People make a lot mistakes in financial and retirement planning. One I see regularly is pre-retirees, of almost every age, say they won’t need or rely on Social Security. Many say they assume they won’t get anything from it. Routinely surveys of pre-retirees indicate that 30% or fewer expect SS to be a “major source of income.” That’s in great contrast to surveys of those already retired. Social Security is reported to be a major source of income for 50% to 60% of retirees, in the same surveys.
SS retirement benefits will be important to many of us. They’ll be even more important if you plan properly to maximize both retirement and survivor benefits. That’s why I wrote my report, Secrets to Boosting Social Security Benefits. I encourage people to take SS retirement benefits seriously. A part of your planning, several years before retirement, should be to determine the best age and form for you to take the benefits. Too many people leave money on the table by not maximizing their SS retirement benefits.
Both of these analyses focus on people in their 60s. As people get older, it seems that they rely on Social Security even more—not only because they stop working, but probably because they exhaust their other assets, or because their other pensions are not indexed for inflation (unlike Social Security). According to Sylvia Allegretto, if you look at retirees in the middle of the income distribution in California, a full 70 percent of their income comes from Social Security, with only 16 percent coming from retirement funds.
Let’s draw another lesson from the big hedging loss at JPMorgan Chase. James Kwak of The Baseline Scenario follows up on the theme of why so many people were surprised that a major loss such as this could have happened at JPM. Almost all the commentators expressed surprise and said this was the last bank they thought would make such an announcement. Kwak, an economist, says that’s a mistake inherent in decisionmaking. As a rule, we discount the role of luck in our success and the success of others. Kwak says performance reverts to the mean eventually, and lucky people eventually have some bad luck. We need to keep that in mind. I’ve seen many people who achieved fortunate results and completely downplayed the role of luck. That led them to make mistakes down the road, because they thought all their past success was due to brains and skill. We also need to keep the role of luck in mind when choosing mutual funds, money managers, and other professional services.
The performance of anyone doing anything will exhibit regression to the mean. If you do well at something, it’s because of some combination of skill and luck. If JPMorgan came through the financial crisis well, it was some combination of skill and luck. Remember, JPMorgan didn’t have as big a portfolio of toxic assets as its competitors because it was late to the party; only in retrospect do we ascribe this good fortune to the supposed skill of Jamie Dimon. JPMorgan was never as good as people (both supporters and critics) made it out to be, so we shouldn’t be so surprised that it just lost $2 billion (and counting).
A number of analysts believe the Fed made a number of mistakes through the failure of Lehman Brothers but acted admirably since. The Fed, they believe, is the only policymaker acting responsibly and kept us from plunging into a deflationary depression. The JPMorgan Chase hedging fiasco announced last Friday should make everyone question their confidence in the Fed’s approach to financial regulation and the condition of the banks, says Simon Johnson of MIT. Since the financial crisis, JPM and its head Jamie Dimon have been held up as role models for the rest of banking and were said to have the best risk management operation in the banking world, if not all the financial world. The other “too big to fail” institutions were encouraged to be more like JPM.
Johnson is especially concerned that JPM could incur such large losses, so suddenly and with such surprise, when the global economy and markets are relatively placid. Johnson believes these banks are too big to manage, too unsafe, and shouldn’t be allowed to be this big and engage in the financial transactions they’re doing.
The lessons from JP Morgan’s losses are simple. Such banks have become too large and complex for management to control what is going on. The breakdown in internal governance is profound. The breakdown in external corporate governance is also complete — in any other industry, when faced with large losses incurred in such a haphazard way and under his direct personal supervision, the CEO would resign. No doubt Jamie Dimon will remain in place.
And the regulators also have no idea about what is going on. Attempts to oversee these banks in a sophisticated and nuanced way are not working.
The SAFE Banking Act, re-introduced by Senator Sherrod Brown on Wednesday, exactly hits the nail on the head. The discussion he instigated at the Senate Banking Committee hearing on Wednesday can only be described as prescient. Thought leaders such as Sheila Bair, Richard Fisher, and Tom Hoenig have been right all along about “too big to fail” banks (see my piece from the NYT.com on Thursday on SAFE and the growing consensus behind it).
For the last few years a number of analysts urged income-seeking investors to buy high-yielding stocks instead of different types of bonds. I haven’t done that, because there’s a risk-return trade off that’s ignored in this advice. The trade off became obvious last Friday when JPMorgan announced a large hedging loss and its stock declined sharply.
You can generate higher income from a high dividend stock than from treasury and investment-trade corporate bonds. And best of all, that dividend is likely to grow over time. Most dividend-paying corporations routinely increase their dividends, and the increases often exceed the inflation rate. That’s the good part.
The bad part is that dividend-paying stocks still have stock market and company risk. That doesn’t matter if you never plan to sell the stocks or aren’t concerned with fluctuations in the value of the stock. In that case, as long as the company is solid enough to pay its dividend and increase it indefinitely, you can be a buy-and-hold investor and buy stocks with high dividend yields. But you need to know before buying that fluctuations in the value of the stock easily could wipe out several years’ worth of additional income in a short time. If the fluctuations will bother you or reduce your standard of living, then high-yielding stocks aren’t a good replacement for bonds. Above all, be sure any stocks you buy have strong businesses and enough cash flow to pay their dividends.
The big loss announced by JPMorgan baffles many market observers. What specific trade did the bank make that could cause such a loss? How was the bank able to take such a position? The best explanations I’ve been able to find are in the Financial Times’ blog FTAlphaville from the paper’s credit expert, Lisa Pollack. The explanation is a big complicated. But it’s accompanied by charts that show what the bank might have had in mind and what happened in the markets that made it go wrong. There are a few themes in this and other discussions on the loss that are worth repeating.
Despite the widespread belief among many after the 2008 crash that credit derivatives should be regulated and traded on a liquid, transparent market, all the regulatory changes did nothing on the issue. Therefore, JPM’s trades were over-the-counter. Also, JPM’s positions became big enough to dictate market actions, at least for a while. This is another thing that shouldn’t have been allowed after the regulator overhaul, but it was. Finally, was JPM really hedging other parts of its business or was it operating as a hedge fund and trying to trade for profit?
A flattener trade is just fine in reasonable doses, i.e. if there’s enough liquidity in the market to support it.
Unfortunately, with curve trades, you have to rebalance them reasonably actively, due to spread movements and the passage of time. “Rebalancing” here means keeping the ratio of protection bought at the short end to protection sold at the long end just right. Get this wrong and your position will start to look even more risky and volatile — as it seems JP Morgan has recently discovered. But before talk about recent events, let’s look at the build up to it.
The $2 billion-plus loss announced by JPMorgan yesterday made a lot of headlines. But the irony in the loss, and in all of the losses in recent years, is ignored. The irony is important, because understanding it would change public policy.
For years before the financial crisis, many analysts and policymakers openly worried about those risky hedge funds. They talked about how much money was in hedge funds, how regulated they were, and their potential to roil the markets and adversely affect the economy. The textbook case was Long-Term Capital Management, which triggered a world-wide financial crisis in 1997.
But the problems since the financial bubble popped weren’t caused by hedge funds. Some hedge funds profited greatly from the crisis. Others went out of business, losing money for their investors. But these were routine events in a diverse economy. The real problems are caused by the big commercial and investment banks. The regulated portion of the financial world did very poorly and caused a lot of problems while the unregulated hedge funds didn’t cause problems for the economy.
And since the debt bubble popped, the regulated institutions have become bigger and taken a greater share of their markets. Their inept regulators also have been given more authority and scope. The world is becoming more risky, not less risky, because of deliberate changes made in response to the crisis.
The supposedly world’s best run major bank stunned the financial world late yesterday by announcing it incurred at least $2 billion of losses, and counting, in a hedging transaction. You might think there aren’t lessons here for individual investors. If so, you’re wrong. Consider these points.
1. JPM was reaching for yield. Its statute as the best-run bank plus generous Federal Reserve policies caused a lot of cash to flow into the firm. It had to invest this cash. As the Fed’s zero interest rate policy limited options, the bank sought higher and riskier yields. Don’t be a yield hog. Don’t think you’ll be able to hedge or exit a risky position in time to avoid the losses.
2. The bank sought to hedge its risky positions with investments that were good hedges on paper and the computer. But the real world intervened. Apparently, the problem was liquidity. This is the overlooked factor that repeatedly traps investors when world events are different than what was expected. At some point, liquidity for an investment disappears. The investment will work well over the long term, if the investor can hold on through the period of illiquidity. Often, they can’t. In JPM’s case, the rules require the positions to be marked to market. When liquidity dries up, the price declines. In other cases, the investor purchased the investments with debt. The price decline triggers a margin call. In other cases, the investor needs cash for other reasons and has to sell something.
I repeat, don’t be a yield hog. And pay attention to the factor that’s not in any of the investment text books: liquidity. If you won’t need to sell an investment for a long time and declines on paper in the mean time don’t bother you, you can earn extra long term returns by taking on liquidity risks. But if you might need the cash or paper losses could hurt you, avoid investments that are illiquid or could have periods of illiquidity. Above all, don’t put too much faith in quantitative investing. Math is important, but there also are subjective and human elements to investing that you can’t ignore. Investing isn’t like the natural sciences or engineering.
Debt and credit are the issues of the decade. We have too much debt in the developed world, and that’s creating a number of problems. To put all this in perspective Bill Gross of PIMCO in his latest monthly essay begins in the early days of civilization when there wasn’t credit. We advance to the days when people would make loans and graduate to the fractional reserve banking system that allows rapid economic growth but also ushers in bank failures and credit cycles. The current state of central bank money printing causes Gross to expect economic growth but at a low rate and gradually rising inflation. Expect low interest rates to be with us for a while. He recommends short duration bonds and stocks with high dividends.
With the dotcoms, the subprimes and now the reflexive delevering of our financial system, it is practically impossible to know what interest rate is applicable. With the QEs and LTROs reducing real yields far below absolute zero, a central banker must wander aimlessly in policy space, wondering how much credit to create, how many Treasuries to buy, and how firm a twist to give the yield curve in order to allow Wimpy the chance for another burger and a side order of fries.
What they should know – and what the following chart, provided by the always observant Jim Bianco, shows – is that when QEI and QEII lapsed in recent years, stock prices declined by 10%–15% until magically they came back to live another day. The same stunting effect can be observed in the bond market when measured by real as opposed to nominal interest rates. They go down with QEs and up in their absence.
This week there have been several pieces on the changing relationship between central bank policies and inflation. The conclusion of the items is that all the money the central banks created the last few years won’t necessarily translate into much higher inflation. That’s because the private sector isn’t turning all that money into credit that’s used to buy things. If you want to read a short but relatively scholarly take on this, click here.
The enormous increase in bank reserves reflects a substitution of monetary base largely for highly liquid government securities in private-sector portfolios. But as government securities serve as collateral in the private-credit market, the effective size of the market liquidity fulcrum is unchanged by such operations. Little wonder then that market liquidity conditions remain tight despite the increase in bank reserves. That is, although quantitative easing which merely swaps bank reserves for US Treasury bills increases the textbook monetary base and “should” lead to an increase in market credit, in our view this accomplishes virtually nothing in terms of easing liquidity pressures. It merely changes the composition of assets within a given sized liquidity fulcrum.
Protests take place in Europe over government austerity, and many incumbents recently were voted out as a reaction against austerity. But how much austerity has occurred? Not much, according to this data. The “cuts” mostly are reductions in the amount of increased government spending that was planned before the crisis hit. All the governments are spending more than they did in 2004.
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