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Capitalization vs Regulation

While the left claims the greedy 1% led us to financial ruin, years of reflection indicate that wrongheaded regulation and policy had much to do with magnifying the depth of the recession. Deregulation was not the problem, wrong regulation was the problem and Dodd Frank has not fixed it.

Regulations are not better if they are longer. Most likely the opposite is true. Simple regulations strongly enforced will serve us better.

Letting banks opt out of regulations by holding higher capital ratios is a great way to bring competition to the bloated salaries on Wall Street while protecting the taxpayer.

From the editors of The Wall Street Journal, Fixing American Finance

Don’t believe the shrieks that this is about “rolling back” financial reform to let the banks run wild. The financial system was heavily regulated before the 2008 panic; regulators failed to do their job (see Citigroup) and missed signals from the housing market, among other mistakes. The Dodd-Frank Act of 2010 doubled down on the same approach: Give even more power to regulators with the promise they’ll be smarter the next time.

History tells us that is a fantasy. Regulators will focus on solving the previous problem, while they miss where the excesses are really building. As Charles Kindleberger taught, the essence of a credit mania is that everyone follows everyone else and thinks it will never end. Regulators are no better than bankers. As late as March 2008, then New York Fed President Tim Geithner was telling his colleagues on the Open Market Committee that banks were in good shape.

Mr. Hensarling has a better idea, which is to let banks build much higher equity-capital cushions to protect against the next mania and panic. Now, as before the crisis, regulators pretend that giant banks have abundant resources to absorb losses by allowing them to report a bogus “Tier 1 risk-based capital ratio.”

With a complicated process subject to intense lobbying, regulators undercount exposures they deem to be safe—the way they designated mortgage-backed securities rock-solid before the last panic. This allows well-connected bankers to convince Washington that their favorite assets should have low “risk weights.” Regulators can politically allocate credit by favoring some types of lending over others.

The Texas Congressman wants a simpler system in which private investors with money at risk decide which assets are safe. Under the Hensarling plan, banks can opt out of today’s complicated rules if they have capital equal to 10% of their assets. Their tally of assets has to include off-balance-sheet exposures. No more hiding toxic paper in conduits or structured-investment vehicles as Mr. Geithner allowed Citi to do before the financial crisis. And no more pretending that a financial instrument has no risk because a regulator says so.

Capital at the largest banks today often runs below 7% of assets. The Wall Street giants would have to raise a lot more equity—and therefore pose less danger to the public—to get regulatory relief. They thus may not like the Hensarling plan, which is fine. Smaller competitors willing to operate without a taxpayer safety net deserve the advantage of lower regulatory costs.

The promise of the Hensarling plan is more safety for taxpayers and a banking system that supports a growing economy. One reason Dodd-Frank has never delivered the economic boost that PresidentObama promised in 2010 is that Washington’s distorting role in the flow of credit was dramatically increased.

In this era of hyper-regulation, David Malpass of Encima Global notes that banks have been making relatively few loans to small and mid-size companies while extending huge credit to large corporations and government. A slow-growth economy that doesn’t efficiently allocate credit isn’t safe for anyone.

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Risk Horizons

pittraders

There are a lot of ways to lose money in the stock market, but far fewer effective ways to make money.

Looking at two managed accounts over the same time period, one was far more profitable than the other.  One had far less turnover than the other, one had no mutual fund positions, and was far less diversified.  The one with fewer stocks, less turnover and no positons in funds or alternative investments showed much better returns- even in most down markets.

The account with much less turnover also had a far larger amount in unrealized gains. This means that the growth was tax deferred. The lower turnover meant less was eaten up in taxes.

If you have enough money for a managed account- at least a half million dollars, then there are few reasons to own mutual funds in that account. You are paying a management fee already. Mutual funds have another layer of expenses  that should be unnecessary.  In the current era of single digit returns these fees greatly hobble your return.  An index fund will beat most managed mutual funds. Funds used by managers are usually specialty funds with singular purposes and high hidden fees, often with an intent to diversify into areas that the manager has no expertise of his own.

The poorer performer was much more focused on risk avoidance. They largely missed the 6 year bull market by under allocating to stocks.  This led to the subject of the best way to avoid excessive risk.

While it is a common theme that index funds will outperform most money managers, it is worth knowing why.  If the managers have much more than 25 to 30 stocks they are likely to mirror an index fund anyway.  Mistimed allocation and increased friction costs as noted will underperform the index.

Wealth in equities is built by carefully selecting companies that compound their capital on a continuous long term basis. Such selection takes focus and discipline.  And even when such companies are discovered you want to buy them when they are undervalued.    I have found that few equity managers do this and if you are not one of them or currently being managed by them then yes you are much wiser to be in an index fund.

The risk profile of such companies is very low DEPENDING ON YOUR TIME HORIZON. Even in a flat market a company that continues to compound capital will show little risk on a ten year time horizon.  In any two year period any of the stocks can sell off substantially or market PEs can drop due to monetary issues or alternative investment options.

Instead of risk profile questionaires your allocation should be dependent on your time horizon.  This may or may not be dependent on your age.  If you are 70 and you have money in a trust that you do not plan to spend then the horizon is not limited to your mortality.

Decide how much of your investment you want to access in two years and keep most of it in cash with the highest safe yield you can find. Today that number is probably less than 50 basis points.  How much do you think you may need in 5 years?  Perhaps – depending on where you start- that portion should be a 50/50 equity cash split. This cash may be in bonds purchased at par or less that mature in that time period.

With a ten year horizon you have a chance to build wealth with an 80/20 mix of equity and bonds. You can even get more aggressive.

Warren Buffett recommends selecting a stock that you would be comfortable holding if the market shuts down for ten years.  He buys companies like an owner, not a trader. He does not panic if the stock market has a selloff and his market value declines.  Usually he is sitting on billions in cash and sees such period as buying opportunities.

If you do not have access to equity managers who do their homework or if you are not so inclined yourself then definitely go with the index funds. Even if you think you have the gift put a portion of your funds in the index and compare it to your results. If you don’t beat the index over a period of at least five years then admit your shortcoming and put the rest in the index.

You can adjust your risk by keeping a portion in cash to match your risk profile.

A tip to gin up your index returns- decide what portion you want in the market. Say 60%. If the market is toppy allocate your investment over three years to avoid buying all at the top. If the market is down maybe allocate over a much shorter period. Don’t try to find a bottom, but avoid the top.  Once you reach your allocated amount, just keep the rest in cash, get the most secure return without capital risk. This is boring but if you want excitement look elsewhere.

Then set a parameter of return, for example 3% per quarter (you can go higher , but no higher than 5% per quarter).  If the return is between 0% and 3% in a quarter, do nothing and watch your money grow. If the market falls and your return is less than 0% then buy half the difference from your cash portion.  If the gain is in excess of your top return parameter then sell half the difference and save it in cash.

Most quarters you will not make a trade, but you will improve your returns buying some when it is down and selling some amount into the up market. Most fo the time the market will fluctuate within your parameters and will just regularly compound.

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Pretending to Balance the Budget

Kevin_Williamson (1)

from Kevin Williamson at National Review, We’re Not That Far from a Balanced Budget

One, Americans earning $100,000 or more pay basically all of the federal income taxes, about 80 percent. That is far in excess of their portion of national income (“national income” being another thing that does not exist but which we are obliged to talk about), and they are only about 15 percent of all taxpayers. Households earning $250,000 or more, a tiny group (2.4 percent of taxpayers) pay about half of all federal income taxes, which is, again, disproportionate to their income relative to the rest of the population.

You do have to stop pretending that you can give the American middle class a big income-tax cut when it hardly pays any income taxes, and stop pretending that you can get spending under control without touching the tiny handful of popular programs (Social Security, Medicare, Medicaid, national security) that constitute the vast majority of federal spending. You don’t have to reinvent the wheel; you just have to cut federal spending from 21.4 percent of GDP to 19.1 percent a couple of years from now, and maybe reform the tax code with an eye toward making revenue meet spending halfway. That isn’t going to make everybody happy, but it isn’t landing on Omaha Beach, either.

Read more at: http://www.nationalreview.com/balanced-budget-is-possible

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Currency Manipulation

US and Chinese currencies

from the editors of the Wall Street Journal, Emerging Market Rip Tide:

The destabilizing effect of QE threatens global growth at a moment when none of the major economies is firing on all cylinders. By encouraging overinvestment in developing countries, it may have created new deflationary pressures. China built massive steel-making capacity that will now drive down the global price and lead to protectionist pressure in the U.S. This dislocation and wasted investment should make policy makers reconsider their faith in the power of monetary policy to stimulate growth, and put the emphasis back on pro-market reforms.

There has often been a tension between the Fed’s roles as regulator of the U.S. domestic economy and custodian of the world’s reserve currency. The QE era shows what happens when it ignores the latter responsibility. Bond-buying allowed the U.S. to pump up asset values, even as it has failed to stimulate the real economy.

U.S. presidential candidates have been quick to jump on China’s recent small devaluation as proof of currency manipulation aimed at stealing American jobs. The irony is that the Federal Reserve has been guilty of the biggest currency whipsaw the world has ever seen. And it has beggared its neighbors in the process.

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Financial Myths

doddfrank

from Forbes Five Years Of Dodd-Frank: ‘Too Big To Fail’ Still Unresolved by Norbert Michel
excerpt:

The notion that these transactions took place in some shadowy, hidden room of finance, where regulators had no clue what was going on, is absolutely false. Not only did they know, they actually blessed the transactions as safe. Repeatedly.

More broadly, even AIG was regulated. And there was no substantial reduction in financial market regulations in any of the previous 10 decades. Many rules and regulations had been changed over the yearsbut virtually none were eliminated.

Perhaps it’s tradition. The practice of blaming speculators for financial turmoil is as old as the hills. Back in the 1600s, the English Parliament blamed a major crisis on the “pernicious Art of Stock-jobbing.” In 1929, members of Congress blamed the stock market crash (and the Great Depression) on speculators. They subsequently used the event to radically alter federal regulations.

One major piece of legislation was the Glass-Steagall Act of 1933. It prevented – for the first time in the U.S. – commercial banks from engaging in many securities-related activities through companies known as securities affiliates.

Sen. Carter Glass argued that these affiliates “made one of the greatest contributions to the unprecedented disaster which has caused this almost incurable depression.”

Even though the evidence suggests combined commercial and investment banking activities did not cause excessive risk taking, much less the Great Depression, this myth persists to this very day.

Senators John McCain (R-Ariz.) and Elizabeth Warren (D-Mass.) have just introduced a new bill to reinstitute Glass-Steagall restrictions on commercial and investment banking affiliates.

Yet there’s not one shred of credible evidence that these affiliations, legally permitted by the 1999 Gramm–Leach–Bliley Act (GLBA), caused the 2008 financial crisis. It’s just as much a myth now as it was in the 1930s.