with greaterfeats of money printing. Revolu-tions devour their children, evenrevolutions undertaken by the mild-mannered scholars of the global cen-tral-banking community.

Surmising that yield-starved Japa-nese will snap up fixed-income secu-rities denominated in non-yen curren-cies, speculators have taken anticipatoryaction. They have pushed zloty-de-nominated 10-year Polish governmentbonds down to 3.52%, peso-denominat-ed Mexican government 10-year yieldsdown to 4.72%, lei-denominated Ro-manian government seven-year yields

down to 5.05%, and high-grade Euro-pean corporate yields down to 2.31%.They have created such an alignmentof the fixed-income stars that Ba2/BB-rated CNH Global N.V., the product ofa 1999 merger between Case Corp. andNew Holland N.V., was able last week

to raise $600 million for five years at ayield of just 35/8%.

On April 12, European Union financeministers gave Portugal and Irelandseven-year extensions in which to repaytheir bailout loans. Preceding this act ofpurposeful charity, the split-rated Euro-pean Financial Stability Facility paid ayield of just 0.956% to borrow 8 billionfor five years. So great was the unslakeddemand that the supra-national bail-out fund could have raised 14 billionWhat once looked rich is no longer richany more, the weekend Financial Times

quoted Steven Major, head of fixed-in-come research at HSBC, as saying. Saygoodbye to the yield floor.

And goodbye, tooat least in a tem-porary, cyclical wayto old-fashionedcredit work. Uniformly tiny interestrates dull the effort to distinguish goodinvestments from bad. At next-to-noth-ing percent, one credit looks much likeanother. The blurring of gradationsin credit quality, owing to the undif-ferentiated flight into fixed-incomesecurities, will do nothing to enhancethe reasoned allocation of capital. Ona positive notewe speak now as jour-nalistsunreasoned capital allocationnever fails to make for good copy.

According toMoney Fund Intelligence,

4/12/131/121/111/101/091/08

Example of an intended outcome

Nikkei (left scale) vs. yen (right scale)


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U.S. prime money-market mutual fundsraised their exposure to euro zone issu-ers to 20% of assets in February from14% of assets in August. Assume thatthe relevant funds know their credits.But with yields on euro zone money-market instruments pinned at only a

few basis points above zero, the differ-ence between money-good and money-not-so-good is of little or no practicalconsequence. For a return of virtuallynothing, what avails due diligence?

In the sovereign debt market, too,fund flows quash analysis. Last week,the European Commission issued alengthy indictment of French publicfinance and French industrial competi-tiveness. Government debt is too high,the labor market is too rigid and taxesare too high, said the bill of particulars.French public-sector indebtedness rep-

resents a vulnerability, not only for thecountry itself, but also for the euro areaas a whole, the commissioners added.Yet, in the face of these risks, the yieldon 10-year French sovereign debt hasdwindled to 1.82%, about as low as ithas ever been. A double-A-plus credit,France is under surveillance for down-grade by Moodys, Standard & Poorsand Fitch. It is not, however, as yet un-der surveillance by Mr. Market.

The clustering of sovereign bondyields in the neighborhood of nothingafter tax and after inflation figured insome weekend brainstorming about themobilization of European gold. Wouldit not be better to issue bonds againstthis national treasure rather than to sellit outright? You may recall that Franceissued bonds in 1973 secured by the na-tional gold stock. Dubbed Giscards,after the then-French president ValeryGiscard dEstaing, they featured inTom Wolfes novel, Bonfire of theVanities. Yet, as the Lex column ofthe Financial Timesnoted the other day,with interest rates pressed to the floor,the yields on gold-backed bonds mightnot be meaningfully lower than thoseattached to plain-vanilla securities de-nominated in paper currencies.

Even fewer basis points would remainfor private consumption if the EuropeanCommissions mooted financial transac-tions tax were enacted, as it might verywell be, effective Sept. 1. The taxtheFTTwould be levied at each stage ofa financial transaction, according to FTcolumnist John Dizard: So if a U.S.bank sells a French company bond to aU.K. insurer, and each, as is customary,

uses a bond broker, the tax on the onetransaction adds up to 60 basis points.At current rates of decline in Continen-tal yields, there will hardly be 60 basispoints left for the EU to seize.

Kuroda-sans break ball may ricochetaround the monetary billiards table for

many a moon. Chinese lending and bor-rowing were on a tear before the Japanesedemarche. In the first quarter, the broad-est measure of Chinese lending climbedby 6.16 trillion renminbi, or $1 trillion, theequivalent of 12% of 2012 GDP. Howwill Chinese finance officials answerthe competitive threat presented by thesuddenly cheaper yen and by the pro-spectively reflating Japanese economy?We will venture that China will respondby keeping up the torrid gait of creditgrowth. If the first-quarter rate persistedfor the rest of the year, growth in cred-

ittotal social financingin China in2013 would amount to 47% of output,

the most on record since at least 2002 andsix percentage points ahead even of theemergency rate of infusion in 2009.

Prolonged periods of extreme mon-etary ease are good for journalists,governments and speculators, but notfor savers and producers. We take this

truth to be self-evident (although theIMF has lent its authority to the propo-sition in a new Global Financial Stabil-ity Report), and we accept as given thatthe central banks have no informedidea of what the money they conjurewill finally do or to whom it will ulti-mately do it.

It isnt only the central bankers whocant predict the consequences of un-precedented actions. Most mortalscant. But we will take a guess. The

Japanese initiative of April 4 will pro-voke other central banks to act, per-

haps to cheapen their own currenciesor to nip a nascent panicMondays,

The history of modern financein Grants cartoons

See The World According to Grants,

a pictorial and musical journey. Just log on tograntspub.com for this special holiday treat.

All this and more!Go to www.grantspub.com

And as long as youre visiting, check 30 years of archivedGrants articles, searchable by date or keyword.

OUT ARCHIVES OUR IDEAS VIDEOS RESOURCES CONF

This

A GRANTS retrospective

is the

yearthat was


14/27


for examplein the bud. In so acting,the mandarins will scatter another rackof monetary billiard balls. Ultimately,the central banks themselves will drivethinking investors out of bonds andinto assets the value of which does notdepend on the stable value of money.

Uncommonly preferred

(September 21, 2012) If marketswere efficient, inquires colleague Da-vid Peligal, why would Hyundai Mo-tors second preferred securities (005387KS on Bloomberg) trade at 32% ofthe price of Hyundais common stock(005380 KS on Bloomberg) when, forall intents and purposes, the two securi-

ties are economically identical? Therehappens to be no good reason. Now un-folding is a bullish expos on a distantmarket inefficiency.

Mind you, South Korea does not ex-actly roll out the welcome mat for foreignvalue seekers. Professionals will find noinsuperable barrier to buying Koreanpreferreds that trade at anomalous dis-counts to the corresponding common.And neither, for that matter, will thepersistent retail investor. But to com-plete the required documentation willrequire some intercontinental e-mailing.You cant just call Charles Schwab.

The analysis now unfolding dealsmainly, though not exclusively, withthe eccentric market in Korean pre-

ferreds. Other topics include the na-ture of value, corporate governance,cultural differences in this supposedage of financial globalization and theimportance (or non-importance) ofcatalysts, market liquidity and vot-ing rights in the delivery of superiorinvestment returns. Buy the persis-tently discounted, evidently catalyst-free Korean preferreds, even withouthedging through a sale of the underly-ing common, is our conclusion.

To begin at the beginning, 148 issuesof Korean preferred are listed with a col-lective market cap of some $10 billion.While a portion of these issues are tiny

and illiquid, others trade $10 million ormore a day. None is listed in the MSCIIndex, which means that, for the index-hugging, Korean-focused mutual funds,they might as well not exist.

In Korea, Peligal explains, theterm preferred share will appear assomething of a misnomer to an investorin U.S. equities. While giving the holderfull economic participation rights in theearnings stream of a business and a pri-ority dividend, Korean preferred shareslack voting rights. One may thereforethink of them as non-voting commonshares. Theres no question that votingrights have value, but how much of it?In Korea, the value of a vote is quite low.Investors willing to pay three times theprice for a vote are paying a hefty pricefor a quiet vote in a country with chae-bols, concentrated family ownership anda distinct lack of corporate activism.

Then, too, you cant buy and sell thepreferreds as easily as you can the com-mon. Besides, Korean common shareshave delivered better returns than thecorresponding preferreds over the pastfive to seven years. Furthermore, Kore-an managements (in general) seem in nohurry to help in closing a valuation gapthat, according to a six-foot pile of CFAmanuals, shouldnt even exist. Maybethe valuation anomaly wouldnt persistif more foreigners could read prospec-tuses written in Korean, but few can.

But maybe, Peligal proceeds, thesheer size of the discounts is reasonenough to take the plunge. Lets go backto the Hyundai Motor example. That

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second preferred issue (the automakerhas three) is trading at 79,700 won andyields 2.3%. Hyundai common is tradingat 248,500 won and yields 0.7%. Ergo, a68% discount, about as steep a discountas any in the past 10 years. Historically,Korean preferreds have traded at an av-

erage discount of 54%; its 69% today.In fact, the preferreds, on average, are asdeeply discounted as they were duringthe 1997 Asian financial crisis. Remem-ber, if a discount narrows to 60% from70%, you dont make a 10% return. Youmake a 33% return.

Arbitrageurs might choose to golong the preferreds and short the un-derlying common. Sticking withHyundai, Peligal notes, such a strat-egy would deliver an after-tax carryof 1.4%, although there are good rea-sons to buy the preferreds outright. So

doing, one would not necessarily betrusting in the market to close an un-reasonably (say we) wide discount, butrather in the tendency for good thingsto happen to cheap stocks.

Korean preferreds, an anonymi-ty-seeking, buy-side analyst informsPeligal, are a bizarre exception tothe phenomena we see with investorsoverpaying for yield without regard forNAV. It would seem prudent that Ko-rean investors arent reaching for yield.However, in this instance, its actu-ally incredibly imprudent, because aninvestor could basically buy the sameeconomic claim at a much cheaperprice. This behavior is so inconsistentwith what we, as a fund, are seeing else-where in the world.

Unusual, too, are Korean preferredvaluations in comparison with thoseof similar securities in other countries.Whether set against Indian differen-tial voting-rights shares, Italian savingsshares, Swiss participation certificatesor German preferred shares, Korean dis-counts vis--vis the relevant commonshares are in a league of their own.

Theres no guarantee, of course, thatcheap securities cant become cheap-er (it happens all the time in ValueLand). But, as discounts widen, otherthings being the same, yields increase.Thus, Peligal observes, if the Hyun-dai second preferred securities wereto trade at a 90% discount, their yieldwould jump to roughly 8%. By com-parison, short-dated Hyundai corporatedebtthe 4s of 2017, for instancearepriced to yield less than 3%. The Kore-an governments two-year note fetches

2.87%, its 10-year note 3.08%.At a 60% discount, Peligals afore-

quoted informant says, you might havesaid that it would never go to a 70%discount. But when we buy somethingcheap enough, our experience has beenthat we are more likely to be positively

surprised than negatively surprised.Armor Capital, a New York-head-

quartered hedge fund with $382 mil-lion under management, has had itsshare of pleasant preferred-inducedsurprises. Boris Zhilin, principal (and,let the record show, a paid-up subscrib-er to Grants), says that two such issueshave been in the funds portfolio sincethe mid-2000s. They are AmorepacificCorp. (090435 KS on Bloomberg) andLG Household and Healthcare (051905KS on Bloomberg), the former tradingat six times, the latter nine times, Ar-

mors estimate of 2013 earnings, and atdiscounts to the underlying common of72% and 69%, respectively.

One has to be happy with a returnthat comes from dividends and rein-vestment decisions by managementand not from people waking up andrealizing, My God, these discountsare crazy, Zhilin says. If peopledo come to this realization, great. Butone shouldnt invest expecting thatto happen. The other big takeawayis that high-quality businesses, theones that tend to become intrinsicallymore valuable over time, are the bestinvestments when it comes to deeplydiscounted preferred shares. Thesebusinesses turn time, as an investmentparameter, from a potential detractorto a very helpful friend and ally. Thisallows one to earn attractive absolutereturns, even in periods like the pastfive to seven years, when the mul-tiples of many preferred shares con-tracted and the discount to the com-mon shares widened.

Kyung Suk Choi is the man at Dae-woo Securities who sets up brokerageaccounts for foreign nationals. To fillout the necessary forms and secure aninvestment ID from the Korean finan-cial authorities, e-mail him at [email protected]. Or, if you can come toterms with the name, Boom Securities,affiliated with Monex Group, executesorders for American investors in Asianmarkets: https://baby.boom.com.hk/en/is the Web address.

Yellen on deck

(November 16, 2012) By reelectingPresident Barack Obama, the Ameri-can people have very likely securedthe reappointment of Federal Re-

serve Chairman Ben S. Bernanke.Or, if not Bernanke himself, then anintellectual doppelgnger. The Ph.D.standard won in a walk two Tuesdaysago, though it wasnt even on the bal-lot.

This back-door affirmation of pro-fessorial monetary management willeventually go down as the electionsmost important outcome. We sayeventually. Come the next col-lapsed asset bubble or the next roar-ing inflation, many will recall thatthey actually never did understand

what the various distinguished formerIvy League economics departmentheads were talking about. Then,again, as will come to light, neitherdid the supposed experts.

Either the lessons of monetary his-tory are moot or our mandarins arewrong. We write, in the first place,to support the latter hypothesis, and,second, to speculate anew on theconsequences of QE, ZIRP, Opera-tion Twist and modern central bankcommunications policy. Look-ing back at todays ultra-low interestrates, investors will think of the fableof the boiled frog and belatedly real-ize that they were the duped amphib-ians.

The lessons of monetary historyis an admittedly vague and conten-tious term. But its easy enough toshow that paper currencies tend tolose their value, and that govern-ments that borrow in paper currenciestend to overborrow. It is writ.

Unwritten is the timing of the de-nouement of the printing of boodlesof money, though the sequence ofsin and suffering makes a comeup-pance of some kind inevitable. Sincomes first, always. If we sufferedbefore we sinned, we wouldnt sin.If the pleasure and pain of monetaryoverstimulation were coterminous,there would be no inflation, no fast-climbing public debt and no explod-ing asset bubbles. The cost of over-cranking the presses would be justas obvious, and just as immediate, asthe thrill induced by the monetarypick-me-up. As it is, the pleasure


16/27


is immediate, the pain prospective.And ifas in the case of ChairmanBernankes central bankthe ma-terialization of new money perks upthe prices of stocks, bonds and realestate, there is a general submissionto the wisdom of the professors.

Dont worry, they say. There isplenty of slack in the product andlabor markets. There is the needfor continued de-leveraging. Thereis a shortfall in aggregate demand.There has been a collapse in the rateof monetary turnover, or velocity,as well as a breakdown in the link-age between central bank credit andcommercial bank credit. There is, inconsequence, no realistic chance thattodays unconventional policy will bethe source of tomorrows inflation.Anyway, inflationary expectationsare most satisfactorily anchored. Andwho anchored them? Why, the deepthinkers at the Fed assert, they them-selves did.

If Chairman Ben S. Bernanke is thedeep thinker-in-chief, the Feds vicechairman, Janet Yellen, is his princi-pal doppelgnger. She is as depend-able a voice as there is on the Fed forradical experimentationon Tues-day, she urged that the FOMC holdthe funds rate at zero until the unem-ployment rate and the inflation ratemeet with the mandarins approval.Gold bulls should light a candle onher birthday, August 13, and pray thatshe rises to lead the Fed when itstime for the chairman to go. If Ber-

nanke is good for, let us say, $3,000an ounce in the bullion price, Yellenis a force for $4,000. If, at the closeof Bernankes term in January 2014,he chooses to step down, or is chosento step down, she would be a strongcontender to succeed him.

The holder of a Ph.D. in econom-ics from Yale University, Yellen hasevery necessary credential to man-age the pure paper monetary system.Chairman of the Council of EconomicAdvisers under Bill Clinton, a one-

time Fed governor, a one-time presi-dent of the Federal Reserve Bank ofSan Francisco and a former professorat the Haas School of Business at theUniversity of California at Berkeley,Yellen has taught, as well, at HarvardUniversity and the London School of

Economics. And while it is true thatshe was presented with the AdamSmith Award by the National Associa-tion for Business Economics, that hon-or should not be counted against her inthe running to manage the institutionthat strives to manage the economy bymanipulating the value of the curren-cy. She has no slavish attachment tothe price mechanism. On the contrary,shes foursquare for mandarin rule.

Neither will it hurt Yellens chan-ces when the time comes to pick anew chairman that the vice chairman

is a company woman. I will be thefirst to say that it is always difficultto get monetary policy just right,she acknowledged at the Common-wealth Club of California in June2009, two years after the start of thefinancial panic that our central bankso signally failed to anticipate. Butthe Feds analytical prowess is top-notch and our forecasting record issecond to none.

Which is not to say, however, thatthis possible nominee to lead theFOMC has no mind of her own. Ina 2003 talk at the Federal Reserve

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3/113/013/913/813/713/611.2

1.4

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2.4xPushing on a string

U.S. monetary base in billions of dollars (left scale)vs. velocity of M-2 (right scale)

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Bank of St. Louis, former Fed gover-nor Laurence H. Meyer described atelltale exchange on how to define thefraught phrase, price stability. Thescene was Meyers first FOMC meet-ing, in July 1996, and then-governor

Janet Yellen was making the case for

inflation targeting; she said she wouldaim for 2%. Chairman Greenspan re-plied that the Federal Reserve had amandate to foster stable prices, notrising ones. Whereupon Yellen re-plied that the Fed also had a mandateto promote full employment. To hearher tell it, some increment of curren-cy depreciation was a necessary lubri-cant for economic growth.

Janet then seized the initiative,Meyer related, asking the chairmanto indicate how he would define pricestability. Greenspan tried to get away

with his vague definition. Price sta-bility is the state in which expectedchanges in the general price leveldo not effectively alter business orhousehold decisions. But Yellenpressed him and asked if he couldput a number on that. Remarkably,the chairman agreed, and said he pre-ferred zero inflation, correctly mea-sured. Janet asked him if he couldsettle for 2% incorrectly measured.

It was a rare flash of recorded witfor the vice chairman, but Greenspanhad the better point. Measurementof inflation is inherently subjective.But even Greenspans definition wastoo narrow. Changes in the measuredprice level these days are admittedly

minor. They do not effectively al-ter business or household decisions.But zero-percent interest rates areanother matter. They have scram-bled investment decision-making.They have changed the way firmsand households think about risk, andthey have warped the structure ofthe economy itself.

Open before us is an essay in theJuly-September issue of the Englishjournal, World Economics, entitled,Too Loose for Comfort. Comparereal interest rates with real incomegrowth in the G-7 countries from 1950and 2009, and you make an interest-

ing discovery, write the authors, JohnC. Michaelson and Sbastien E.J.Walker. You find that falling interestrates are only so effective in nurturinggrowth; beyond a certain point, theyseem to hinder it. Not that this obser-vation proves anything, they hasten toadd: maybe low growth causes lowreal interest rates, and not the otherway around. However, they go on,we believe that there is a reasonableargument to be made to support thehypothesis that low (indeed, nega-tive) real interest rates are impedingeconomic growth at present, at leastin the U.S. and in the U.K. (euro-areacountries currently face problems of arather different nature).

ZIRP and QE amount to centralbank-led attacks on saving and sav-ers, Michaelson and Walker contin-ue. The famine in interest incomehas ground down households andthe beneficiaries of trusts, who haveless income to spend; retirement ac-counts, which need replenishing tocompensate for lower investment in-come; pension plans, which have toseek additional funding from theirsponsors or from taxpayers; endow-ments, which have fewer resourcesavailable to support their missions;foundations, which have less funds togive; and companies with cash. Thesestresses also undermine the resto-ration of confidence, which is a keyingredient for recovery. Moreover,high earners in the financial sector,which benefits from an implicit sub-

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2012E20072002199719921987

Low rates, slow growth

Japan economic growth vs. 10-year bond yield

sources: The Bloomberg, IMF

10-yearyield re

algrowth

10-year Japanese government bond yield

real GDP growth

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restore the governments finances hasalmost exhausted its own $15 billionborrowing authority. If there were atournament to decide the most mis-erably managed government in thecountry, Puerto Rico would enter asthe top seed.

And what makes the Puerto Ricanfinancial hole so much deeper anddarker, say, than the ones the Land ofLincoln or the Empire State havedug for themselves? Pension malprac-tice could alone explain the disparity.Puerto Ricos main pension plan,the Employees Retirement Service(ERS), which serves about 250,000past and present workers, showeda funding ratio of just 6% as of June30, 2011, relates colleague CharleyGrant. What is a funding ratio? Di-vide the value of a plans assets by the

present value of its obligations. To puta 6% ratio in context, the five Illinoispension plans, deservedly the subjectsof scorn and handwringing, show afunded ratio of about 40%.

Its true that the Illinois pensionplans assume a quite generous 8% dis-count rate, Grant continues, and thefunded ratio would be significantlylower if the Springfield actuaries usedthe 3.75% rate assumed by all but one

of the regional Federal Reserve banks.Puerto Rico assumes 6.4%. Regardlessof discount-rate assumptions, though,Illinois is not projected to exhaust itspension assets for at least seven years,according to Sean McShea, presidentof Ryan Labs Asset Management. Cali-

fornias projected depletion of pensionassets is decades away. As for PuertoRico, relates the commonwealths Gov-ernment Development Bank, the ERSwill exhaust its plan assets by June 30,2014. On the same authority, the un-funded liability of the ERS representsmore than half the commonwealths$64 billion GDP. Whereas membershipof CalPERS and CalSTRS comprisesabout 6.6% of Californias population,Puerto Ricos two plans (the teachersplan included) cover 9% of the PuertoRican population.

Only by the skin of its teeth is the com-monwealth an investment-grade credit.In reducing its rating to Baa3 from Baa1in December, Moodys had a few thingsto say about the quality of the islandspension management. In addition tolow asset levels, the agency noted,ERS commingles the assets of both itsdefined benefit [after the closing of thedefined benefit plan in 1999, new en-trants into the workforce were enrolled in

a defined contribution plan] and definedcontribution members, meaning futureD.C. payouts must be paid by ERS. Nocorresponding liabilities for these even-tual payouts have been disclosed.

No argument, then, that Puerto Ricois a weak credit. But there is a market

for tax shelters, Uncle Sam is gener-ous to a fault, and the newly installedgovernor (in a disputed election), Ale-

jandro Garca Padilla, pledges to enacta springtime pension reform (no details

just yet). So the Puerto Rico 51/4s ofJuly 2023 (callable at par in July 2022)change hands at 101.72 to yield 5.03%,161 basis points higher than a com-parable 10-year Illinois G.O., whichMoodys rates A2.

Taste as much as science deter-mines what is adequate compensationfor risk-taking. We judge that Puerto

Rican debtholders are inadequatelycompensated (though they seem notto mind). If the market is indeed com-placent, why does it not speak up foritself? Economists at the Federal Re-serve Bank of Cleveland took a crack atthe answer in a February essay entitled,Do Public Pension Obligations AffectState Funding Costs? No, they con-clude. Just perhaps, the authors ven-ture, investors might conclude that . . .while the risk-adjusted returns offeredby municipal bonds may be negative,these returns might still exceed the re-turns on other investments in the lowinterest-rate environment. In otherwords, in an environment of depressedyields, municipal bonds are the leastbad investment.

Which would make Puerto RicanG.O.s the most bad of the least bad. Thetax-exempt market should be carefulwhen it finally does wake up. It mightfall out of bed.

Short Koons, long Lincoln(September 6, 2013) What should

I hang on the wall to show that Imrich? New answers to an old ques-tion will be provided in November atthe New York auction-house sales. So-thebys has already promised works byCy Twombly (1928-2011), John Cham-berlain (1927-2011) and Barnett New-man (1905-1970). If the forthcomingNewman fetches anything like whatthe springtime Newman commanded,there could be a run on paint, brushes

Call today for group and bulk rates to GRANTS.

212-809-7994

Why wait around?


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newspaper printing of the Declarationof Independence; he paid $632,500. Itwas, announced the gallery, a recordprice for any historic newspaper, butwhat would you rather have on yourwall, When in the course of humanevents or a deep shade of blue?

The American historical documentsmarket hasnt been the same since theForbes estate unloaded its treasures ina pair of sales in 2002. While the rarestand most precious items do commandfancy pricesBill Gates reportedly paid$23 million in a recent private sale for afirst edition of the Declaration of Inde-pendenceother books, broadsides andletters go for a few dozen pounds worthof a Koons stainless-steel construction.

Consider, for instance, PresidentLincolns 1862 letter to the reluctantGeorge B. McClellan prodding the gen-

eral to battle: Is it your purpose, anexasperated Lincoln demanded, notto go into action? The letter fetched$81,250 at a June sale at Christies.

Or another: The official printing,signed by Thomas Jefferson, of Hamil-tons 1790 Assumption Act, the law au-thorizing the federal government to is-sue United States securities in exchangefor the debts of the states. It sold for$112,500 at Sothebys on June 4.

Or this: Hamiltons 1789 Report onthe Public Credit, also on the block atSothebys on June 4. It could have beenyours for a dollar more than the winningbid of $40,625.

Or, finally, a first edition of Jeffer-sons Manual for U.S. Senate Proce-

dure, annotated and inscribed by Jef-ferson to a friend in Virginia. It sold lastyear at Heritage Auctions for $115,000.

Like any other market, the art mar-ket is cyclical, and public taste is foreverfickle. As Cynthia Saltzman relates in her2008 history, Old Masters, New World:Americas Raid on Europes Great Pic-tures, no less a financier than J.P. Mor-gan was caught up in the fashionablefrenzy for English portraits at the turnof the 20thcentury. He paid 30,000, orthe equivalent of almost $150,000, forThomas Gainsboroughs Georgiana,Duchess of Devonshire, in 1901. Theprice was three times what Sir WilliamAgnew had spent for the same work in1876. It was not the best investment,

Saltzman reports: Prices of English por-traits continued strong through the 1920s(with Gainsboroughs Blue Boy sellingin 1921 for $148,000 to Samuel Hunting-ton) and then collapsed with the Crashand never recovered, she says. A pairof portraits by Joshua Reynolds that soldfor 16,000 in 1926 came up at auction in1941 and the bidding rose to only 400(they were bought in).

Todays contemporary art market isbroader than it used to be, and the poolof would-be acquirers is certainly big-ger and richer than ever before. But thevalues? We say they have never beenmore precarious. You can overpay for aCzanne, but it wont ever go to zero,Hurowitz observes. The same cantbe said for such aesthetic experimentsas Hirsts The Physical Impossibil-ity of Death in the Mind of SomeoneLiving, which happens to be a sharkfloating in a tank of formaldehyde.How many millions of dollars Steven A.Cohen paid for this production in 2004is unknown. What posterity may pay isstill more problematic.

Memo to Morgan Stanley

(September 20, 2013) On the oc-casion of the fifth anniversary of the2008 financial upheaval, the CEO ofMorgan Stanley, James P. Gorman,told the TV cameras, I would saythe probability of it happening againin our lifetime is as close to zero as Ican imagine. We write to dispute thatcontention. Gorman, a youthful 55


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tivities are not being undertaken any-more, Brady Dougan, CEO of CreditSuisse, told the Financial Times lastweek. But also, a fair amount of riskhas been transferred to other parts ofthe system, like shadow banking, in-surance companies, pension funds orretail investors.

Its a fact, according to the Bank forInternational Settlements, that thetoo-big-to-fail banks no longer controlmost of the trading in interest-rate andforeign-exchange derivatives; at theApril tally, for the first time, smallerbanks, hedge funds and non-bank fi-nancial institutions did. Perhaps reg-ulation, not unlike derivatives, redis-tributes rather than eliminates risk,observes colleague Charley Grant.

Then, again, booms and busts arethe way of humanity, or at least of lev-eraged humanity. The lesson fromhistory is clear: asset price bubblesand crashes are here to stay, declared

John Williams, president of the Fed-eral Reserve Bank of San Francisco, inSept. 9 remarks. They appear to bea consequence of human nature. Andthe events of the past decade demon-strate the enormous human costs of as-set price bubbles and crashes.

Next up, we say, will be a livingdemonstration of the enormous humancosts of market intervention to preventasset-price bubbles and crashes. Inparticular, the allied policies of zero-percent interest rates and quantitativeeasing will catalyze troubles all alongthe yield curve, from money-marketinstruments to long-dated bonds.

In the Sept. 11 testimony of AlexJ. Pollock of the American EnterpriseInstitute before a congressional panelon the topic of the Feds looming 100thbirthday is a quotation attributed toformer Sen. Jim Bunning (R., Ky.).How can you regulate systemic riskwhen you arethe systemic risk? thesenator supposedly asked former FedChairman Alan Greenspan.

A dozen leading bankers, orga-nized as the Federal Advisory Coun-cil, seemed to channel Bunning intheir quarterly meeting with the FedsBoard of Governors on May 17. Theadvisers warned about the perils oflow interest rates. They noted thatFederal Reserve purchases of mort-gage-backed securities absorbed morethan 70% of gross mortgage-backed is-suance, causing price distortion andvolatility in the MBS market.

Many are concerned about theFeds significant presence in the mar-ket, the minutes continued. Theyhave underweighted MBS in favor ofcorporate, municipal and emerging-market bonds. There is also a concernabout the possibility of an outbreak ofinflation, although current inflation riskis not considered unmanageable, and ofan unsustainable bubble in equity andfixed-income markets given currentprices. Among the dozen worrywartswas the CEO of Morgan Stanley.

The Federal Advisory Council couldhave met all day and all night beforerunning out of complaints about ZIRP,in your editors opinion. By pressingmoney-market interest rates to zero,

the Fed has eliminated credit differ-entiation at the short end of the yieldcurve. For would-be issuers of commer-cial paper, the ZIRP-paralyzed credit

judgment is binary: 18 basis points, plusor minus four basis points, is the cost ofborrowing, whether you happen to be

Toyota Motor Corp. (Aa3/AA-minus) orJ.P. Morgan Chase (A2/A) or a credit inbetween. Let us say you are Handels-banken of Sweden. Your credit ratingsare identical to Toyotas, but you showsome concerning vulnerabilities, in-cluding an elevated loan-to-deposit ra-tio (267%, meaning that you must fundin the credit markets), and exposure toa bubbly real estate market. Accordingto the Aug. 29 issue of TheEconomist,Swedish house prices are 32% higherthan they ought to be in relation torents (by the same method of appraisal,

American houses are back to fair value).What does a credit analyst do when

credit doesnt matter? The conscien-tious Robert Litterst, portfolio man-ager of the $120.4 billion FidelityCash Reserves, puts in an honest dayswork. He tries to add value by main-taining a long weighted average matu-rity and by investing in floating ratesecurities issued by banks of very highquality, and by investing in securitiesissued by firms that were favorably re-garded by Fidelitys research team,as he advises his shareholders. In thesix months to May 31, he bought veryshort-maturity obligations of banksin the core of the euro zone, includ-ing France, Germany and the Neth-erlands. And the fruit of this diligentlabor? A seven-day yield of 0.01%atwhich rate, before tax, ones moneywould double in 6,932 years.

As much as any other department ofWall Street, the money-fund businesshas felt the full, asphyxiating weightof post-crisis regulation. As the Fedmaintains ZIRP, the Securities andExchange Commission has imposednew rules on the maximum weighted-average maturity of a money fundsassets (no longer than 60 days, downfrom 90 days) and is proposing newregulations as to the fraught questionof net asset values: Should they remainat a constant $1, or should they float?As youd expect, money-fund manage-ment is not much more lucrative thanmoney-fund investment. Except forthe parents subsidies, Fidelity CashReserves would have yielded a minus0.08% on May 31, not the princely

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